EXERCISE ANSWERS UNIT 11

UNIT 11
EXERCISE 11.1 AN INCREASE IN THE PRICE OF BREAD (FALL IN
MC)

Eileen Tipoe
UNIVERSITY COLLEGE LONDON

Consider a market in which bakeries supply bread to the restaurant
trade. A new technology becomes available to the bakeries, shifting the
supply curve as shown in the figure.

1. Explain why the bakeries would want to increase sales. Why can
they not do so at the
original price?
2. Describe how the actions of bakeries could adjust the industry to a
new equilibrium. o

3. Is it always the seller who benefits from the economic rents that
arise when the
market is in disequilibrium?
4. What action might restaurants take while the market is not in
equilibrium?

Answer

1. The movement of the supply curve implies there is an excess supply at the
current equilibrium price. Hence, suppliers are willing to sell more than
indicated by the current equilibrium A at this price. However, there are not
enough willing buyers to purchase the quantity that suppliers wish to supply.
Buyers will attempt to seek rents by offering lower prices than the prevailing
price. Suppliers will be competing for these buyers and will begin to reduce
prices to retain or gain sales.

2. Bakers will start to reduce prices and this downward pressure on the price
will cease once there is no possibility of gaining rents by offering different
prices. This will happen once the price falls to the new equilibrium at B where
the excess supply has disappeared.

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3. No, in this case the demanders benefit as they can seek to pay less than they
might otherwise be willing to pay for the bread because of the existence of an
excess supply. In general, the distribution of rents in disequilibrium will depend
on the distribution of relative bargaining power between buyer and sellers.

4. The restaurant might offer a lower price for a loaf of bread to the bakery.
Given there is excess supply and the bakery can increase revenues by selling
extra loaves, the price will decrease. The price will keep adjusting until the new
equilibrium at B is reached.

EXERCISE 11.2 COTTON PRICES AND THE AMERICAN CIVIL WAR

Read again the introduction to Unit 8 and the box about Hayek. Use the
supply-and-demand model to represent:

1. The increase in the price of US raw cotton (show the market for US
raw cotton, a market with many producers and buyers).
2. The increase in the price of Indian cotton (show the market for
Indian raw cotton, a market with many producers and buyers).
3. The reduction in textile output in an English textile mill (show a
single firm in a competitive product market).
In each case, indicate which curve(s) shift and explain the result.

Answer

1. The diagram below shows the shift in the supply curve consequent on the the
blockade of the Confederate states ports. The immediate situation is an excess
demand and rent seeking behavior eventually results in a new equilibrium at B
which has involved a movement along the demand curve.

2. Mill owners started to look for other sources of cotton, which increased
demand in India. The diagram below shows this shift in the demand curve
facing Indian producers. The immediate situation is an excess demand which
results in cotton producers raising their prices in order to capture short-term
economic rents. The result is a movement along the supply schedule to the new
equilibrium at B.

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3. The marginal cost for firms increased due to the increased cost of raw
material (cotton). Since the market supply is the horizontal sum of all individual
firm supply curve (which in turn are their marginal cost curves), the market
supply curve shifts up. The price therefore rises in the market from P1 to P2.

The diagram below shows a competitive firm in the industry. The initial
equilibrium is at A. Since marginal costs for the firm have risen rise the marginal
cost curve (i.e. firm supply curve) shifts upwards and the new equilibrium will
be at B where the new marginal cost curve crosses the new price line (which
indicates the firm’s marginal revenue). Each firm is now producing less output
at a higher market price.

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Exercise 11.3 THE WORLD MARKET FOR OIL

Using the supply and demand diagram:

1. Illustrate what happens when economic growth boosts world

demand (i) in the short run, (ii) in the long run as producers invest in
new oil wells, (iii) in the long run as consumers find substitutes for oil.
2. Similarly, describe the short and long-run consequences of a
negative supply shock similar to the 1970s shock.
3. If you observed an oil price rise, how in principle could you tell
whether it was driven by supply-side or demand-side developments?
How would the diagram, and the response to shocks, be different if
there were:
4. A competitive market composed of many producers?
5. A single monopoly oil producer?
6. An OPEC cartel controlling 100% of world oil production and
seeking to maximize the combined profits of its members?
7. Why would individual OPEC member countries have an incentive to
produce
more than the quota assigned to them?
8. Does this logic carry over to the situation in the real world where
there are also non-OPEC producers?

Answer

1. Using diagram 11.9, an increase in world demand for oil would result in a shift
outwards the demand curve as shown. In the long run the supply curve for oil
will shift outwards which will reduce prices. Finally, if consumers find
substitutes for oil the demand curve will shift inwards. The resulting price may
be above, below or the same as the original price.

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EXERCISE ANSWERS UNIT 11

2. Similarly a supply shock will shift the supply curve to the left which will raise
prices in the short run. In the longer run, the higher prices may incentivize
producers to find new types of oil such as from tar sands or shale. This could
shift the supply curve back to the right.

3. An increase in demand (a shift outwards of the demand curve) or a

restriction in supply (a leftward movement of the supply curve) will both raise
the price, ceteris paribus. However, in the first case, the total amount of oil
transacted in the market will increase whereas in the second case the total
amount of oil transacted will fall. This fact can be used to identify which curve
has shifted.

4. In the case of a competitive industry the first part of the supply curve, which
represents the power that OPEC have in controlling supply, would not exist. The
restriction of supply that OPEC imposes would not apply and there would be a
larger supply of oil. The supply curve would be positively sloped throughout
and further to the right. Prices would therefore be lower.

5. In the case of a monopoly producer of oil, there would not be an industry

supply curve. We would be looking at a single firm facing a demand curve and
the firm would, as in Unit 7, try to find the point of production on the isoprofit
curve at which the profits were maximized subject to the demand constraint. An
increase in demand in this situation would allow the firm to increase its output
and raise its prices but the increase in quantity would not be as great as in the
case of a competitive industry because a monopoly has the power to restrict
supply in order to benefit from an increase in prices.

6. If a cartel controls 100% of world output and profit maximizes on behalf of its
members, it is in fact acting as a monopoly firm. It would set its output at the
same level as a monopoly. The price would be higher than in a competitive
industry and the total quantity supplied would be lower.

7. Within such a cartel, each producer would have an incentive to produce more
because the price set by the cartel would be above the marginal costs of
production. This means that any producer can potentially produce more output
and charge a lower price and increase its profits because the price it could sell
the additional output would still be above the cost of that extra production.

8. In a world, as depicted by the diagram in (1) above, where there are also non-
OPEC producers, the world price may still be some way above cost levels.
Though the price is not as high as would be the case if there were only the OPEC

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producers, nevertheless the incentive to produce beyond one’s quota still exists
because there are profits to be had by increasing output.

Exercise 11.4 THE SHALE OIL REVOLUTION

An important development in the past 10 years has been the re-

emergence of the US as a major oil producer via the “shale oil
revolution”. Shale oil is extracted using the technology of hydraulic
fracturing or “fracking”: injecting fluid into ground at high pressure to
fracture the rock and allow extraction. In a speech on “The New
Economics of Oil” in October 2015, Spencer Dale, Group Chief
Economist at oil producer BP plc, explained how shale oil production
differs from traditional extraction.

1. According to Dale, how has the shale oil revolution affected the
world market for oil?
2. How will the world oil market be different in future?
3. Explain how our supply and demand diagram should be
changed if his analysis is correct.

Answer

1. Dale suggests that shale oil production is far more responsive to price
changes (more elastic) than conventional oil so that price volatility is mitigated.

2. He also suggests that the geographical nature of oil markets has changed –
the US is largely self-sufficient but the eastern markets are increasingly net
importers of oil. He also suggests that OPEC is concerned with protecting its
market share, particularly in response to persistent shocks, and is unlikely to try
to use its power to stabilize prices at a high level.

3. In terms of our supply and demand diagram, the supply schedule is likely to
be less inelastic to reflect the changing conditions of oil production.

Exercise 11.5 SUPPLY AND DEMAND CURVES

1. Use the data from the NWS order book in Figure 11.13 to plot supply
and demand curves for shares. o Spencer Dale. The New Economics of
Oil. https://tinyco.re/4892492.
2. Explain why the two curves do not intersect. October 2015

Answer

1.
Data A continuous double auction order
book: Bid and ask prices for News
Corp (NWS) shares
Source Figure 11.14 in The Core Project.
Ebook. Unit 9: Market
disequilibrium, rent-seeking and
price-setting, p. 32
Publish/download date 8 May 2014
Horizontal axis variable Number of shares

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EXERCISE ANSWERS UNIT 11

2. This is data from the order book i.e. quantity of shares at ask and bid prices
which have not yet cleared. All prices where the bid price equals the ask price
have cleared and the transaction has proceeded, and thus are not logged in the
order book. Therefore we can only plot the data for those prices where trades
do not occur.

Exercise 11.6 MARKETS FOR GEMS

A New York Times article (tinyco.re/6343875) describes how the o Victoria Gomelsky. “On the Origins of
Gems”. tinyco.re/6343875. The New
worldwide markets for opals, sapphires, and emeralds are affected by York Times. March 16, 2014.
discoveries of new sources of gems.

1. Explain, using supply and demand analysis, why Australian dealers

were unhappy about the discovery of opals in Ethiopia.
2. What determines the willingness to pay for gems? Why do
Madagascan sapphires command lower prices than Asian ones?
3. Explain why the reputation of gems from particular sources might
matter to a consumer.
Shouldn’t you judge how much you are willing to pay for a stone by how
much you like it yourself?
4. Do you think that the high reputation of gems from particular
origins necessarily reflects true differences in quality?
5. Could we see bubbles in the markets for gems?

Answer

1. The Australians were unhappy because they were losing their monopoly
power on the supply of white opals. In other words, the discovery in Ethiopia
was a supply shock, which decreased the equilibrium price of opals (ceteris
paribus).

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EXERCISE ANSWERS UNIT 11

2. The classic 4 Cs (colour, clarity, cut, and carat weight), but also the origin of
the gem. Madagascan sapphires are sold for lower prices because they do not
come from historically “established sources” with a good reputation.

3. Firstly, reputation may hide unobserved qualities acquired through long-

term experience in the industry. Secondly, consumers may relate the colour of
the gems with the origin (e.g. Kashmir sapphires). Thirdly, consumers may
relate the stones to the area from history books. Fourthly, some stones may
have gained historical significance and are now used as a reference for
comparison of all other stones.

Some characteristics of the stone are only understood and “visible” to an

expert. Hence, if you abide by this rule, you risk purchasing an objectively
“lower quality” stone.

4. The tone of the article suggests that it does not. The true quality probably lies
in the 4 Cs.

5. Yes, if people believed that price of a (type of) stone will rise, they would
increase demand for the (type of) stone. By their nature, these stones hold
value and can relatively easily be resold. Others will see the rise in price and
may wish to purchase the stones for their increasing resale value. This in turn
will increase the price further, and so on.

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Exercise 11.7 WHAT IS THE FUNDAMENTAL VALUE OF A BITCOIN?

A bubble may have occurred in the market for the virtual currency
called Bitcoin. Bitcoin was introduced by a group of software
developers in 2009. Where it is accepted, it can be transferred from one
person to another as payment for goods and services.

Unlike other currencies it is not controlled by a single entity such as a

central bank, but instead is “mined” by individuals who are willing to
lend their computing power to verify and record Bitcoin transactions in
the public ledger. At the start of 2013, a Bitcoin could be purchased for
about $13. At its peak on 4 December 2013 the same coin was trading at
$1,147. It then lost more than half its value in two weeks. These and
subsequent price swings are shown in Figure 11.20.

o Coindesk.com. 2015. Bitcoin News,

Prices, Charts, Guides & Analysis
(tinyco.re/8792662) and Bitcoincharts
(tinyco.re/4434190). Both accessed
August 2016.

Figure 11.21 The value of Bitcoin (2013-2015).

Use the models in this section, and the arguments for and against the
existence of bubbles, to provide an account of the data in Figure 11.20

Answer

In the few months following September 2013, there was a lot of optimism about
Bitcoin as the new currency. At the same time, there was little information on
what Bitcoin actually is, how it works, and what it can be used for. Taken all
together, there was optimism in the markets, which increased demand and
hence increased prices, creating expectations about future price increases,
further increasing demand and prices and so on. This is what we see in the
second half of 2013 in Figure 9.20 (now Figure 11.21) and is illustrated in Figure
1 below. Note that supply is relatively inelastic, because mining new Bitcoins
takes a long time.

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EXERCISE ANSWERS UNIT 11

Since then, more information became available and many investors realized
the limitations of Bitcoin as a new currency and its use for funding illegal
activities. We see the price declining and stabilising at around $200/share.
Demand thus decreased and investors sold their shares (supply increased),
dampening the price. This is illustrated in Figure 2 below.

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EXERCISE ANSWERS UNIT 11

EXERCISE 11.8 THE BIG TEN ASSET PRICE BUBBLES OF THE LAST
400 YEARS
o Charles P. Kindleberger. 2005. Manias,
Panics, and Crashes: A History of
According to Charles Kindleberger, an economic historian, asset price Financial Crises (Wiley Investment
bubbles have occurred across a wide variety of countries and time Classics). Hoboken, NJ: Wiley, John &
Sons.
periods. The bubbles of the last 100 years have predominantly been
focused on real estate, stocks, and foreign investment.

• 1636: The Dutch tulip bubble

• 1720: The South Sea Company
• 1720: The Mississippi Scheme
• 1927–29: The 1920s stock price bubble
• 1970s: The surge in loans to Mexico and other developing
economies
• 1985–89: The Japanese bubble in real estate and stocks
• 1985–89: The bubble in real estate and stocks in Finland,
Norway and Sweden
• 1990s: The bubble in real estate and stocks in Thailand,
Malaysia, Indonesia and several other Asian countries between
1992 and 1997, and the surge in foreign investment in Mexico
1990–99
• 1995–2000: The bubble in over-the-counter stocks in the US
• 2002–07: The bubble in real estate in the US, Britain, Spain,
Ireland, and Iceland

Pick one of these asset price bubbles, find out more about it, and then:
1. Tell the story of this bubble using the models in this section.
2. Explain the relevance to your story, if any, of the arguments in the
‘Do bubbles exist?’ box in Section 11.7 about the existence of bubbles.

Answer

1. Tulips have been grown in Europe since around mid-sixteenth century. Due o Wikipedia: http://tinyco.re/5674474.
to the fact that tulips in Europe only bloom in April and May, tulip traders began o The Economist. 2013. Was Tulipmania
to sign (essentially) futures contracts to buy the flowers at a pre-determined Irrational? http://tinyco.re/2563631
price. By 1634, the demand for Dutch tulips rose significantly and speculators
began to trade the futures contracts. Due to the speculation in the futures
markets, the demand and price of tulips skyrocketed in 1636.

In February 1637, the price of the flowers started falling rapidly. The reasons for
this fall are still a matter of controversy. Some argue this is simply because
demand at such high prices dried up. Others argue this was a standard price-
cycle for flowers. In any case, many traders went bankrupt immediately.

2. Some argue that prices simply followed the growing cycle of the flowers. This
was supported by (limited) data on prices of the hyacinth flower, which
followed a similar pattern. Hence, there was no real mania and markets for
tulips were still efficient.

On the other hand, investors buying futures contracts had an interest to drive
the price of the bulbs up, since they could have then sold the contracts at a
higher price. Hence, they might have willingly driven the prices of the tulips up,
unwilling to “lean against the wind”.

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EXERCISE 11.9 IOC POLICY

1. Do you think the IOC policy of using a lottery is fair?

2. Is it Pareto efficient? Explain why or why not.
3. Using the criteria of fairness and Pareto efficiency, how would you
judge the widely criticized practice of “scalping” tickets.
4. Can you think of any other arguments for or against scalping?

Answer

1. To the extent that everybody had equal access to purchasing the tickets and
an equal chance of receiving them the process can be regarded as fair. With a
significant excess demand of this type some kind of rationing mechanism is
necessary and a lottery is a way of providing a random allocation rather than
prioritizing in some other way.

2. It is not Pareto efficient. Compared to choosing a market-clearing price or

allocation based on bidding, this system made people who were willing to pay
more for tickets but were unable to buy them due to high demand worse off.

3. It is often argued that scalping is unfair because it deprives poorer spectators

the chance of seeing the performance. Tickets are often priced low to
encourage wide participation. Scalping is also often considered unfair because
of the high rents that scalpers acquire are generated by work done by others
(e.g. musicians in concerts). On the other hand, if prices in the secondary
market end up being lower than expected then scalping could lead to an
allocation which favours poorer sections of the community.

To the extent that scalping redistributes tickets to those who value them most,
it moves the market towards market-clearing which would be a Pareto efficient
outcome.

4. For: it is simply a market transaction as any other and there is no economic

reason to ban it; people who did not manage to buy ticket at the face value are
negligent; banning ticket scalping would lead to emergence of illegal markets.

Against: may lead to other criminal activities – for example bribery to obtain
tickets at the point of sale; it may encourage fraudulent tickets; tax revenues
are uncollected on these sales.

EXERCISE 11.10 THE PRICE OF A TICKET

Explain why the seller of a good in fixed supply (such as concert tickets
or restaurant reservations) might set a price that the seller knows to be
too low to clear the market.

Answer

• Uncertain demand: sellers are often not able to estimate demand for
tickets precisely. Hence, they sell the tickets at a value that covers their
costs and ensures that all tickets are sold.
• Prestige: major sporting events and celebrities whose events are recorded
on TV may want to be perceived as popular, hence they need a sold-out
event.

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EXERCISE ANSWERS UNIT 11

• Social goal: the seller may want to appeal to the “common person” e.g.
may want to build the image of a socially committed company.
• Retaining long-term customers: long-term customers are likely to buy
tickets even if demand from the relatively wealthier (and possibly less
enthusiastic) customers decreases.

EXERCISE 11.11 WHY NOT RAISE THE PRICE?

Discuss the following statement: ‘The sharp increase in cab fares on a

snowy day in New York led to severe criticism of Uber on social media,
but a sharp increase in the price of gold has no such effect.’

Answer

Gold is considered a luxury and it is expected that its price is high. It is also
thought of as an asset which holds and increases its value because of its
relative scarcity so rises in its price are not surprising. Moreover, the price of
gold is set by world market transactions and so large rises in price are not
perceived as profiteering by any particular firm.

Taxi rides are not considered to be luxury goods although they may in some
countries be one of the more expensive forms of public transport. The fact that
a firm (Uber) may raise its prices at a time of high demand may be perceived as
profiteering at a time of need. A similar example is that of Coca Cola and
variable pricing machines (http://tinyco.re/8567364)

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