ANSWERS, SOLUTIONS, AND EXERCISES
PROBLEM SET
1. a. 40 units will be traded since that is all that buyers are willing and able to buy at the
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
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
3. When an (effective) price ceiling is imposed, quantity demanded exceeds quantity
supplied at that ceiling price. To prevent black-market activity, the government would
Opinions may vary, but this seems a very inefficient way of enforcing the ceiling. The
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
5. If the $10,000 subsidy is paid to colleges, the effect would be to shift the supply curve
downward by $10,000 per student. That’s because part of the cost of providing
35
Price per
Year
$31,000
D
S After
Subsidy
S1
A
B
25,000
21,000
36 Instructor’s Manual for Economics: Principles and Applications, 6e
6. a. Total farm acreage in the U.S. is a stock variable, because it measures the quantity
b. Total spending on food in China is a flow variable, because is measures the
c. Total value of U.S. imports from Europe is a flow variable, because it measures the
d. Worldwide iPhone sales is a flow variable, because it measures the number of
e. The total number of parking spaces in Los Angeles is a stock variable, because it
f. The total value of human capital in India is a stock variable, because it measures
g. Investment in new human capital in India is a flow variable, because it measures
7. This student is thinking of the supply of housing as a flow (the number of new homes
built per period), whereas the chapter views the supply of housing as a stock (the
number of homes that exist at a particular moment in time). At any particular time, the
Chapter 4 Working with Supply and Demand 37
8. a. By using $200,000 of your own funds to buy a home, you forego 5% interest on
b. If the price at which you could sell the home rises to $300,000, deciding not to sell
c. If the interest rate rises to 7%, you’ll now forgo 7% on $300,000, costing you 0.07 x
9. a. If you make a $40,000 down payment on a $200,000 home, you’ll be taking out a
mortgage of $200,000 – $40,000 = $160,000. Your annual interest payment on the
b. If the price of the home rises to $300,000 and you still owe the same $160,000 on
your mortgage, then selling the home and paying off the mortgage would give you
$300,000 – $160,000 = $140,000 in cash. This cash could then be invested elsewhere
10. 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
Q Q+500
P1
2
S1 S2
D1
D2
Price of Homes
Q+800 Stock of Homes
AB
C
38 Instructor’s Manual for Economics: Principles and Applications, 6e
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
Q
P2
P1
S1 S2
D1
D2
Price of Homes
b) Interest Rates Fall
Q+500 Stock of Homes
C
A
Chapter 4 Working with Supply and Demand 39
c. If zoning laws prevent construction of new homes in Monotone, the supply curve
Q
P2
P1
S1
D1 D2
Price of Homes
c) Zoning Laws – No New Construction
Q+500 Stock of Homes
C
A
40 Instructor’s Manual for Economics: Principles and Applications, 6e
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
Q
P2
P1
S1
D1
D2
Price of Homes
d) Zoning and Expectations Go Up
Q+500 Stock of Homes
C
A
1
D
Q
P2
P1
S1
D2
D3
Price of Homes
e) Earthquake, People Leaving
Q -2500 Stock of Homes
C
A
Q -1500 Q+500
S2
S3
B
D1
Q
P2
P1
S1
D2
Price of Homes
Quantity of Homes
C
A
Q+2000
S2
D1
Q+5000
Chapter 4 Working with Supply and Demand 41
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
11. For the following answers assume that the existing stock of homes in Houseville, CA
is Q.
a. We start at equilibrium point A, where the price of home is P1 and the stock of
homes is Q. Because Houseville won the award, demand shifts to the right by
Q
P1
S1
D2
Price of Homes
Quantity of Homes
C
A
Q+2000
S2
D1
Q
P2
P1
S1
D2
Price of Homes
Quantity of Homes
C
A
Q+1000
S2
D1
Q+2000
42 Instructor’s Manual for Economics: Principles and Applications, 6e
b. Relaxation of restrictions by the city council does not affect the equilibrium price.
Even though home builders are now allowed to build up to 3,000 new homes, they
choose to build only 2,000 new homes, just enough to meet the increase in
c. Home builders in Houseville build 2,000 new homes as usual (dashed vertical line
at Q+2000), but then an earthquake destroys 1,000 homes in Houseville, resulting
in supply curve S2. Because of the city council restriction, Houseville’s home
d. If events in a., b. and c. all happen at the same time, the new housing stock would
be Q+2000 homes (Q existing homes – 1000 destroyed in earthquake + 3000 new
homes built, the maximum allowed by city council = Q+2000). Said differently,
Q
P2
P1
S1
D2
Price of Homes
Quantity of Homes
C
A
Q+2000
S2
D1
Q+5000
Chapter 4 Working with Supply and Demand 43
12. a. Before any changes in price, the value of equity is equal to the down payment,
$100,000.
c. The new value of your equity is $500,000 – $300,000 = $200,000. The new simple
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
13. a. Your equity in the home is now $150,000, since $500,000 – $350,000 = $150,000.
b. At the end of the three years, you are 3.33 times leveraged, since
c. If the total debt associated with your home is $350,000, then your equity is wiped
out if the price of your home falls to $350,000, a 30% fall. If we start with a price
14. To buy a $300,000 home with a $60,000 down payment, the homeowner must have
a. First, we find that owner’s equity = $300,000 – $240,000 = $60,000, which is
b. The home’s value drops by 15%, so the dollar drop is 0.15 x $300,000 =
$45,000. This puts the new value of the home at $300,000 – $45,000 = $255,000.
44 Instructor’s Manual for Economics: Principles and Applications, 6e
c. To buy a $300,000 home with a $30,000 down payment, the homeowner
borrowed $300,000 – $30,000 = $270,000. The leverage ratio = [value of home] /
[equity in home] = $300,000 / $30,000 = 10. When the home’s value drops by
d. In general, the greater the leverage, the greater the likelihood of becoming
underwater when housing prices fall. In this problem, the home’s value dropped by
the same 15% in both instances. But the homeowner did not go underwater when
MORE CHALLENGING
15. 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
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
16. No. The minimum possible leverage is 1, which is the case in which you finance your
home purchase only with your own funds (i.e. no mortgage). In that case the value of
EXPERIENTIAL EXERCISES
Cross-price elasticities are important in the computer industry. Read the “Personal
Technology” column in Thursday’s Wall Street Journal and find a story that describes a
hardware or software product. Make a list of other products that you think would be
substitutes (positive cross-price elasticity) for the product in the article. Arrange the items in
Chapter 4 Working with Supply and Demand 45