Chapter 4 Working with Supply and Demand

**CHAPTER 4 - WORKING WITH SUPPLY AND DEMAND**

**ANSWERS TO EVEN-NUMBERED PROBLEMS**

2. a. With the $2 price ceiling people would still demand 60,000 bottles of maple syrup per month, but the suppliers would only be willing to supply 30,000 bottles (that is, 10,000 bottles less than before the supply curve shift). Thus the supply curve shift leads to an even higher shortage of 30,000 bottles per month.

b. If all of the maple syrup supplied (30,000 bottles) is purchased and resold in the black market, the black market price would be greater than before the supply curve shift. The black market price is read off the demand curve, as the price that corresponds to 30,000 bottles. Because the demand curve is downward sloping, the price that corresponds to 30,000 bottles is higher that the price that corresponds to 40,000 bottles (which was the old black market price, before the supply curve shift). Draw a graph to convince yourself.

4. In order for the $0.60 tax to be divided equally between buyers and sellers, the price paid by buyers would have to be $0.30 higher than it was originally and the after-tax price received by sellers would have to be $0.30 lower. That is, the new market price paid by consumers would have to be $3.00 + $0.30 = $3.30 and the price received by sellers would have to be $3.00 - $0.30 = $2.70. From the diagram, however, it is clear that at $3.30 per gallon, consumers would want to purchase more than 300 million gallons per day while at $2.70 per gallon (after taxes), sellers would want to offer fewer than 300 million gallons. Therefore, with an equal split of the tax, the market could not be in equilibrium.

6. a. Total farm acreage in the U.S. is a stock variable, because it measures the quantity of farms that exist in the U.S. at a point in time.

b. Total spending on food in China is a flow variable, because is measures the spending over some period of time.

c. Total value of U.S. imports from Europe is a flow variable, because it measures the value of imports over time.

d. Worldwide iPhone sales is a flow variable, because it measures the number of iPhones sold over a period of time.

e. The total number of parking spaces in Los Angeles is a stock variable, because it measures the quantity of parking spaces at a point in time. In contrast, the total number of newly constructed parking spaces per month would be a flow variable.

f. The total value of human capital in India is a stock variable, because it measures the value of human capital at a point in time.

g. Investment in new human capital in India is a flow variable, because it measures the amount of investment over a period of time.

8. For the following answers assume that the existing stock of homes in Monotone, AZ is Q.

a. We start off at point A, where the housing market in Monotone is in equilibrium. Without the special tax breaks, 500 new homes would be built in Monotone (dashed vertical supply curve to the right of S1). With the special tax breaks we observe an additional 300 new homes built, resulting in a new stock of Q+800 homes (vertical supply curve S2). The special tax breaks only affect the home builders, i.e. suppliers, and have no effect on demand. Demand, as usual in Monotone, shifts to the right by 500 homes. Since supply shifted to the right by more than demand, the price of homes in Monotone will fall from P1 in the old equilibrium (point A) to P2 in the new equilibrium (point C).

b. If interest rates fall, it effectively becomes cheaper to buy a house, thus shifting demand for homes to the right by more than 500 (D1 shifts to D2). The vertical supply curve however only shifts to the right by 500 homes, as usual for Monotone. Since there is a greater rightward shift in demand than in supply, the price of homes increases from P1 to P2, as we move from the old equilibrium (point A) to the new equilibrium (point C).

c. If zoning laws prevent construction of new homes in Monotone, the supply curve is fixed at S1, while the demand shifts rightward from D1 to D2 by 500 homes, as usual. This will lead the price to increase from P1 to P2.

d. If in addition to zoning laws, home buyers’ expectations about the future go up (i.e. they expect their homes to be more valuable in the future) then demand shifts to the right by more than 500 homes. As in part c. supply is fixed at S1, but demand shifts from D1 to D2. The resulting price P2 is even higher than in part c.

e. We assume that before the earthquake, both the supply and demand in Monotone shifted to the right by 500, as usual (S1 shifts to S2 and D1 shifts to D2). The earthquake destroys 2,000 homes, shifting supply to the left to S3. At the same time 3,000 homeowners decide they don’t want to own homes in Monotone, shifting demand to the left to D3. The resulting price, P2 is lower than the original P1.

10. a. Before any changes in price, the value of equity is equal to the down payment, $100,000.

b. Before any changes in price, the simple leverage ratio is $400,000/$100,000 = 4.

c. The new value of your equity is $500,000 - $300,000 = $200,000. The new simple leverage ratio is $500,000/$200,000 = 2.5.

d. False. As you can see from parts b. and c., an increase in the value of a home, with no additional borrowing or repayment, decreases the degree of leverage on the investment in the home. (However, note that if the initial leverage was 1, then a change in price does not change the simple leverage ratio. You can work this out on your own.)

**MORE CHALLENGING QUESTION**

12. a. You borrow $100,000 beyond the original mortgage over the three years. Your original equity was $100,000 and the original debt was $300,000. When the value of the home increases to $500,000, and you keep the same equity, it must be that your total debt is $500,000-$100,000 = $400,000, which implies that your additional debt is $100,000.

b. Your simple leverage ratio at the end of the three years is $500,000/$100,000 = 5.

c. If the total debt associated with your home is $400,000, then your equity is wiped out if the price of your home falls to $400,000. If we start with a price of $500,000, a fall to $400,000 would be a 20% fall in the price, since ($500,000-$400,000)/$500,000 = 0.20. Hence, the price of your home could fall up to 20% before your equity is wiped out.