ECON 262 - Practice Problems

Out of Class Practice Problems - Supply and Demand Model

1. Draw a supply and demand situation where there is a shortage (and define what a shortage is). Clearly show where the shortage is on the graph.

2. Draw a supply and demand situation where there is a surplus (and define what a surplus is). Clearly show where the surplus is on the graph.

3. Assume the market clearing price is $20 and the market clearing quantity is 500 for a steak dinner. But you don't have this information (you being a supplier of steak dinners) and have just opened your steak house. You decide to price your steak dinners at $15.00. You notice that when you do this you could have sold 650 steak dinners but are willing and able to sell only 400. Draw this situation on a graph. Put all numbers given on your graph. What will happen in this market? Will there be a shortage or a surplus? Show this on your graph. Then explain what will happen in this market (assume there are no price controls).

Graphically and in words (arrows are OK) show what will happen to the market clearing price (P*), market clearing quantity (Q*) and resource allocation (RA) in each case. Be sure to label your axes correctly and make it clear which way you are shifting your graphs. Assume ceteris paribus.

1. Assume books and magazines are substitutes. Paper is used to make books. What will happen in the book market if the price of magazines increases and at the same time the price of paper goes down?

2. What will happen in the lemonade market if a new technology is introduced in the production of lemonade and at the same time the price of fruit punch decreases (assume fruit punch and lemonade are substitutes)?

3. What will happen in the market for cats if the income of the population who buy cats increases and at the same time the price of dogs decreases? Assume dogs are a substitute for cats and cats are a normal good.

4. What will happen in the market for golf clubs if the price of golf balls increases and at the same time the price of steel decreases? Assume golf balls are a complement to golf clubs and steel is used to make golf clubs.

5. What will happen in the market for stereos if the price of boom boxes goes up and at the same time the price of radios goes up? Assume both boom boxes and radios are substitutes for stereos.

6. Assume Spam is an inferior good. What will happen in the market for Spam if the income of the people who buy Spam goes down?

7. What will happen in the market for beef if the price of chicken increases and at the same time the price of cow hides decreases? Assume beef and chicken are substitutes to consumers and beef and cow hides are complements in production.

8. What will happen in the market for jean shirts when the price of jeans (pants) increases? Assume jean shirts and jeans (pants) are substitutes in production.

9. What will happen in the market for cattle if the government subsidizes beef production?

10. What will happen in the market for healthcare if the government (taxpayers) subsidizes the demand for healthcare (by subsidizing healthcare insurance) and at the same time the government caps the profitability of insurance companies?

Out of Class Practice Problems - Supply and Demand Model

ANSWERS - These answers are only explanations of how you should have drawn your graphs.

You need to draw the graphs to get full credit.

1. Draw a supply and demand situation where there is a shortage (and define what a shortage is). Clearly show where the shortage is on the graph.

ANSWER: The price would be below the market clearing price. Quantity demanded is greater than quantity supplied = shortage.

2. Draw a supply and demand situation where there is a surplus (and define what a surplus is). Clearly show where the surplus is on the graph.

ANSWER: The price would be above the market clearing price. Quantity supplied is greater than quantity demanded = surplus.

ANSWER: The price of $15 is below the market clearing price. Quantity demanded is greater than quantity supplied = shortage. The shortage is a signal. Out of stock inventory costs are very high. Therefore, suppliers will increase their prices. This would lead to an increase in quantity supplied and a decrease in quantity demanded (movements along the curves) until Satisfactory Inventory Level is met.

Graphically and in words show what will happen to the market clearing price (P*), market clearing quantity (Q*) and resource allocation in each case. Be sure to label your axes correctly and make it clear which way you are shifting your graphs. Assume ceteris paribus.

1. Assume books and magazines are substitutes. Paper is used to make books. What will happen in the book market if the price of magazines increases and at the same time the price of paper goes down?

ANSWER: The demand for books will increase, the supply of books will increase. Q* will increase, P* is unknown. Resources will move in.

ANSWER: The supply of lemonade will increase, the demand for lemonade will decrease. P* will decrease, Q* in unknown. Resource allocation is unknown.

ANSWER: The demand for cats will increase, the demand for cats decrease. Both P* and Q* are unknown. Resource allocation is unknown.

ANSWER: The demand for golf clubs will decrease, the supply of golf clubs will increase. P* will decrease, Q* in unknown. Resource allocation is unknown.

5. What will happen in the market for stereos if the price of boom boxes goes up and at the same time the price of radios goes up? Assume both boom boxes and radios are substitutes for stereos.

ANSWER: The demand for stereos will increase TWICE. Both P* and Q* will increase. Resources will move in.

6. Assume Spam is an inferior good. What will happen in the market for Spam if the income of the people who buy Spam goes down?

ANSWER: The demand for Spam will go up. Both P* and Q* will increase. Resources will move in.

ANSWER: The demand for beef will increase, the supply of beef will go down. P* will increase, Q* is unknown. Resource allocation is unknown.

8. What will happen in the market for jean shirts when the price of jeans (pants) increases? Assume jean shirts and jeans (pants) are substitutes in production.

ANSWER: The supply of jean shirts will go down. P* will increase, Q* will decrease. Resources will move out.

9. What will happen in the market for cattle if the government subsidizes beef production?

ANSWER: The supply of cattle will increase. P* will decrease, Q* will increase. Resources will move in.

ANSWER: The demand for healthcare will increase, the supply of healthcare will decrease. P* will increase, Q* is unknown. Resource allocation is unknown.