1. Decide whether each of the following statements is true or false and explain why:
Fast-food chains like McDonald’s, Burger King, and Wendy’s operate all over the United States. Therefore the market for fast food is a national market.
This statement is false. People generally buy fast food locally and do not travel large distances across the United States just to buy a cheaper fast food meal. Because there is little potential for arbitrage between fast food restaurants that are located some distance from each other, there are likely to be multiple fast food markets across the country.
People generally buy clothing in the city in which they live. Therefore there is a clothing market in, say, Atlanta that is distinct from the clothing market in Los Angeles.
This statement is false. Although consumers are unlikely to travel across the country to buy clothing, they can purchase many items online. In this way, clothing retailers in different cities compete with each other and with online stores such as L.L. Bean. Also, suppliers can easily move clothing from one part of the country to another. Thus, if clothing is more expensive in Atlanta than Los Angeles, clothing companies can shift supplies to Atlanta, which would reduce the price in Atlanta. Occasionally, there may be a market for a specific clothing item in a faraway market that results in a great opportunity for arbitrage, such as the market for blue jeans in the old Soviet Union.
Some consumers strongly prefer Pepsi and some strongly prefer Coke. Therefore there is no single market for colas.
This statement is false. Although some people have strong preferences for a particular brand of cola, the different brands are similar enough that they constitute one market. There are consumers who do not have strong preferences for one type of cola, and there are consumers who may have a preference, but who will also be influenced by price. Given these possibilities, the price of cola drinks will not tend to differ by very much, particularly for Coke and Pepsi.
2. The following table shows the average retail price of butter and the Consumer Price Index from 1980 to 2000, scaled so that the CPI = 100 in 1980.
Retail price of butter (salted, grade AA, per lb.)
Calculate the real price of butter in 1980 dollars. Has the real price increased/decreased/stayed the same since 1980?
Real price of butter in year t =*(nominal price of butter in year t).
Real price of butter (1980 $)
The real price of butter decreased from $1.88 in 1980 to $1.21 in 2000, although it did increase between 1995 and 2000.
What is the percentage change in the real price (1980 dollars) from 1980 to 2000?
Real price decreased by $0.67 (1.88 1.21 = 0.67). The percentage change in real price from 1980 to 2000 was therefore (–0.67/1.88)*100% = 35.6%.
Convert the CPI into 1990 = 100 and determine the real price of butter in 1990 dollars.
To convert the CPI into 1990 = 100, divide the CPI for each year by the CPI for 1990 and multiply that result by 100. Use the formula from part (a) and the new CPI numbers below to find the real price of milk in 1990 dollars.
Real price of butter (1990 $)
What is the percentage change in the real price (1990 dollars) from 1980 to 2000? Compare this with your answer in (b). What do you notice? Explain.
Real price decreased by $1.07 (2.98 1.91 = 1.07). The percentage change in real price from 1980 to 2000 was therefore (1.07/2.98)*100% = 35.9%. This answer is the same (except for rounding error) as in part (b). It does not matter which year is chosen as the base year when calculating percentage changes in real prices.
3. At the time this book went to print, the minimum wage was $5.85. To find the current value of the CPI, go to http://www.bls.gov/cpi/home.htm. Click on Consumer Price Index- All Urban Consumers (Current Series) and select U.S. All items. This will give you the CPI from 1913 to the present.
With these values, calculate the current real minimum wage in 1990 dollars.
The last year of data available when these answers were prepared was 2007. Thus, all calculations are as of 2007. You should update these values for the current year.
Real minimum wage in 2007 = * (minimum wage in 2007) = * $5.85 = $3.69. So, as of 2007, the real minimum wage in 1990 dollars was $3.69.
Stated in real 1990 dollars, what is the percentage change in the real minimum wage from 1985 to the present?
The minimum wage in 1985 was $3.35. You can get a complete listing of historical minimum wage rates from the Department of Labor, Employment Standards Administration at http://www.dol.gov/esa/minwage/chart.htm.
Real minimum wage in 1985 = * $3.35 = * $3.35 = $4.07.
The real minimum wage therefore decreased from $4.07 in 1985 to $3.69 in 2007 (all in 1990 dollars). This is a decrease of $4.07 3.69 = $0.38, so the percentage change is (0.38/4.07)*100% = 9.3%.
Chapter 2 - EXERCISES
1. Suppose the demand curve for a product is given by Q = 300 – 2P + 4I, where I is average income measured in thousands of dollars. The supply curve is Q = 3P – 50.
If I = 25, find the market clearing price and quantity for the product.
Given I = 25, the demand curve becomes Q = 300 2P + 4(25), or Q = 400 2P. Setting demand equal to supply we can solve for P and then Q:
400 2P = 3P 50
P = 90
Q = 220.
If I = 50, find the market clearing price and quantity for the product.
Given I = 50, the demand curve becomes Q = 300 2P + 4(50), or Q = 500 2P. Setting demand equal to supply we can solve for P and then Q:
500 2P = 3P 50
P = 110
Q = 280.
Draw a graph to illustrate your answers.
It is easier to draw the demand and supply curves if you first solve for the inverse demand and supply functions, i.e., solve the functions for P. Demand in part (a) is P = 200 0.5Q and supply is P = 16.67 + 0.333Q. These are shown on the graph as Da and S. Equilibrium price and quantity are found at the intersection of these demand and supply curves. When the income level increases in part (b), the demand curve shifts up and to the right. Inverse demand is P = 250 0.5Q and is labeled Db. The intersection of the new demand curve and original supply curve is the new equilibrium point.
2. Consider a competitive market for which the quantities demanded and supplied (per year) at various prices are given as follows:
Calculate the price elasticity of demand when the price is $80 and when the price is $100.
With each price increase of $20, the quantity demanded decreases by 2 million. Therefore,
Similarly, at P = 100, quantity demanded equals 18 million and
Calculate the price elasticity of supply when the price is $80 and when the price is $100.
With each price increase of $20, quantity supplied increases by 2 million. Thus,
At P = 80, quantity supplied is 16 million and
Similarly, at P = 100, quantity supplied equals 18 million and
What are the equilibrium price and quantity?
The equilibrium price is the price at which the quantity supplied equals the quantity demanded. As we see from the table, the equilibrium price is P* = $100 and the equilibrium quantity is Q* = 18 million.
Suppose the government sets a price ceiling of $80. Will there be a shortage, and if so, how large will it be?
With a price ceiling of $80, price cannot be above $80, so the market cannot reach its equilibrium price of $100. At $80, consumers would like to buy 20 million, but producers will supply only 16 million. This will result in a shortage of 4 million.
3. Refer to Example 2.5 (page 38) on the market for wheat. In 1998, the total demand for U.S. wheat was Q = 3244 – 283P and the domestic supply was QS = 1944 + 207P. At the end of 1998, both Brazil and Indonesia opened their wheat markets to U.S. farmers. Suppose that these new markets add 200 million bushels to U.S. wheat demand. What will be the free-market price of wheat and what quantity will be produced and sold by U.S. farmers?
► Note: The answer at the end of the book (first printing) used the wrong demand curve to find the new equilibrium quantity. The correct answer is given below.
If Brazil and Indonesia add 200 million bushels of wheat to U.S. wheat demand, the new demand curve will be Q + 200, or
QD = (3244 283P) + 200 = 3444 283P.
Equate supply and the new demand to find the new equilibrium price.
1944 + 207P = 3444 283P, or
490P = 1500, and thus P = $3.06 per bushel.
To find the equilibrium quantity, substitute the price into either the supply or demand equation. Using demand,
QD = 3444 283(3.06) = 2578 million bushels.
4. A vegetable fiber is traded in a competitive world market, and the world price is $9 per pound. Unlimited quantities are available for import into the United States at this price. The U.S. domestic supply and demand for various price levels are shown as follows: