Chapter 4

Demand, Supply, and Equilibrium

Questions
1. What is meant by holding all else equal? How is this concept used when discussing movements along
the demand curve? How is this concept used when discussing movements along the supply curve?
Answer: Holding all else equal means that everything other than the variable in question is assumed to
remain constant. When we move along a demand curve we are assuming that all of the determinants
of the demand for a good other than the price of the good (e.g., income, the prices of other goods)
remain constant. When we move along a supply curve we are assuming that all of the determinants of
the supply of a good other than the price of the good (e.g., wage rates, the price of raw material,
technology) remain constant.
2. What is meant by diminishing marginal benefits? Are you likely to experience diminishing marginal
benefits for goods that you like a lot? Are there exceptions to the general rule of diminishing marginal
benefits? (Hint: think about batteries that you would use in a flashlight that requires two batteries.)
Explain your answer.
Answer: Diminishing marginal benefit from a good suggests that the willingness to pay for an
additional unit declines as more is consumed. You are likely to experience diminishing marginal
benefit even from goods that you like a lot, although you will probably consume more of those goods
before diminishing marginal benefits sets in. The first ice cream is delicious. The second is still very
tasty but not quite as good as the first. The third might make you sick to your stomach.
Yes, there could be exceptions to the rule of diminishing marginal returns. If a flashlight does not
function without both batteries, you would experience increasing marginal benefits; the first battery is
useless but the second makes the flashlight work.
3. How is the market demand schedule derived from individual demand schedules? How does the
market demand curve differ from an individual demand curve?
Answer: We would derive the market demand schedule by summing the individual demands at every
possible price. So, for example, if Consumer 1 would buy 6 units of a good when the price is $5 and
Consumer 2 would buy 4 units, then the market demand at $5 is 10 units.
The market demand curve is the sum of the individual demand curves of all the potential buyers. The
market demand curve plots the relationship between the total quantity demanded and the market
price, holding all else equal.
4. Explain how the following factors will affect the demand curve for houses in an economy.
a. Commercial banks raise the housing loan rate.
b. An increase in immigration results in a large increase in population in the economy.
c. An increase in the income of people in the economy.

Answer:
a. Since people usually borrow from banks to finance the purchase of houses, we can

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consider housing loans and houses as complements. A higher interest rate will increase
the cost of owning a house, leading to a decrease in the demand for houses. The demand
curve for houses will shift to the left.

b. The large increase in population will lead to an increase in the demand for houses. The
demand curve for houses will shift to the right.

c. Houses are considered as normal goods where people will buy more when their income
increases. Hence, higher income will lead to an increase in the demand for houses. The
demand curve for houses will shift to the right.

5. What does it mean to say that we are running out of “cheap oil”? What does this imply for the price
of oil in the future?
Answer: To say that we are running out of “cheap oil” means that much of the oil that is needed to
meet the demand for oil in the future is relatively expensive to find and extract. This suggests that the
price of oil will increase in the future. There is an enormous amount of oil under the surface of the
earth, but for firms to profitably drill for oil, the price of oil needs to be high enough to pay for the
costs of drilling.
6. What does the Law of Demand state? What is the difference between an individual demand curve and
a market demand curve?

Answer: The Law of Demand states that in most cases, the quantity demanded rises when the price
falls (holding all else equal).

The market demand curve is the sum of the individual demand curves of all the potential buyers. The
market demand curve plots the relationship between the total quantity demanded and the market
price, holding all else equal.
7. What is the difference between willingness to accept and willingness to pay? For a trade to take place,
does the willingness to accept have to be lower, higher, or equal to the willingness to pay?
Answer: Willingness to accept is the lowest price that a seller is willing to receive to sell an extra unit
of a good, while willingness to pay is the highest price that a buyer is willing to pay for an extra unit
of a good. For a trade to take place, the buyer’s willingness to pay must be greater than or equal to the
seller’s willingness to accept.
8. Explain how the following factors will affect the supply curve for cars.
a. An increase in the working age population of a country.
b. A restriction on the inflow of foreign labor employed in the car industry.
c. More companies are producing cars.

Answer:
a. The growing working age population increases the pool of workers in the car producing industry. This

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 Chapter 4 | Demand, Supply, and Equilibrium 29

will increase the supply of cars and lead to a rightward shift in supply.
b. The restriction of foreign labor employed in the car industry will increase wages in the car industry,
thus increase the cost of production of cars. The supply curve will shift to the left.
c. As more companies start producing cars, the supply of cars will increase. This will lead to a rightward
shift in supply.

9. How do the following affect the equilibrium price in a market?

a. A rightward shift in demand
b. A leftward shift in supply
c. A leftward shift in supply and a rightward shift in demand of the same magnitude
d. A small rightward shift in supply and a large leftward shift in demand
Answer:
a. Everything else remaining unchanged, a rightward shift in demand will increase the equilibrium
price in the market.
b. Everything else remaining unchanged, a leftward shift in supply will increase the equilibrium price
in the market.
c. Everything else remaining unchanged, a leftward shift in supply together with a rightward shift in
demand of the same magnitude will increase the equilibrium price in the market.
d. Everything else remaining unchanged, a small rightward shift in supply and a large leftward shift
in demand will decrease the equilibrium price in the market.

10. Why was a fixed price of $50 not the best way of allocating used laptops? Suggest other possible
ways of distributing the laptops that would be efficient.
Answer: At the price of $50, the quantity of laptops demanded far exceeded the quantity supplied.
This excess demand led to long queues and a stampede at the Richmond International Raceway. One
of the other ways of allocating the laptops would have been to use flexible prices. Those who valued
the laptops the most would have paid the most for them. An auction would have raised revenue and
allocated the laptops better than a fixed price. Henrico County could also have used a random lottery
to allocate the used laptops. Those who got the laptops through the lottery could have then sold it to
anyone who valued them more than they did. The lottery would not, however, lead to an efficient
outcome if people who won the lottery were not allowed to sell the laptops.

Problems
1. Suppose the following table shows the quantity of laundry detergent that is demanded and supplied at
various prices in Country 1.

P Quantity Demanded Quantity Supplied

($) (million oz.) (million oz.)
2 65 35
4 60 40
6 55 45
8 50 50

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10 45 55
12 40 60
14 35 65

a. Use the data in the table to draw the demand and supply curves in the market for laundry
detergent.
b. What is the equilibrium price and quantity in the market?
c. The following tables give the demand and supply schedules for two of its neighboring countries,
Country 2 and Country 3. Suppose these three countries decide to form an economic union and
integrate their markets. Use the data in the table to plot the market demand and supply curves in
the newly formed economic union. What is the equilibrium price and quantity in the market?
Country 2:

Quantity Demanded Quantity Supplied

P ($) (million oz.) (million oz.)
2 35 5
4 30 10
6 25 15
8 20 20
10 15 25
12 10 30
14 5 35

Country 3:

Quantity Demanded Quantity Supplied

P ($) (million oz.) (million oz.)
2 40 10
4 35 15
6 30 20
8 25 25
10 20 30
12 15 35
14 10 40

Answer:
a. The following figure shows the domestic market for laundry detergent:

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 Chapter 4 | Demand, Supply, and Equilibrium 31

b. The equilibrium price in the market is $8 and the equilibrium quantity is 50,000,000 oz.
c. If the three countries decide to integrate, the individual country demand and supply curves
need to be aggregated to arrive at the demand and supply curves in the economic union. The
following figure shows the demand (DM) and supply (SM) curves in the economic union:

As can be seen in the figure, the equilibrium price remains $8 while the total quantity sold is
equal to 95 million oz.
2. In 1999, the Coca-Cola Company developed a vending machine that would raise the price of Coke in
hot weather. Present a supply and demand diagram to explain the logic behind this machine.
Answer: When the temperature rises, the demand for soft drinks rises. As a result, the equilibrium
price of soft drinks rises. In the diagram below, the increase in temperature leads to a shift in the
demand curve for soft drinks from D1 to D2. As a consequence, the equilibrium price of soft drinks
rises from P1 to P2. The temperature-sensitive vending machine would therefore automatically
increase the price of Coke from P1 to P2 when it became hotter.

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32 Acemoglu, Laibson, and List | Microeconomics

See http://www.nytimes.com/1999/10/28/business/variable-price-coke-machine-being-tested.html
3. The following two incidents involve simultaneous shifts in the demand and the supply curves.
Analyze the final effects on the equilibrium price and quantity after the changes. Explain your
answers.
a. Severe drought at the peak of summer reduces the production of watermelons. With even more
people consume the fruit to quench their thirst, the equilibrium quantity remains unchanged.
b. The government allocates land to build more houses in the country. At the same time, it
relaxes the criteria of citizenship to entice more foreigners to settle down in the country. The
price of houses increases.

Answer:

a. The hot weather reduces the watermelon crop and thus, for a given price, supply decreases.
This will increase the equilibrium price and decrease the equilibrium quantity of the fruit. At the
same time, when more people consume watermelons, for a given price, the demand for
watermelon increases. This will lead to a higher equilibrium price and higher equilibrium
quantity of watermelons. Since the equilibrium quantity of watermelons ultimately remains
unchanged, the supply curve shifts by the same magnitude as the demand curve.
b. With more land available to build houses, for a given price, the supply of houses increases.
This results in a lower equilibrium price and a higher equilibrium quantity in the housing market.
As more people take up citizenship in the country, for a given price, the demand for houses
increases. This will lead to a higher equilibrium price and a higher equilibrium quantity. Since the
price of houses ultimately increases, the demand curve shifts by a larger magnitude than the
supply curve.

4. Suppose people who are thinking about buying a home (demanders in the housing market) and
current home owners who are thinking about selling their homes (suppliers in the housing
market) suddenly believe that home prices are likely to be significantly higher next year than this
year.
a. Will this change in expectations cause the demand curve for housing this year to shift to the left
or shift to the right? Explain.

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 Chapter 4 | Demand, Supply, and Equilibrium 33

b. Will this change in expectations cause the supply curve for housing this year to shift to the left or
shift to the right? Explain.
c. Will these shifts in the demand and supply curves lead to an increase or a decrease in the price of
housing this year? Use supply and demand curves to explain your answer.
Answer:
a. The change in expectations will cause the demand curve for housing to shift to the right.
Some people who were planning to buy a home next year will decide to buy now because
they believe they would have to pay more for a home in the future.
b. The change in expectations will cause the supply curve for housing to shift to the left. Some
people who were planning to sell their home this year will decide to wait to sell next year to
take advantage of the expected higher price.
c. The shift in demand from D1 to D2 and the shift in supply from S1 to S2 will raise the
equilibrium price of housing from P1 to P2.

5. Brazil is the world’s largest coffee producer. There was a severe drought in Brazil in 2013-14 that
damaged Brazil’s coffee crop. The price of coffee beans doubled during the first three months of
2014.
a. Draw and discuss a supply and demand diagram to explain the increase in coffee prices.
b. Are coffee and tea substitutes or complements? Explain.
c. What do you think the impact of this drought has been on the equilibrium price and quantity of
tea? Draw a supply and demand diagram for the tea market to explain your answer.
Answer:
a. The drought will cause the supply curve to shift to the left from S to S′. As a result the
equilibrium price of coffee rises from P1 to P2.

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b. For many people, coffee and tea are substitutes; they are different ways to take in caffeine.
An increase in the price of coffee will therefore lead to an increase in the demand for tea.
c. Since coffee and tea are substitutes, the increase in the price of coffee leads to an increase in
the demand for tea. As a consequence the price of tea rises from P 3 to P4 and the equilibrium
quantity of tea rises from Q3 to Q4.

6. There is a sharp freeze in Florida that damages the orange harvest and as a result, the price of
oranges rises. Will the equilibrium price of orange juice rise, fall, or remain constant? Will the
equilibrium quantity of orange juice rise, fall, or remain constant? Present a supply and demand
curve diagram to defend your answers.
Answer: The freeze raises the price of oranges, one of the major inputs in the production of orange
juice. As a result, the supply curve shifts to the left from S to S′. As a consequence the equilibrium
price rises from P1 to P2 and the equilibrium quantity falls from Q1 to Q2.

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7. An appendectomy is an operation to have your appendix removed. To simplify the analysis,

assume that everyone has health insurance, so that anybody who needs an appendectomy will
have one. (a) Show that the demand curve for appendectomies is vertical. (b) There is a
technological breakthrough that allows surgeons to perform appendectomies at a much lower
cost. Will the equilibrium price of appendectomies rise, fall, or remain constant? Will the
equilibrium quantity of appendectomies rise, fall, or remain constant? Present a supply-and-
demand curve diagram to defend your answers.
Answer:
a. The quantity of appendectomies demanded will not change if the price of an appendectomy
changes. No one who does not need an appendectomy would rush out to have one if the local
hospital held an appendectomy sale. Assuming everyone has health insurance, anyone who
needed an appendectomy would have one no matter how high the price rose. Therefore the
demand curve for appendectomies is vertical.
b. The technological breakthrough shifts the supply curve to the right from S to S′. As a result,
the equilibrium price falls from P1 to P2 but the equilibrium quantity is unchanged.

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8. A freshwater aqua farm in Singapore can breed tiger prawns and tilapia. Recently, it was found that
there may be a risk of contracting a type of disease from the consumption of tiger prawns – this
discovery has led to fear among its consumers. How will this affect the equilibrium price and
quantity of tilapia in Singapore?

Answer: The fear of contracting a disease from the consumption of tiger prawns decreases their
demand. This will lead to a lower equilibrium price, thereby reducing profit in breeding tiger
prawns. This, in turn, will decrease the demand for breeding tiger prawns at the freshwater aqua
farm in Singapore. The consequent fall in the equilibrium price of conducting aquaculture leads to an
increase in the supply of tilapia. Thus, the supply curve for tilapia will shift to the right. In the
diagram below, the equilibrium price falls from P 1 to P2 and the equilibrium quantity increases from
Q1 to Q2.

Market for Tilapia

Price of Tilapia S1
S2

E1
P1

P2 E
2

D1

Q1 Q2 Quantity of Tilapia

See http://www.nytimes.com/2011/09/02/us/02apples.html
9. Suppose one of your friends offered the following argument:
A rightward shift in demand will cause an increase in price. The increase in price will cause a
rightward shift of the supply curve, which will lead to an offsetting decrease in price. Therefore, it is
impossible to tell what effect an increase in demand will have on price.
Do you agree with your friend? If not, what is the flaw in your friend’s reasoning?
Answer: The given argument is flawed because it claims that an “increase in price will cause a shift of
the supply curve...” The increase in price will cause a movement along the supply curve and not a
shift of the curve.
10. The UK government is contemplating introducing a minimum price for alcohol to reduce binge
drinking and the consumption of alcohol in general. Suppose the following diagram shows the
alcohol market in the UK. The current price of alcohol is 23 pence per unit, and 8 units of alcohol are
consumed each week. What happens in the market if the government sets a minimum price of 30

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 Chapter 4 | Demand, Supply, and Equilibrium 37

pence per unit of alcohol? Will there be an excess supply or an excess demand for alcohol if the
government adopts this policy? Explain.

Answer: If the price of alcohol is set at 30p per unit, the quantity demanded in the market will fall.
The quantity of alcohol supplied however, will exceed the quantity demanded. As shown in the
following figure, consumption will fall to 6 units per week. The excess supply will be the difference
between the quantity supplied at a price of 30 pence (10 units) and the quantity demanded at that
price (6 units).

See http://www.independent.co.uk/news/uk/politics/minimum-alcohol-price-would-cut-binge-
drinking-1835850.html
11. Airlines tend to offer more flights in December due to the holiday season as compared to the number
of flights offered in October. Compare the equilibrium price and quantity of air travel in October to
that of December. Support your answers with a suitable demand-and-supply diagram.

Answer: Compared to October, in the month of December, for a given price, both the demand for and
the supply of air travel increases. Thus, the demand curve shifts to the right from D 1 to D2, and the
supply curve also shifts to the right from S1 to S2, as shown in the diagram. As a result, the
equilibrium quantity of air travel in December will definitely be higher than that in October, but the

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equilibrium price can be higher, lower, or remain unchanged. In the diagram, the equilibrium price in
December is less than that in October but if the increase in demand were small relative to the increase
in supply we would have found that equilibrium price in December is lower than that in October.

12. The market price of rice in Thailand is 100 baht. The Thai government offers to buy rice for 140 baht.
a. How is this likely to affect other buyers in the domestic market for rice?
b. Present a supply and demand diagram to show how much rice the Thai government will have to
buy under this program.
Answer:
a. If a single buyer in the market (the government) is willing to buy any amount of rice at a
price that is higher than the market price, then suppliers would be unwilling to sell to
consumers at a price below the government’s price. Therefore everyone in Thailand would
have to pay the government’s price of 140 baht.

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 Chapter 4 | Demand, Supply, and Equilibrium 39

b. The quantity demanded at a price of 140 baht is Q1, the quantity supplied is Q2, and therefore
the government would have to buy the excess supply Q2 – Q1.

See http://in.reuters.com/article/2012/07/17/asia-rice-idINL4E8IG2NE20120717
13. The equilibrium price of coffee in an economy, measured in dollars, is about $2,000 per ton. To help
the coffee farmers earn a higher income, the government set the price to $2,500 per ton.
a. How will this affect the demand and supply of coffee in the coffee market?
b. Construct a diagram for the coffee market to show the effect of the government action. Will the
coffee farmers be better off?
Answer:
a. The price set above the market equilibrium level will lead to an increase in the quantity of coffee
supplied but a decrease in the quantity of coffee demanded in the coffee market.
b. At a market price of $2,500 per ton, the quantity supplied will exceed quantity demanded. There
will be an excess supply of coffee in the market. Only those farmers who are able to sell their product
at the higher price of $2,500 will be better off. Those who are unable to do so will be worse off.
Price of coffee per ton

S
excess supply
$2500

$2000

Q 3 Q1 Q2 Quantity of coffee per ton

14. Note: This problem requires some basic algebra. The demand for ice cream is QD = 70 − 4P, and the
supply of ice cream is QS= 10 + 2P, where P is the price of ice cream.

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a. Find the equilibrium price and quantity of ice cream.

b. Suppose consumers’ income increases and ice cream is considered as a normal good. As a result,
the demand curve for ice cream becomes QD = 100 − 4P. Find the new equilibrium price and quantity
of ice cream.

Answer:
a. At equilibrium, the quantity demanded must be equal to the quantity supplied. Thus, we have 70 −
4P = 10 + 2P. Solving for P, we have 60 = 6P and hence, P = 10. Substituting P = 10 into the demand
or supply equation, we have Q = 70 – 4 (10) or 10 + 2 (10) = 30. The equilibrium price is $10, and the
equilibrium quantity is 30 units.

b. Equating the new QD with QS, we have 100 − 4P = 10 + 2P. Solving for P, we have 90 = 6P and
hence, P = 15. Substituting P = 15 into the demand or supply equation, we have Q = 100 – 4 (15) or
10 + 2 (15) = 40. The new equilibrium price of ice cream is $15 and the equilibrium quantity is 40
units.

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