Homework 2Market Equilibrium and ShocksEcon 101Professor Guse1. This question is taken verbatum from the study guide accompanying the 1967 edition of theclassic Economics textbook by Paul Samuelson. We say that in a competitive market, thereis an “equilibrium” price at which demand and supply curves intersect.(a) Why do we single out this intersection and call the price there “equilibrium price ”?What makes this price different from other prices, and what do we mean by equilib-rium?ANSWER. This special price at the intersection is the market clearing price. Itis (usually) the only price at which the quantity demanded of the good is equal to thequantity supplied. We (economists) tend to believe that market forces will push theprice for a good toward this clearing price in equilibrium. Why? When an economicsystem is in equilibrium it means that none of the participants have an incentive tochange their behavior. In the type of market environments we are talking about, thismeans that buyers (demand) have no incentive to change the quantity the buy each pe-riod and suppliers have no incentive to change the quantity they produce and sell eachperiod. Our claim is that the market clearing price is the equilibrium price. To see why,imagine that the price is above the market clearing price. Then the quantity suppliersare willing to bring to market exceeds the quantity demanders are willing to purchase.Suppliers will be left with unsold goods at the end of the trading period. Do they haveincentive to change their behavior? Yes! Unless they want to pay the cost of keepinglarge inventories, at the very least they will have incentive to produce less output inthe next period. Alternatively, they could continue to produce the same amount andlower the post a lower price so that they sell more. Or they may pursue some blend ofthese tactics. Either way, the price and quantity in the next period would move in thedirection of the market clearing price and associated quantity.(b) Is there any reason to suppose that in the actual dealings between buyers and sellersthere will be foreces at work tending to push price to this level? If so, what are thoseforces? E xplain as c arefully as you can.2. Consider the market for gasoline. For each of the following shocks, draw a diagram illustratingthe direction of change in price and quantity of gasoline traded. Note that for some, theremay be more than one correct answer, so be sure to explain your reasoning.(a) World income increases causing a outward shift in the demand for crude oil. (Crude is aninput in the production of gasoline.)ANSWER One possible answer. Demand for crude1shifts out (and up). Ceteris paribus, this means the new equilibrium price of crude willbe higher. Since crude oil is an input in the production of gasoline, we should see a shiftin (and up) in the supply of gasoline. This leads to a higher price and lower quantityexchanged of gasoline. COMMENT 1 Have we described the story with causalityin the right direction? Maybe not. World income increases should have its first-orderinfluence on final products and services. In other words, there is good reason to thinkthat an increase in world income will lead to an outward shift in the demand for thingslike car travel, jet travel, larger homes, and freight transport and therefore gasoline, jetfuel, heating oil and deisel. The incre ased demand for these refined products should inturn increase their price which in turn shifts out the demand for the input, crude oil. Soa slightly more sophisticated look at the increased demand for refined products mightask whether, for example, the outward shift in the demand for gasoline was greater orless than the average outward shift in the demand for other refined products (deisel, jetfuel, etc.). What do I mean by this? How would you measure it? and why do we care?Suppose the really big jump in demand was in freight transport and therefore diesel fueland there was only a small direc t outward shift in the demand for personal transport(and therefore gasoline). This would indeed put upward pressure on the price of crudeoil, which normally (in ceteris paribus world) would mean a shift up in the supply curveof gasoline. However ceteris is not paribus. Besides the upward pressure on gasoline’ssupply curve because of the increase in the price of oil, there may also be some counterveiling downward pressure on that supply curve to the extent that deisel and gasolineare complements in production in the short run.1Moreover there is the simultaneouslyoutward shift in the demand for gas.2So what do we have? Suppose we knew theupward pressure on the supply cureve for gas was greater than the downward pressure(because the complement in production effect is small), then we would certainly be ableto say that the new price of gas is going to be higher. But the quantity movementis less certain. The supply shift pushes quanitity lower while the demand shift pushesquantity higher. Now overall the quantity of crude oil should be increasing, so we expectoverall to have more refine pro ducts, but not necessarily in a uniform manner. All theprices (for LPG, gas, deisel, jet fuel, heating oil) will probably be higher, but in someof these markets the supply shift due to the increased price of crude will overpower thedemand shift and quantities may be lower. COMMENT 2 Global versus local. Crudeoil trades in a truly integrated world market. It is very difficult for the price of crude oilto be radically different in Texas than it is in Indonesia (adjusted for grade of course).This is b e cause demanders of crude oil have the freedom to order it up from whom everis offering the best deal. That freedom derives from low to non-existent trade barriersand ability of modern tankers and pipelines to carry the stuff over long distances at low1Without knowing how easily and in what time frame a oil refineries can shift the proportion of crude they makeinto various refined products, we cannot say precisely whether two refine products are su bstitutes or complements inpro d uction. However, I think it is safe to say that the longer the length of run the more subs titutes in productionthere will be.2Both because of the primary income motivate increase in demand for personal transport and also because dieseland gasoline are substitutes in consumption2cost.3That said, this is less true for refined products. Refineries tend to be locatedcloser to where the final products are consumed.