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1. Chapter 2 MARKET TRANSACTIONS: DEMAND AND SUPPLY ANALYSIS

1. A market is a mechanism through which buyers and sellers communicate to trade goods and services. Through the price system, markets link potential buyers to potential sellers. 2. Demand is a schedule that shows various amounts of a good or service buyers are willing and able to purchase at each possible price during a particular period. A demand curve is a graphical portrayal of the data comprised by a demand schedule. A movement along a demand curve, resulting from a change in price, is called a change in quantity demanded. 3. According to the law of demand, price and quantity demanded are inversely related, assuming the other factors affecting the quantity demanded remain the same. Economists explain the law of demand in terms of the substitution effect, the income effect, and the principle of diminishing marginal utility. 4. A demand shifter is a variable that causes a shift in a demand curve. Among the most important demand shifters are consumer tastes, number of buyers, consumer income, prices of related goods, and expected future prices. When a demand shifter causes an increase in demand, the demand curve shifts rightward; a decrease in demand is shown by a leftward shift in the demand curve. 5. Supply is a schedule or curve showing the amounts of a good or service that firms or households are willing and able to sell at various prices during a specified period. The quantity supplied refers to a single point on a supply curve. Changes in quantity supplied are caused by changes in the price of the product. 6. According to the law of supply, sellers are willing and able to make available more of their product at a higher price than a lower price, other determinants of supply being constant. The tendency for the cost of additional output to increase explains the law of supply. 7. A supply shifter is a variable that causes a shift in a supply curve. Among the major supply shifters are resource prices, technology, prices of other goods, expected future prices, taxes and subsidies, and the number of suppliers. When a supply shifter results in an increase in supply, the supply curve shifts rightward; a decrease in supply is shown as a leftward shift in the supply curve. 8. In a competitive market, equilibrium occurs when the price of a product adjusts so that the quantity that consumers will purchase at that price is identical to the quantity that suppliers will sell. The price that sets buyers’ intentions equal to sellers’ intentions is called the equilibrium price. A surplus of a product results in price falling to its equilibrium level; a shortage of a product results in price rising to its equilibrium level.

9. Concerning shifts in the demand curve or supply curve, we can make the following predictions, other factors remaining constant: 10. When demand increases, both the equilibrium price and the equilibrium quantity increase. 11. When demand decreases, both the equilibrium price and the equilibrium quantity decrease. 1 2 Chapter 2: Market Transactions: Demand and Supply Analysis

12. When supply increases, equilibrium price falls and equilibrium quantity rises. 13. When supply decreases, equilibrium price rises and equilibrium quantity falls.

Chapter Objectives After reading this chapter, you should be able to: 1. Identify the major factors affecting demand. 2. Identify the major factors affecting supply. 3. Explain how prices and quantities are determined in competitive markets. 4. Explain why prices sometimes decrease, and sometimes increase. 5. Predict how prices and quantities will respond to changes in demand or supply.

Key Concept Quiz 1. substitution effect _____ a. price and quantity demanded are negatively related 2. income effect _____ b. when quantity supplied exceeds quantity demanded 3. diminishing marginal utility _____ c. consumers substitute the cheaper good 4. change in demand _____ d. price and quantity supplied are positively related 5. change in quantity supplied _____ e. consumers experience a decline in the purchasing 6. normal good power of their income when price increases 7. complementary good _____ f. is caused by a change in price 8. market equilibrium _____ g. when quantity supplied equals quantity demanded 9. surplus _____ h. each additional unit provides less and less utility 10. shortage _____ i. goods that go together 11. law of demand _____ j. when quantity demanded exceeds quantity 12. law of supply supplied _____ k. something you buy more of when income increases _____ l. a change in the demand schedule Chapter 2: Market Transactions: Demand and Supply Analysis 3

Multiple Choice Questions

2. The law of demand states that a. price and quantity demanded have a positive relationship b. price and quantity demanded have no relationship c. price and quantity demanded have a negative relationship d. when price increases, quantity demanded also increases

3. If the price of computers decreases, a. the demand for compatible software increases a. the demand for compatible software decreases c. the demand for computers increases d. there is no effect in the market for computers

3. If used cars are inferior goods and incomes decline a. sales of new cars remain unchanged b. sales of used cars decline c. sales of new cars increase d. sales of used cars increase

1. If Burger King lowers the price of its hamburgers a. demand for McDonald hamburgers increases b. demand for Burger King hamburgers increases c. demand for McDonald hamburgers decreases d. demand for Burger King hamburgers decreases

4. In voting for subsidies to dairy farmers, a legislator is a. helping to decrease the supply of dairy products b. helping to increase the supply of dairy products c. wasting taxpayer dollars d. helping allocate resources efficiently

5. If the supply of good X increases and the demand for good X remains the same a. the equilibrium price rises b. the equilibrium quantity decreases c. the equilibrium price remains unchanged d. the supply curve shifts to the right

6. When the demand for computers increases and the salaries in the computer industry also increase a. the equilibrium price and quantity of computers decrease b. the equilibrium price of computers increases c. the equilibrium quantity of computers increases d. the equilibrium quantity of computers decreases 4 Chapter 2: Market Transactions: Demand and Supply Analysis

1. Suppose that the equilibrium price of CD players increases due to an increase in consumer incomes. If the supply of CD players remains stable a. equilibrium quantity must increase b. equilibrium quantity will remain unchanged c. CD players are inferior goods d. there is a decrease in the quantity demanded of CD players

7. Due to improvement in productivity, Boeing is able to reduce its production time. At the same time demand for Boeing airplanes falls due to an economic downturn in Asia. This will lead to a. a decrease in the equilibrium quantity of Boeing airplanes b. an increase in the equilibrium quantity of Boeing airplanes c. a decrease in the equilibrium price of Boeing airplanes d. an increase in the equilibrium price of Boeing airplanes

14. If California orange growers experience labor shortages due to stricter restrictions on immigrant pickers, while the demand for oranges remains stable a. the equilibrium price of oranges will increase b. the equilibrium quantity of oranges will increase c. the supply of oranges will remain unchanged d. the equilibrium price of oranges will remain unchanged

11. When new Internet companies enter existing markets, they help to a. increase the demand b. increase the supply c. decrease the equilibrium quantities d. increase the equilibrium prices

12. The supply curve illustrates how a. quantity supplied increases as price decreases b. quantity supplied increases as price increases c. quantity supplied increases as technology improves d. quantity supplied increases as resource prices decrease

13. The demand curve for Coca Cola would most likely shift to the left in response to a (an) a. decrease in the price of corn nuts which are consumed with Coca Cola b. increase in the money income of households c. decrease in the price of Coca Cola d. decrease in the price of Pepsi Cola Chapter 2: Market Transactions: Demand and Supply Analysis 5

14. In a free market, the pricing system would ration natural gas to those buyers who a. owned the most homes that were heated with furnaces using natural gas b. had the greatest amount of income c. did the best job of conserving natural gas d. were willing and able to pay the highest price

15. When Mary purchases dresses, her gains in satisfaction become smaller as successive dresses are purchased. Therefore, Mary will purchase additional dresses only if their price declines. Which of the following applies to this situation a. income effect b. substitution effect c. law of diminishing marginal utility d. law of decreasing opportunity costs

16. A producer’s supply curve is upward sloping when a. production costs of additional units of output increase b. the producer envisions an inverse relationship between price and quantity supplied c. the producer realizes decreased profits as output expands d. mass production efficiencies take place as output expands

17. The income effect, substitution effect, and law of diminishing marginal utility explain a. why the demand curve for a product is downsloping b. why the demand curve for a product is upsloping c. why the supply curve of a product is downsloping d. why the supply curve of a product is upsloping

18. A movement along the demand curve for HP computers will occur in response to a. a change in buyer income b. a change in the price of HP computers c. a change in the price of Gateway computers d. buyer expectations of changing future prices of HP computers

19. The production of additional barrels of oil tends to entail a. increasing costs b. constant costs c. decreasing costs d. zero costs

20. If the demand for coal increases more than the supply of coal, we would expect a. a decrease in market quantity and a decrease in price b. a decrease in market quantity and an increase in price c. an increase in market quantity and a decrease in price d. an increase in market quantity and an increase in price 6 Chapter 2: Market Transactions: Demand and Supply Analysis

21. Rush-hour congestion on the highways of large cities could be reduced by all of the following except a. building additional highways b. encouraging people to travel on buses or subways c. assessing drivers tolls during peak driving periods of the day d. decreasing the cost of a driver’s license

True-False Questions 1. T F Change in quantity demanded and change in demand are identical concepts. 2. T F The principle of diminishing marginal utility implies that total satisfaction declines when more of a good is consumed. 3. T F When a good is inferior and income decreases, we buy more of the good. 4. T F Future prices have no effect on quantity demanded. 5. T F When the price changes, the demand changes as well. 6. T F If the price of a substitute in production changes, the supply curve shifts. 7. T F A decline in resource prices and a tax cut have similar effects on supply. 8. T F A shortage causes prices to decline. 9. T F If demand decreases while supply remains stable, a temporary surplus ensues. 10. T F When both supply and demand change simultaneously, it is not possible to determine the direction of change for both equilibrium price and quantity. 11. T F When there is excess supply in the market, prices will tend to move down. 12. T F If people take more vacations when incomes increase, vacations are normal goods. 13. T F Other things remaining constant, if the demand for Coca-Cola decreases due to a health scare in Europe, the equilibrium price of Coca-Cola also decreases. 14. T F If the productivity of the U.S. worker improves in the software industry, the equilibrium price of software will increase. 15. T F Prices react to shortages and surplus and move the market back to equilibrium. 16. T F A tax on cigarettes reduces the demand for cigarettes. 17. T F A subsidy placed on the production of steel lowers the price of steel. 18. T F An increase in the demand for software engineers increases the supply of software engineers. Chapter 2: Market Transactions: Demand and Supply Analysis 7

19. T F Other things remaining the same, a decrease in the annual fees charged by credit card companies would increase the demand for credit cards. 20. T F A decrease in the price of steel would increase the supply of automobiles. 21. T F Compared to motorists in many European countries, American motorists tend to pay higher taxes for each gallon of gas. 22. T F Economic theory predicts that at least part of the current nursing shortage would be eliminated if wages were increased for nurses.

23. T F If the demand curve for wheat decreases more than the supply curve of wheat, the price of wheat will rise while equilibrium quantity will decrease.

24. T F The production of oil tends to be consistent with the law of supply.

25. T F An increase in the price of beans will cause the supply curve of beans to shift rightward.

26. T F The income effect and substitution effect explain why the supply curve of wheat is upsloping.

27. T F A market is a mechanism through which buyers and sellers communicate to trade goods and services.

28. T F An increase in demand suggests that a buyer is willing and able to purchase a larger quantity at a particular price.

Application Questions ______

Quantity Quantity Price Demanded Supplied ______$100 1000 200 $200 800 400 $300 600 600 $400 400 800 $500 200 1000 ______

1. The table above describes the market for VCRs. a. Plot the demand and supply schedules. What is the equilibrium price? The equilibrium quantity? 8 Chapter 2: Market Transactions: Demand and Supply Analysis

b. At the price of $200, what is the quantity demanded? What is the quantity supplied? Will price tend to increase?

c. At the price of $400, what is the quantity demanded? What is the quantity supplied? Will price tend to decrease?

2. A new product, DVD is introduced into this market and consumers prefer it to VCRs. The new demand schedule for VCRs is represented in the following table. ______Quantity Demanded Price of VCRs ______

$100 800 $200 600 $300 400 $400 200 $500 0 ______

a. Plot the new demand schedule. What is the direction of the shift in the demand curve?

b. What is the new equilibrium price and quantity?

c. Is there an excess demand or excess supply at the old equilibrium price?

3. Now the VCR producers organize and are able to secure a subsidy for production. What will happen to the supply schedule? Will this new equilibrium quantity and price be more or less than the answer to question 2a? Chapter 2: Market Transactions: Demand and Supply Analysis 9

Key Concept Answers 1. c 7. i 2. e 8. g 3. h 9. b 4. l 10. j 5. f 11. a 6. k 12. d

Multiple Choice Answers 1. c 5. b 9. c 13. d 17. a 21. d 2. d 6. d 10. a 14. d 18. b 3. c 7. b 11. b 15. c 19. a 4. c 8. a 12. b 16. a 20. d

True-False Answers 1. F 6. T 11. T 16. F 21. F 26. T 2. F 7. T 12. T 17. T 22. T 27. T 3. T 8. F 13. T 18. F 23. F 28. T 4. T 9. T 14. F 19. F 24. T 5. F 10. T 15. T 20. T 25. F

Application Question Answers

1. a. Equilibrium price = $300 10 Chapter 2: Market Transactions: Demand and Supply Analysis

Equilibrium quantity = 600 VCRs

b. Quantity demand = 800 VCRs Quantity supplied = 400 VCRs Yes, there is a shortage and price will increase.

c. Quantity demanded = 400 VCRs Quantity supplied = 800 VCRs Yes, there is a surplus and price will decline.

2. a. The demand curve shifts to the left

b. Equilibrium price = $250 Equilibrium quantity = 500 VCRs

c. There is an excess supply at the old equilibrium price.

3. The supply curve will shift to the right. The equilibrium price will be lower and the quantity will be higher.

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