Chapter 2: Answers to questions for review
Chapter 2: Answers to questions
for review
2.2 [10 marks] Growing populations and rising
incomes in developing countries have affected
the price of meat.
(a) Assuming meat is a normal good, use a
demand and supply diagram to explain the
impacts on the price of meat.
(b) Producers of meat responded to the change
in price by increasing the quantity of meat
supplied; use your diagram from part (a)
to show the increase in quantity of meat
supplied.
(a) Assuming meat is a normal good, use a
demand and supply diagram to explain the
impacts on the price of meat.
l Draw a correctly labelled demand and
supply diagram, as in Figure 2.14(a),
which represents the market for meat.
l Explain that the number of buyers in a
market (the size of the population) and
income are two determinants of demand,
or factors that can cause changes in
demand, shown by shifts in the demand
curve.
l Since meat is a normal good, an increase
in income leads to an increase in the
demand for meat.
l Therefore both the increase in the
population and increasing incomes lead
to an increase in the demand for meat.
l Show the increase in demand by drawing
a rightward shift in the demand curve,
from D1 to D2.
l The new equilibrium determines a higher
equilibrium price, P2.
(b) Producers of meat have responded to the
increased price by increasing the quantity
of meat supplied; use your diagram from
part (a) to show the increase in quantity of
meat supplied.
l In the new equilibrium shown in the
diagram, there is also a larger quantity of
meat supplied, Q2.
© Cambridge University Press, 2009
l The new equilibrium is determined by
the point of intersection of the supply
curve, S, with the new equilibrium
demand curve, D2.
l The increase in meat supplied resulted
from a movement along the supply
curve, S.
2.3 [10 marks] ‘Quantity demanded increases as
price falls. Yet a fall in demand, ceteris paribus,
leads to a fall in price.’ Do these two statements
contradict each other? Explain.
l There is no contradiction, because the first
statement refers to a movement along the
demand curve and the second refers to a shift
of the demand curve.
l Draw a demand curve, as in Figure 2.2(a)
(make sure your axes are correctly labelled).
l State the law of demand, that there is an
inverse relationship between price and
quantity demanded, and use your diagram to
show that as price falls, quantity demanded
increases.
l Draw a demand and supply diagram, as in
Figure 2.14(b), and explain that a fall in
demand is shown by a leftward shift in the
demand curve from D1 to D2.
l The shift in the demand curve determines
a new point of equilibrium with a new
equilibrium price and quantity.
l Ceteris paribus (meaning that everything else
is unchanging), the fall in demand leads to a
fall in price from P1 to P3.
2.5 [10 marks] In the standard demand and supply
analysis, an increase in demand, ceteris paribus,
leads to a larger equilibrium quantity supplied,
and yet supply does not change. How is this
possible?
l The question is making a distinction between
supply (which refers to the supply curve) and
quantity supplied (which refers to movements
along the supply curve).
Economics for the IB Diploma   1

l Draw a demand and supply diagram, as
in Figure 2.14(a) (make sure your axes are
correctly labelled).
l Show the increase in demand by a rightward
shift in the demand curve, from D1 to D2.
l Explain that the statement ‘supply does not
change’ means that the supply curve does not
shift.
l The increase in demand leads to a new
equilibrium, where there is a larger quantity
supplied; quantity supplied has increased
from Q1 to Q2.
l The larger equilibrium quantity has resulted
from a movement along the supply curve,
from the point of initial equilibrium to the
point of final equilibrium.
2.6 [10 marks] Using supply and demand diagrams,
show how prices function as signals and
incentives in a market economy.
l Define a market economy (discussed in
Chapter 1).
l Explain that a market economy uses prices
that are freely determined in markets by the
forces of supply and demand, as a method
of rationing (or parcelling out) resources and
goods and services among all possible users.
l Prices are able to ration resources and goods
and services because they work as signals
and as incentives for all economic decision-
makers, who are consumers and firms.
l As signals, prices convey information to
decision-makers, and as incentives, they
provide the motivation to make economic
decisions.
l Draw a demand and supply diagram (as in
Figure 2.17) and explain that demand and
supply determine equilibrium price and
quantity for all resources and for all goods
and services.
l Assume a change in demand (which may
occur for any reason; you may show an
increase or a decrease); if there is an increase
in demand as in Figure 2.17(a), there results
a shortage of the good at the initial price P1,
and the price begins to rise.
l The increase in price signals (conveys
information) to producers that there is a
shortage, and it provides an incentive for
them to increase quantity supplied.
© Cambridge University Press, 2009
Chapter 2: Answers to questions for review
l Producers therefore begin to increase their
quantity of the good supplied, and there is
a movement along the supply curve from
A to C.
l The increase in price also signals to
consumers that the good is more expensive,
and since they now have to pay a higher
price, it is an incentive for them to buy less of
the good; this is why Q3 is smaller than Q2 in
Figure 2.17(a).
l (Note that you can explain the same ideas
by using an example showing a change in
supply, as in Figure 2.17(b); one or the other
is sufficient as an answer to this question.)
2.7 [15 marks] (Based on Chapters 1 and 2.)
Wassily Leontief, a Russian-born economist
who emigrated to the United States in 1925
because of his opposition to Soviet communism,
and who in 1973 won the Nobel Prize in
Economics, was a keen supporter of strong
government intervention in the economy and
state economic planning (central planning).
Using a mathematical technique he developed
known as input–output analysis, he proved that
a centrally planned economy can achieve the
identical allocation of resources as a free market
economy. Yet, in practice, one of the greatest
shortcomings of economies that made heavy
use of central planning (such as communist
systems) has been the failure to achieve efficient
resource allocation.
(a) Explain resource allocation and relate it to
the ‘what to produce’ and ‘how to produce’
economic questions.
(b) What are the most likely causes of
inefficient resource allocation in centrally
planned economies?
(c) What characteristics of market systems
do you think are mainly responsible
for the advantages that markets have
over command mechanisms and central
planning? (Hint: consider the problem of
information required by decision-makers
to plan economic activities, as opposed to
the role of prices as signals and incentives;
how does the invisible hand in market
economies solve this problem?)
Economics for the IB Diploma   2

(a) Explain resource allocation and relate it to
the ‘what to produce’ and ‘how to produce’
economic questions (see Chapter 1).
l Resource allocation refers to the
parcelling out or apportioning of
resources among their competing uses;
a particular allocation of resources
determines what particular resources and
what quantities of these will be used to
produce goods and services, and so it
answers the ‘how to produce’ question.
At the same time, the allocation of
resources also determines what types and
what quantities of goods and services will
be produced, and so it also answers the
‘what to produce’ question. (For more
details, use the information on pages 17
and 18.)
(b) What are the most likely causes of
inefficient resource allocation in centrally
planned economies?
l Central planning depends on very
detailed technical information on all
economic activities; this information is
extremely difficult to find, collect and use
effectively.
l Under central planning there are no
incentives for producers since they do
not own resources (land and capital) and
have no price system on which they can
base their decisions.
l Under central planning there is a
large bureaucracy that interferes with
achieving economic objectives effectively.
l Because of these difficulties, the resulting
allocation of resources is inefficient,
meaning that there is waste in the use of
resources; and the what to produce and
how to produce questions do not give
rise to answers that are in society’s best
interests.
(c) What characteristics of market systems
do you think are mainly responsible
for the advantages that markets have
over command mechanisms and central
planning?
l In a market system, there is private
ownership of resources, and economic
decision-makers (consumers and firms)
are free to make their decisions according
to their own preferences and their own
self-interest.
l Economic decision-makers make their
decisions by responding to prices that are
freely determined in markets.
© Cambridge University Press, 2009
Chapter 2: Answers to questions for review
l Prices determined in free markets ration
(apportion) all resources and goods
and services by acting as signals and
incentives for all decision-makers. This
way, prices solve the very complicated
problem of finding, collecting and using
the information that is needed to allocate
resources efficiently.
l The market economy, working through
supply and demand that determine
prices, achieves a coordination of
innumerable decisions without any
central authority. The ‘invisible hand’
of markets solves the problem of
information that is needed to provide
answers to the ‘what to produce’ and the
‘how to produce’ questions of economics
that are in the interest of societies.
2.8 [15 marks for part (a); 15 marks for part
(b)] Greece has legislation that determines
a national minimum wage. At one time
the government proposed that the law be
suspended (not enforced) in areas that have
high unemployment. Public reaction to the
proposal was mixed, with some people in favour
and others against.
(a) Use demand and supply diagrams to
explain what the proposal was trying to
achieve.
(b) Evaluate the likely impacts of such a policy,
considering who may gain, who may lose,
and why.
(a) Use demand and supply diagrams to
explain what the proposal was trying to
achieve.
l Define wages, as the price of labour
resources, per unit of time.
l In a free market, wages are determined by
the demand for labour by firms, and the
supply of labour by workers.
l Draw a correctly labelled diagram
showing a labour market, as in
Figure 2.21(a).
l A minimum wage is a type of price
control, which imposes a legal minimum
price for labour, which is the minimum
wage.
l In the figure, show the minimum wage
to be at a level which is higher than the
equilibrium market wage, and explain
that the wage is not allowed to fall below
this minimum.
l Explain that at the minimum wage, the
quantity of labour supplied by workers,
Qs, is larger than the quantity of labour
demanded by firms, Qd.
Economics for the IB Diploma   3

l Therefore at the minimum wage, there
results a labour surplus equal to Qs − Qd,
which corresponds to unemployed
labour, or workers who would like to
work but cannot get jobs.
l If the law on minimum wages were
suspended (not enforced), the wage
would be able to fall to its equilibrium
level, or We, determined by the
intersection of the demand-for-labour
and supply-of-labour curves.
l If the wage drops to its equilibrium level,
the result will be to eliminate the labour
surplus, or unemployed labour; therefore,
the proposal was trying to find a solution
to the problem of unemployment.
(b) Evaluate the likely impacts of such a policy,
considering who may gain, who may lose,
and why.
2.9 [10 marks for parts (a) and (b); 15 marks
l If unemployment is eliminated, the
unemployed workers who get jobs will
gain. (However, not all the workers who
were unemployed when the wage was We
will get jobs, because at the lower wage,
We, there is a smaller quantity of labour
supplied, meaning that some workers are
not willing to work at the lower wage.)
l The workers who were already employed
will suffer a fall in their wages, as before
they were getting the wage Wm, and after
the elimination of the minimum wage
they will get We; therefore, they will be
worse off.
l Firms will benefit, because their wage
costs per worker will fall (from Wm to
We), and they will be able to hire more
workers.
l The fall in the costs of labour may work
to increase the output produced by
firms and decrease the price at which
this output is sold. You can show
this by drawing a diagram such as in
Figure 2.15(a). Firms’ costs of production
are a determinant of supply, and when
costs fall, the supply curve shifts to the
right. You can show a shift of the supply
curve from S1 to S2, and explain that this
leads to a fall in the price and an increase
in the quantity of the good or goods
produced by the firms enjoying lower
labour costs.
l Consumers benefit because of the fall in
price and the increase in quantity of the
good(s) produced.
© Cambridge University Press, 2009
Chapter 2: Answers to questions for review
l Workers who may have been working
illegally at wages below the minimum
wage may lose their jobs, since now firms
can hire workers legally at the lower
wage; on the other hand, the fall in
the legal wage may induce some illegal
workers to begin working legally.
l Some economists argue that when wages
are higher than the equilibrium level
(such as at Wm), workers are motivated
to work harder and increase their
productivity (output per worker). This
would mean that when the wage falls to
the equilibrium level, some workers may
be less motivated to work as hard, and
some of the beneficial aspects of lower
wage costs described above (increased
output and lower prices) may not come
about.
for parts (c), (d) and (e)] In 1973 OPEC (the
Organization of the Petroleum Exporting
Countries) increased the price of crude oil,
which is the key input in petrol (gasoline)
production. This led to an increase in the price
of petrol. Some countries initially responded
by imposing price controls (a price ceiling, or
legal maximum price) on petrol. Following this
sequence of events, there emerged shortages in
the petrol market.
(a) Use a demand and supply diagram to show
the impact of the increase in the price of
crude oil on the equilibrium price and
quantity of petrol/gasoline. (Hint: what
effect does an increase in the price of an
input (crude oil) have on the supply of
petrol?)
(b) Use a supply and demand diagram to show
the effects of the price ceiling in the petrol
market.
(c) Was the petrol shortage due to the actions
of OPEC or due to the price controls?
Explain.
(d) What could have been done to prevent the
shortage?
(e) Evaluate the policy of petrol price controls.
(a) Use a demand and supply diagram to show
the impact of the increase in the price of
crude oil on the equilibrium price and
quantity of petrol/gasoline. (Hint: what
effect does an increase in the price of an
input (crude oil) have on the supply of
petrol?)
l An increase in the price of crude oil
represents an increase in the costs of
production of firms that produce petrol,
and so this results in a fall in supply, or
a shift to the left of the supply curve of
petrol.
Economics for the IB Diploma   4

l Draw a supply and demand diagram like
the one in Figure 2.15(b), showing a shift
in the supply curve from S1 to S2, which
results in a higher equilibrium price and
lower quantity of petrol.
(b) Use a supply and demand diagram to show
the effects of the price ceiling in the petrol
market.
l Draw a correctly labelled supply and
demand diagram like the one in
Figure 2.19(a) for the petrol market.
l Explain that the price ceiling is a type of
price control, and that the price ceiling is
a legal maximum. In the diagram, show
the price ceiling, Pc, to be lower than the
equilibrium price, Pe.
l At the price Pc, there is a shortage of
petrol equal to Qd − Qs, meaning that the
quantity consumers are willing and able
to buy at the price Pc (Qd) is larger than
the amount that firms are willing and
able to supply (Qs).
(c) Was the petrol shortage due to the actions
of OPEC or due to the price controls?
Explain.
l The shortage was due to the price ceiling,
and not to the actions of OPEC.
l OPEC increased the price of crude oil (an
input in the production of petrol), which
led to an increase in the equilibrium
price of petrol. This did not result in
any shortage, since the new, higher
equilibrium price made quantity of petrol
demanded equal to quantity of petrol
supplied, as in Figure 2.15(b)
l The imposition of the price control
prevented this market from clearing, and
therefore created a shortage, as in
Figure 2.19(a).
(d) What could have been done to prevent the
shortage?
l If there had been no price ceiling
imposed on the petrol market, there
would have been no shortage, as the
market would clear at the price Pe in
Figure 2.19(a).
(e) Evaluate the policy of petrol price controls.
l The price controls led to a smaller
quantity of petrol supplied and sold.
You can show this using Figure 2.19(a),
by indicating that that the quantity
supplied and sold, Qs, is smaller than the
equilibrium quantity, Qe.
© Cambridge University Press, 2009
Chapter 2: Answers to questions for review
l This happened because the price controls
interfered with the price mechanism, or
price rationing, and sent out the wrong
signals and incentives to producers, who
ended up producing less.
l The price controls also sent out the
wrong signals and incentives to
consumers, who demanded a larger
quantity of petrol (Qd instead of Qe). This
did not provide them with the incentive
to economize on the use of petrol (to try
to use less of it) and to find alternative
means of transport rather then the use of
cars.
l The price controls led to an
underallocation of resources (too few
resources) to the production of petrol,
meaning that less than the ‘best’ quantity
was being produced (Qs instead of Qe).
(This resulted in allocative inefficiency.)
l Consumers were worse off because a
smaller than ‘best’ quantity was being
produced (Qs instead of Qe).
l However consumers also benefited
because they were able to buy petrol at a
lower than equilibrium market price.
l Since the price control created a larger
quantity demanded than quantity
supplied, there could no longer be
price rationing of petrol, and non-
price rationing methods had to be used
to distribute the available petrol to
consumers. The most common non-price
rationing method that was used was the
queue, where people waited in line to
buy petrol on the first come, first served
principle; this gave rise to a waste of time
of consumers.
l In some cases, black markets emerged,
where some people bought the petrol at
the legal maximum price and then resold
it to consumers at a higher, illegal price.
Prioritize your arguments
l The overall effects of the price
controls were negative because of their
interference with the price mechanism.
They resulted in ‘wrong’ signals and
incentives to consumers and producers,
and gave rise to a misallocation of
resources.
Economics for the IB Diploma   5
 Chapter 2: Answers to questions for review

2.11 [10 marks] In athletic and artistic events

where ticket prices are fixed ahead of time by
the organizing body, and are not allowed to
fluctuate in response to demand and supply, we
often see the practice where some people buy
tickets at the official price and later resell them
to interested viewers at a higher price. Use a
demand and supply diagram to explain why this
practice occurs.

l Since this practice occurs in athletic and

artistic events, it means that the quantity of
tickets supplied is determined by the theatre’s
or stadium’s seating capacity, and cannot
change in response to changes in price.
Therefore you must use a demand and supply
diagram with a vertical supply curve, as in
Figure 2.22(a).
l If some people can buy tickets at the official
price and resell them at a higher price, this
means that the official price must be lower
than the equilibrium market price, which
gives rise to some unsatisfied buyers (buyers
who were willing and able to pay the price
to buy the tickets but couldn’t because there
weren’t enough of them).. You can show this
using Figure 2.22(a), where the official price
is Pf.
l At price Pf, the quantity of tickets demanded
is larger than the quantity supplied, and
there is a shortage of tickets equal to the
distance b − a.
l Some people can buy tickets at the price Pf
and resell them at a price that is higher than
Pf. They can do this as long as there are some
unsatisfied theatre-goers who were unable
to buy tickets at the price Pf, and who were
willing to pay a higher price than Pf.

© Cambridge University Press, 2009 Economics for the IB Diploma   6