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Econ101_W10_Quiz2_solutions

# Econ101_W10_Quiz2_solutions -...

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Unformatted text preview: Economics 101 Section 400  Winter 2010    Quiz 2   Solutions  For discussion in section, February 4th and 5th  Name:______________________________________  Section:________________  Consider the market for gasoline in Michigan.  Assume that the marginal value of  gasoline decreases as the quantity of gasoline consumed increases, and that the  opportunity cost of supplying the marginal gallon of gasoline increases as more gasoline  is supplied.  In each of the following questions, assume that the gasoline market initially  attains equilibrium at a price of \$2.60/gallon.    (a) Draw a diagram showing the shape of the demand curve for gasoline (measured  in gallons/day) and the shape of the supply curve for gasoline (also measured in  gallons/day).  Identify the equilibrium market price on your diagram.        (b) Ethanol is derived from corn syrup and is used as an additive in regular gasoline.   Suppose the price of ethanol rises.  Will this generate an excess supply or excess  demand for gasoline at the price of \$2.60/gallon?  Explain why.  How do you  think the price of gasoline will adjust?  What will happen to the quantity of  gasoline sold each day?    Since ethanol is an input into gasoline, an increase in its price will increase the marginal  opportunity cost associated with the production of each unit of gasoline, thereby  implying a leftward shift in the supply curve.  At the previous equilibrium price of  \$2.60/gallon, this will lead to excess demand for gasoline since suppliers are willing to  supply less gasoline at any given price and demand is unchanged.  Excess demand will  cause consumers to bid up the price of gasoline until the new equilibrium is reached  where quantity demanded and supplied are equal.  At this higher price, quantity  demanded and supplied will be less than when the price was \$2.60/gallon.      A decrease in the price of cars leads naturally to an increase in quantity demanded of  cars.  Since cars and gasoline are complements, this also leads to an increase in  consumers’ marginal valuation of gasoline and the demand curve for gasoline shifts  right.  At the previous equilibrium price, this produces excess demand for gasoline.   Consumers will consequently bid up its price until a new higher equilibrium price is  reached at a larger equilibrium quantity.    (d) Petroleum corporations refine crude oil into a range of products, including both  gasoline and jet fuel.  If the price of jet fuel changes, then, we expect to observe  changes in the quantities of gasoline and jet fuel produced.  In addition, we  expect that the price of air travel will be affected by the price of jet fuel, and that  air travel and gasoline are substitutes in consumption.  If the prices of jet fuel  and air travel rise, would we observe an excess supply or excess demand for  gasoline at the price of \$2.60/gallon?  Why?   How do you think the price of  gasoline will adjust?   What will happen to the quantity of gasoline sold each  day?    An increase in the price of jet fuel will raise the marginal OC of producing gasoline for  passenger cars, thereby implying a leftward shift in the supply curve for gasoline.  By  itself, this creates a shortage of gasoline at the previous equilibrium price (i.e. excess  demand).  Moreover, if increased jet fuel prices increase the cost of air travel, this will  reduce demand for air travel as consumers substitute toward travelling by car, which in  turn raises consumers’ marginal valuation of gasoline.  Hence, the demand curve for  gasoline will shift right and aggravate the excess demand situation at the former  equilibrium price.   Both effects will unambiguously lead to a higher market price for  gasoline as consumers bid for the scarce good.  Whether the equilibrium quantity  transacted in the market rises or falls will depend on the relative magnitude of the two  effects.                    (c) Suppose that cars and gasoline are complements.  Following a spate of  embarrassing recalls, prices of cars produced by the major manufacturers begin  to fall in Michigan.  Will this generate an excess supply or excess demand for  gasoline at the price of \$2.60/gallon?  How do you think the price of gasoline will  adjust?   What will happen to the quantity of gasoline sold each day?  ...
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