Chapter 2: Supply and Demand—the Basics

Study Questions

1. Use supply and demand curves to analyze the effects on the equilibrium P and Q of rice for each of following
cases.
a. A sharp increase in the demand for dairy products. Hint: rice and alfalfa (a crop that is used mainly for feed
for dairy cattle) are both heavily irrigated crops.
b. The development of new fertilizers that increase rice yields.
c. New information on the health hazards of meat consumption.
d. A fall in income. Assume that rice is a normal good.
e. An increase in wages that farm workers could earn in the urban sector (assume that overall income levels are
unchanged).
f. Government programs which subsidize the price of water.

2. Use the following equations to answer the question below. Qd = 1500 - 0.5P Qs = -1000 + 2P
a. Find the equilibrium price and quantity.
b. Suppose a perfectly-enforced price ceiling is imposed at a price of $950 per unit. Furthermore, assume that
the good is allocated on a first-come, first-served basis. What happens to the cost per unit of acquiring this good
(the total cost = monetary cost + non-monetary cost)? If everyone values their time at rate of $25 per hour, then
what is the equilibrium number of hours spent waiting in line?

3. Kalamazoo County raises revenue through a tax on workers: everybody who has a job in Kalamazoo County
must pay a tax of $25 per year. It has been proposed that this tax be abolished and replaced by a tax on
businesses equal to $25 per employee per year. Use a supply and demand graph to show that the economic
incidence is the same under either tax.

4. Suppose that the only way to reach a certain restaurant is by train, and the train fare is $3. One day a law is
passed requiring the restaurant owner to provide free transportation to his restaurant, which he does by making
an arrangement with the railroad whereby his customers ride free and he pays the $3 fare per customer directly
to the railroad.
a. What does this do to the supply curve for restaurant meals?
b. What does this do to the demand curve for restaurant meals?
c. Compare the following: the price customers paid for meals (including transportation costs) before the law vs.
the price customers pay for meals after the law is passed. Make a similar comparison for the seller.
d. Does anybody benefit by this law? Under what circumstances would the restaurant voluntarily provide free
transportation? Use a supply and demand graph to justify your answer.

5. Suppose the government requires widget sellers to provide “free” guarantees for the products they sell.
Assume that Qs = -200 + 3P*s and Qd = 400 –3P*d. As can be seen from these equations, supply depends
on the effective price P*s where P*s = P – per-unit cost of providing the required guarantee. P is the money
price of the good. Demand depends on the effective price to consumers of P*d where P*d = P – per-unit
value placed on the required guarantee. It is expected to cost sellers $20/unit to comply with the law and
consumers value the guarantee at a rate of $10/unit.
a. What is the equilibrium price and quantity BEFORE the government requirement?
b. Find the new money price of this good. Are buyers better off? Are sellers better off? Explain.
 Answers
1. a. The increase in demand for dairy products would presumably drive up their price, thus increasing
production of these products. The increased production of dairy products would entail an increased demand for
alfalfa, making it more profitable for some farmers to switch from rice production to alfalfa production. This
reduces the supply of rice. In addition, the increased demand for alfalfa would tend to increase the demand for
irrigation water (an input for alfalfa and rice), driving up the price of irrigation water. This would also reduce
the supply of rice.
b. This would increase the supply of rice.
c. If rice consumption can be considered a substitute (at least to some degree) for meat consumption, then it can
be expected that the demand for rice would increase.
d. Demand falls.
e. This would tend to attract some farm workers to the urban areas, thus reducing the supply of farmer workers.
This, in turn, would drive up the wage rate of farmer workers. Since farm workers are inputs into the
production of rice, this wage increase would reduce the supply of rice.
f. By lowering the price of input--namely, water--this subsidy would increase the supply of rice.

2a. First, set quantity supplied equal to quantity demanded and solve for P: 1500-0.5P = -1000 +2P, and
solving for P gives us
P = $1,000. Solving for Q, we get Q = 1000.
b. First, determine the quantity supplied at that price: Qs = -1000 + 2($950) = 900.
Second, determine the TOTAL price (monetary + non-monetary costs) paid by consumers when the quantity is
900. That is, at what total price will quantity demanded equal 900? 900 = 1500 - 0.5P & solve for P. P =
$1,200.
Third, determine what part of the $1,200 represents the non-monetary costs (i.e., time costs). $1,200 = $950+
time costs.
Time costs = $250. Finally, find the number of hours waiting in line. ($250/$25 per hour) = 10 hours.

3. This question is simply the case of comparing an excise tax with a sales tax. As in class, you should get
the same answer for Pd, Ps and Q in either case.

4. a. This law is the equivalent of an excise tax since it increases the seller’s cost by $3/unit. Therefore , it
will shift the supply curve up VERTICALLY by $3. See Figure 3.
b. This law is the equivalent of a $3 per-unit subsidy to buyers [buyers no longer (directly) pay the train
fare].
It will therefore shift the demand curve up vertically by $3. See Figure 3.
c. Looking at Figure 3, we can see that the new equilibrium price of a meal is $3 higher--$13 vs. $10.
Before the law: consumers paid $10 for meal + $3 transportation cost = $13. After the law: Buyers pay
$13 for meal + $0 for transportation = $13. So we conclude that consumers are not affected by this law.
For sellers, they received $10 per meal before the law without having to pay for the transportation costs. So
they received a net price of $10. After the law, they receive $13 for the meal minus the $3 transportation
cost for a price net of transportation of $10. So we conclude that sellers are not affected by this law either.
d. Neither buyers or sellers benefit under this law. Sellers would provide “free” transportation if the cost to
them of doing so was less than the cost paid by consumers. To demonstrate this, I assumed (in Figure 4)
that the transportation cost to sellers = $2/unit and the transportation cost to buyers = $3/unit. As can be
seen in Figure 4, the new price of a meal will be between $12 and $13. Assume that it is $12.50. Buyers
now
pay $12.50 (meal) + $0 (transporation costs) = $12.5. Before this new policy they paid $10+$3= $13. So
they are better off. Sellers now receive a net price of $12.50 - $2 = $10.50, which is, of course, greater than
$10. So they are also better off.
5.a. Before the government requirement P*s = P and P*d = P. So we simply set quantity supplied equal to
quantity demanded and solve for P. Thus, –200 + 3P = 400 – 3P , or 6P = 600. So P = $100.
Quantity equals 400-3(100) = 100 units.
b. Step 1. P*s = P – 20 and P*d = P - 10.
Step 2. Rewrite supply and demand functions as follows:
Qs = -200 + 3 (P-20) = -260 + 3P (new supply curve) and Qd = 400 –3(P-10)= 430-3P(new demand
curve).
Step 3. Set quantity supplied equal to quantity demanded and solve for P.
-260+3P = 430-3P or 6P = 690 , which gives us P= $115.
No, buyers are not better off. P*d = 115-10= $105 which is higher than the initial price of $100.
No, sellers are not better off. P*s = 115-20= $95 which is less than the initial price of $100.

Figure 1(question 3b) Figure 3

P P
220 S1 S2

A S2 S1
Ps=$216.7 P2=$13
B C
P1= $200 G
D E F
Pd=$196.7 P1=$10
H
D2

D1
D1
Q1 Q
100 116.7 Q
Figure 2 (for question 3c) P Figure 4
gap=$3
P
220 S1 S2
$13
A P2 S1
Ps=$216.7 $12
B C
P1= $200 G
D $10
E F
Pd=$196.7 gap = $2
D2

D2
D1 D1

100 116.7 Q Q 1 Q2
Q

Must be that $12<P2<$13.