Chapter 2:

The Basic Theory Using Demand and Supply

Multiple Choice Questions

  1. If a consumer's income doubles and she now purchases more of good X, we can infer that good X is a(n) ______good.
  2. Luxury
  3. Normal
  4. Inferior
  5. Special

ANSWER:B

  1. All of the following can lead to an increase in the demand for ice cream, a normal good, EXCEPT:
  2. A decrease in income.
  3. An increase in the price of popsicles.
  4. A new scientific study that finds eating ice cream does not cause weight gain.
  5. A 10% increase in population.

ANSWER:A

  1. A decrease in supply will lead to:
  2. An increase in price.
  3. A increase in quantity.
  4. An increase in demand.
  5. An increase in sales.

ANSWER:A

  1. Generally, with all else held constant, when the price of a good increases, consumers purchase:
  2. More of the good.
  3. Less of the good.
  4. The same amount of the good.
  5. None of the good.

ANSWER:B

  1. An increase in demand will lead to:
  2. An increase in supply.
  3. A fall in quantity.
  4. An increase in price.
  5. A decrease in producer surplus.

ANSWER:C

  1. Which of the following events would lead to an increase in demand for air travel?
  2. An increase in the number of people who are afraid to fly.
  3. A fall in the price of oil.
  4. An increase in the price of ground transportation.
  5. A decrease in income levels.

ANSWER:C

  1. Which of the following will cause a rightward shift of the market supply curve?
  2. An increase in the product price.
  3. A decrease in input costs.
  4. Change in consumers’ tastes.
  5. An increase in income.

ANSWER:B

  1. If a 1% increase in the price of DVD’s leads to a 3% reduction in the sales of DVD’s, we can conclude that:
  2. DVD’s are normal goods.
  3. DVD’s are inferior goods.
  4. Demand for DVD’s is elastic.
  5. Demand for DVD’s is inelastic.

ANSWER:C

  1. An increase in demand will lead to a higher increase in price;the:
  2. Greater is the price elasticity of demand.
  3. Greater is the population.
  4. Flatter is the supply curve.
  5. More inelastic is supply.

ANSWER: D

  1. Producer surplus is:
  2. Found on a graph as the area under the equilibrium price and above the supply curve.
  3. The net gain in economic well-being associated with producing and selling the equilibrium quantity of a good.
  4. Used to measure the impact of a change in price on the economic well-being of producers.
  5. All of the above.

ANSWER:D

Figure 2.1

  1. Referring to figure 2.1, at a price of $70, the amount of consumer surplus is:
  2. $6,000.
  3. $8,000.
  4. $15,000.
  5. $30,000.

ANSWER:B

  1. Referring to figure 2.1, at a price of $70, the amount of producer surplus is:
  2. $6,000.
  3. $8,000.
  4. $15,000.
  5. $30,000.

ANSWER:A

  1. The opening up of free trade brings gains to:
  2. All producers.
  3. Producers in export industries.
  4. Producers in import-competing industries.
  5. Workers in import-competing industries.

ANSWER:B

  1. An increase in the imports of clothing into the United States will benefit ______and hurt ______.
  2. U.S. clothing producers; foreign clothing producers
  3. foreign clothing consumers; foreign clothing producers
  4. U.S. clothing consumers; foreign clothing producers
  5. U.S. clothing consumers; U.S. clothing producers

ANSWER:D

  1. Which of the following says that any dollar of gain or loss will be equally valued, regardless of who experiences it?
  2. Consumer surplus.
  3. Producer surplus.
  4. Arbitrage.
  5. One-dollar, one-vote metric.

ANSWER:D

  1. Consider a typical two-country model. In the exporting country, consumers will be ______and producers will be ______with the opening of international trade.
  2. Happy; happy
  3. Unhappy; happy
  4. Unhappy; unhappy
  5. Happy; unhappy

ANSWER:B

Use the following information to answer questions 17 thru 24:

Suppose the domestic supply and demand curves for skateboards in the United States are given by the following set of equations:

QS = -60 + 3P

QD = 390 – 2P

  1. In the absence of international trade in skateboards, what will the domestic price in the United States be for skateboards?
  2. $66
  3. $90
  4. $45
  5. $150

ANSWER:B

  1. In the absence of international trade in skateboardshow many skateboards will be sold in the United States?
  2. 138
  3. 258
  4. 210
  5. 930

ANSWER:C

  1. If the United States could trade skateboards freely with the rest of the world at a price of $75, how manyskateboards would be produced in the United States?
  2. 165
  3. 240
  4. 285
  5. It depends on foreign demand for skateboards.

ANSWER:A

  1. If the United States could trade skateboards freely with the rest of the world at a price of $75, how many skateboards would be purchased in the United States?
  2. 165
  3. 240
  4. 285
  5. It depends on foreign supplies of skateboards.

ANSWER:B

  1. If the United States could trade skateboards freely with the rest of the world at a price of $75, the United States would import ______skateboards and export ______skateboards.
  2. 240; 165
  3. 0; 165
  4. 75; 0
  5. 240; 0

ANSWER:C

  1. In the absence of trade with the rest of the world, the amount of consumer surplus in the United States skateboard market is ______and the amount of producer surplus in the United States skateboard market is______.
  2. $7,350; $11,025
  3. $31,500; $9,450
  4. $20,474; $7,350
  5. $11,025; $7,350

ANSWER:D

  1. The opening of free trade with an international price for skateboards of $75 will lead to a change in consumer surplus of:
  2. +$2,812.50.
  3. -$2,812.50.
  4. +$6,300.
  5. +$3,375.

ANSWER:D

  1. The opening of free trade with an international price for skateboards of $75 will lead to a change in producer surplus of:
  2. +$2,812.50.
  3. -$2,812.50.
  4. +$3,375.
  5. -$3,375.

ANSWER:B

Use the following information to answer questions 25thru 31:

Suppose the domestic supply and demand curves for MP3 players in the United States are given by the following set of equations:

QS = 25 + 10P

QD = 925 – 5P

  1. In the absence of international trade in MP3 players, what will the domestic price in the United States be for MP3 players?
  2. $60
  3. $63.33
  4. $90
  5. $180

ANSWER:A

  1. In the absence of international trade in MP3 players, how many MP3 players will be sold in the United States?
  2. 1825
  3. 625
  4. 608
  5. 925

ANSWER:B

  1. If the United States could trade MP3 players freely with the rest of the world at a price of $90, how manyMP3 players would be produced in the United States?
  2. 625
  3. 475
  4. 925
  5. It depends on foreign demand MP3 players.

ANSWER:C

  1. If the United States could trade MP3 players freely with the rest of the world at a price of $90, how many MP3 players will be purchased in the United States?
  2. 625
  3. 475
  4. 925
  5. It depends on foreign supplies of MP3 players.

ANSWER:B

  1. If the United States could trade MP3 players freely with the rest of the world at a price of $90 the United States would import ______MP3 players and export ______MP3 players.
  2. 0; 450
  3. 450; 0
  4. 475; 925
  5. 0; 925

ANSWER:A

  1. In the absence of trade with the rest of the world, the amount of consumer surplus in the United States’MP3 player market is ______.
  2. $22,562.50
  3. $30,062.50
  4. $39,062.50
  5. $19,500.00

ANSWER:C

  1. The opening of free trade with an international price for MP3 players of $90 will lead to a ______to the United States in the amount of ______.
  2. Gain; 2,625 MP3 players
  3. Gain: $6,750
  4. Loss; 150 MP3 players
  5. Loss; $13,500

ANSWER:B

  1. During the time span 1960-2006, the Volume of World Trade has been:
  2. Growing at a lower rate compared to the World Production.
  3. Growing at the same rate as the World Production.
  4. Growing at a higher rate compared to the World Production.
  5. Declining due to the Cold War.

ANSWER:C

  1. Compared to developing countries, industrialized countries:
  2. Export more primary products, especially fuels and ores.
  3. Export more textiles and clothing.
  4. Export more services.
  5. None of the above.

ANSWER:C

Use the following information to answer questions 34 thru 37:

Suppose the domestic supply and demand curves for bicycles in the United States are given by the following set of equations:

QS = 2P

QD = 200 – 2P.

Demand and supply in the Rest of the World is given by the equations:

QS = P

QD =160 – P.

Quantities are measured in thousands and price in U.S. dollars.

  1. In the absence of international trade, ______thousand bicycles will be sold in the United States at a price of ______.
  2. 50; $50
  3. 100; $100
  4. 150; $50
  5. 100; $50

ANSWER:D

  1. In the absence of international trade, ______thousand bicycles will be sold in the Rest of the World at a price of ______.
  2. 80; $80
  3. 100; $100
  4. 50; $100
  5. 100; $50

ANSWER:A

  1. After the opening of free trade with the Rest of the World, the world price establishes itself at $60. The U.S. ______bicycles.
  2. Exports 40,000
  3. Exports 60,000
  4. Imports 60,000
  5. Neither exports nor imports any bicycles

ANSWER:A

  1. After the opening of free trade between the U.S. and the Rest of the World:
  2. Neither the U.S. nor the Rest of the World gain from trade.
  3. Both countries gain from trade, but the U.S. gains more.
  4. Both countries gain from trade, but the Rest of the World gains more.
  5. One cannot determine who gains more.

ANSWER:C

True/False Questions

  1. An increase in demand will lead to a larger increase in price the more elastic is supply.

ANSWER:FALSE

  1. A decrease in income will lead to an increase in the quantity demanded of an inferior good.

ANSWER:TRUE

  1. A simultaneous increase in supply and decrease in demand will lead to a higher equilibrium price.

ANSWER:FALSE

  1. If a 1% increase in price leads to a 5% decrease in quantity demanded, the good is considered to be a normal good.

ANSWER:FALSE

  1. Consumer surplus is the amount of net economic benefit to consumers from being able to purchase in a market.

ANSWER:TRUE

  1. Everyone benefits in a country that was closed to world trade when it begins to freely trade with the rest of the world.

ANSWER:FALSE

  1. While international trade will benefit both the importing and exporting country in a two-country world, the gains from trade in the exporting country will usually be greater than the gains from trade in the importing country.

ANSWER:FALSE

  1. The net national gain from trade can be measured by the change in consumer and producer surplus that results from trade.

ANSWER:TRUE

  1. The free-trade price of a good in an importing country is expected to be lower than the price of the good in that country before trade began.

ANSWER:TRUE

  1. When free trade begins, producers in the importing nation gain while producers in the exporting nation lose.

ANSWER:FALSE

  1. Free trade is a zero-sum activity. That is, one county always gains and the other always loses from free trade.

ANSWER:FALSE

  1. The gains from trade are divided in proportion to the price changes that trade brings to the trading countries.

ANSWER:TRUE

  1. If the world price is higher than the no-trade domestic price, then domestic producers gain and domestic consumers lose as a result of free trade.

ANSWER:TRUE

  1. The elasticity of demand measures the responsiveness of consumers to changes in the price of a product.

ANSWER:TRUE

  1. Over the past half a century the World Trade Volume increased more than ten times.

ANSWER:TRUE

Essay Questions

  1. In a two-country world, the opening of free trade does not make everyone in the two countries better off. What assumption(s) must be made in order to make the claim that both countries do in fact benefit from the free trade?

POSSIBLE RESPONSE: It is true that free trade does not benefit everyone within a country. However, if we accept the one-dollar-one-vote metric, and measure the national well-being of a country, we will find that there are net national gains from trade. That means that the gainers are gaining more than the losers are losing. Among the gainers are the consumers in the importing country,who enjoy lower prices, and possibly a wider variety of the product, and the producers in the exporting country, who are expanding their production as they are receiving a higher price in the international market. Among the losers are the consumers of the export-oriented industry and the import-competing producers.

  1. Assume that there are only two countries in the world, Pacifica and Atlantica. Both countries produce and consume surfboards. The pre-trade price of surfboards in Atlantica is lower than the pre-trade price of surfboards in Pacifica. Draw a three-graph diagram to depict the Pacifica, Atlantica, and international markets for surfboards illustrating the pre-trade price difference. Now assume that free trade opens up between Pacifica and Atlantica. Depict a plausible world price in the graphs. Using what you have learned about consumer and producer surplus, describe what happens to consumers and producers in each country as a result of the move to free trade. What happens to overall economic welfare in the two countries? Be sure to label and refer to the graphs in your answer.

POSSIBLE RESPONSE:

The above graph illustrates a possible international price. The graph to the left represents demand and supply in Atlantica, the graph in the middle the market in Pacifica, and the graph to the right the World market. The international price of 60 is between the no-trade prices of 40 and 70. The international price is such a price that the excess supply in Atlantica matches the excess demand in Pacifica. As a result Atlantica exports 30 units to Pacifica at a price of 60. Both countries gain from international trade. Atlantica gains area C in the right graph, and Pacifica gains area P.

  1. Carefully explain why nations gain from engaging in international trade. Do nations gain equally from trade? If not,what determines which country gains more? (In your answer you can assume a two-country world.)

POSSIBLE RESPONSE: Demand and supply differ in the two countries and so prices also differ if there is no international trade. With the opening of international trade arbitrage opportunities arise: opportunities to make profit by buying the good cheaper in one country and selling it in another. Due to these opportunities the prices in the two countries equalize. The gain from trade in the importing country arises because consumers in this country gain more than producers lose as a result of the reduced price. Conversely, the gain from trade in the exporting country exists because producers gain more than local consumers lose. In general, nations do not gain equally from trade. The country which experiences a larger change in its price stands to gain more. More precisely, the national gain from trade is proportional to the change in the price that occurs due to the shift from no trade to free trade.

  1. What is the logic of producing winter clothing in countries whose residents have very little demand for such clothing?

POSSIBLE RESPONSE: A country might be interested in the production of winter clothing if this country can export this good in exchange for other goods that cannot be produced at a low cost domestically in this country. This might be due to the specificity of the technology in this country; this country might have an abundance of resources that make the production of winter clothing efficient (low cost), whereas this country might be unable to produce other goods at such a low cost.

  1. China produces shoes at a lower cost than the United States. As a result, most of the shoes purchased in the United States are made in China. Should this be a concern to anyone in the United States? If so, who should be concerned and why? If not, why not?

POSSIBLE RESPONSE:As a result of the free trade between China and the U.S., the price of shoes in the U.S. will be equal to the international price. What are the effects of free trade on producers and consumers of shoes in the United States? As a result of the imports of shoes from China, the price of shoes will be lower (compared to the situation of no trade). Consumers will gain additional consumer surplus due to the lower price and the increased purchases of shoes(consumers’ total surplus is measured by the area below the demand curve for shoes and above the international price). Facing a lower price (the international price), the domestic producers of shoes in the United States will react by decreasing their production of shoes. Hence, there is loss of surplus to producers associated with the opening of trade.Some of the shoe producers might go out of business, which might create temporary unemployment in this industry which will last until the workers producing shoes find employment in another sector of the economy.In general, consumers gain more than producers lose, so there is a net gain for the U.S. of opening to trade.

  1. The difference in the prices of a good in two countries creates opportunities for arbitrage: traders buy the good at a low price in one country and sell it at a higher price in the other. When the difference in the prices vanishes, and the world price is established in both countries, there is no scope for trade anymore because no trader will be willing to buy the good in one country and sell it in another. Discuss the validity of this statement.

POSSIBLE RESPONSE: This is not a valid statement. Consider the countries A and B, and assume that without trade the price of the good is Pa in country A and Pb in country B, where PaPb. With the opening of free trade, the arbitrage possibilities will eliminate the difference in the prices in the two countries. So, the world price, W, will establish itself between the two local prices:

Pa<W<Pb. There will be excess surplus at the price W in country A, and a shortage in country B. Country A will be exporting the good to country B. It is the ongoing trade that keeps the price the same in the two countries.