Market Equilibrium 8

Multiple Choice
1 A* 6 C* 11 D
2 B 7 D 12 A*
3 C* 8 D 13 C*
4 A 9 A 14 D
5 A 10 B 15 D
*Indicates that an enhanced answer has been provided in the section below.

Enhanced Answers
1 A The government is most likely to impose a price floor when the price of a good or service has
experienced a large fall in price, and there is an imbalance in pricing power between firms that
supply a good and firms that demand a good. An example is where supermarket chains use
their market power to force producers to lower their prices. The government may impose a
price floor that is above the market equilibrium, in order to protect the interests of producers.
This might reduce the risk of many dairy farmers being forced to leave the industry because
of a loss of revenue.

3 C
Price $ D2
S2
D1 S1

P2

P1

S2
S1 D2
D1

0 Q1 Quantity

This diagram shows an increase in demand and decrease in supply. The price has clearly
increased, shown by the rise from PE1 to PE2. However, we cannot be sure whether the new
equilibrium quantity has increased or decreased. If the decrease in supply was quite large
compared to the increase in demand, quantity could have decreased. But if the increase in
demand was much larger than the increase in supply, the new equilibrium quantity could have
increased. In situations like this, the best answer is that the change in quantity is indeterminate.

6 C Increased competition in a market encourages firms to reduce prices for consumers, in order
to maintain or increase market share. Firms will also seek to reduce production costs so that
they can maximise their profits (the gap between total revenue and total costs).

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 The Market Economy Eighth Edition Workbook Chapter 8: Market Equilibrium

12 A Market failure occurs when the price mechanism takes into account private benefits of
production, but fails to recognise public costs. Consumers and individual firms are the main
actors in product and factor markets. This means only the costs and benefits that affect them
influence market price and quantity. This can lead to undesirable outcomes that affect broader
society.

13 C Merit goods refer to goods that private companies produce an insufficient quantity of because
not all individuals value the goods enough to want to pay. These include education and health
care.
On the other hand, public goods are those not provided by the market because once provided,
producers cannot exclude those who are unwilling to pay from using and obtaining the
benefits of those public goods. Examples of this include national defence and street lighting.

Short Answers
Question 1

(a) Market equilibrium occurs when the market price reaches a level where the quantity demanded
by consumers is equal to the quantity supplied by producers, and therefore both consumers
and producers are satisfied.

(b) Equilibrium price falls to 0PE2, equilibrium quantity rises to 0QE2.

(c)
Price $ D1 D2
S1

S2

PE1

PE2

S1
D1 D2
S2

0 QE1 QE2 Quantity

(d) Equilibrium price rises and equilibrium quantity rises.

(e) When the market price is below equilibrium, the quantity of a good demanded by consumers
exceeds the quantity supplied by producers. The shortage in supply will result in consumers
bidding up the price, which will lead to higher prices. As the price rises, there will be a
contraction in demand as fewer consumers demand the good. Higher prices will also
encourage producers to increase output, as well as encouraging more producers to enter the
market, resulting in an extension in supply. Equilibrium will be achieved when this process has
led to the quantity demanded equaling the quantity supplied.

(f) Negative externalities refer to unintended negative outcomes of an economic activity that is
not accounted for in the price mechanism. A common example of this is pollution and other
environmental damage that results from a production process (such as the discharge of
contaminated water from mining sites into river systems).

Question 2

(a) A price ceiling is a maximum price imposed by a government. A price ceiling affects market
behaviour if it is set at a level that is below the market equilibrium price. After government
intervention in a market, the price of the good or service in that market cannot increase above
the price ceiling irrespective of market demand or supply.

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 The Market Economy Eighth Edition Workbook Chapter 8: Market Equilibrium

(b) Excess demand = QpQc (this can be calculated as Qc − Qp)

(c) A price ceiling creates excess demand in a market, because once a price ceiling is introduced,
market forces will no longer operate to increase prices when quantity demanded exceeds
quantity supplied. The price that the firm now receives for supplying a good will now be lower
than its market equilibrium. The way in which this affects an individual firm will depend on that
individual firm’s supply curve.

(d) The government may impose a price ceiling when the market price for a good or service is
considered too high, because suppliers are able to exploit their market power to increase their
profits. In addition to lowering the price, this will redistribute money from sellers to producers.
One example which has attracted debate in recent years is price ceilings for the domestic
natural gas and electricity markets, which have seen large price increases.

(e) The correct answer may include any two of the following:
• The government may introduce a sales tax which results in a higher price and a lower
quantity (that is, reduces supply).
• The government may provide a subsidy which increases the supply of a good.
• The government may introduce policy changes that affect income levels and therefore
affect demand.
• The government may introduce regulations that make restrict or encourage the
consumption of a good or service.

Question 3

(a) Merit goods are goods that are not produced in sufficient quantity by the private sector
because private individuals do not place sufficient value on those goods. For example, these
goods may have positive externalities that are not fully experienced by an individual consumer.

(b) Some goods and services known as public goods are not provided by the market because
once provided, producers cannot exclude those who are unwilling to pay from using and
obtaining the benefits of those public goods. Public goods attract free-riders – that is, people
who benefit from goods or services without contributing towards their costs. Consumers will
not pay for goods and services if they can enjoy them without paying. If consumers are not
paying for them, there is no incentive for firms to produce those goods or services. For this
reason, public goods are generally provided by governments. Examples include the
government providing national defence, the police service and public roads.

(c) Pure competition, monopolistic competition, oligopoly and monopoly

(d) Under conditions of pure competition, buyers and sellers in a market all know that the product
is the same and they also know the prices at which the products are being offered for sale
throughout the market. Due to these conditions, firm are price takers, that is, firms must
accept the market price as determined by the forces of supply and demand. At this prices,
firms are able to sell any given quantity that they produce. Because firms are price takers and
not price setters, if a firm was to try to sell their product at a higher price, that is a price level
above that determined by demand and supply, it would find that no consumers would buy their
product.

(e) A monopoly is a market structure in which there is one firm selling a product with no close
substitutes. A monopoly faces no direct competition and there are significant barriers to entry,
allowing the firm to be a price setter. As a price setter, a monopoly can change higher prices
in order to maximise profit, which will also see lower quantities sold under more competitive
market structures. Contrastingly, monopolistic competition is characterised by a large number
of relatively small firms in which there is relatively easy entry into the market. Products sold in
monopolistic competition are similar, but not identical. Because of this, firms must engage in
product differentiation in order to gain an advantage of their competitors. Through product
differentiation, firms are given some degree of price-setting power.

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 The Market Economy Eighth Edition Workbook Chapter 8: Market Equilibrium

Skills Revision Activity 1 – Price Intervention

Example 1: Example 2:
Price $100 Price $2000
Quantity 300 Quantity 40
Revenue $30,000 Revenue $80,000
Price $75 Price $3500
Quantity demanded 400 Quantity demanded 20
Quantity supplied 200 Quantity supplied 60
Shortage 200 Surplus 400
Revenue $15,000 Revenue $70,000

Skills Revision Activity 2

Example Market Structure

The supermarket industry, dominated by a few large firms Oligopoly

The market for the personal delivery of standard letters Monopoly

The market for electronic household items, where many competitors

Monopolistic competition
compete to sell their products

The fish market in Sydney, where many producers sell seafood and
Pure competition
consumers perceive that all seafood is of the same quality

The budget motel industry, where firms attempt to make their service
Monopolistic competition
appear different through offering various packages

The Australian domestic airline industry Oligopoly

The market for water supply in Armidale Monopoly

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