Monday, June 13, 2011

Supply & Demand

A question on a recent exam in my online Introduction to Micro Economics course asked:

If the price of a product increases, we would expect

A. the level of demand to decrease.

B. quantity supplied to increase.

C. the level of supply to increase.

D. an increase in quantity demanded.

The correct answer here was B. quantity supplied to increase. However, one of my students chose option A. the level of demand to decrease and then sent me an email asking why here answer was incorrect.

Here is what I replied:

An increase in price, other things being equal, will cause suppliers to increase the amount they are producing and selling. The idea here is that existing producers can make more profit by producing and selling more while other, less efficient, producers who could not make the product profitably at the current price will be able to make a profit at the new, higher price.

You confused "level of demand" or "demand" with "quantity demanded". "Demand" refers to the entire demand curve and this only changes when the entire curve shifts.

"Quantity demanded" refers to a movement along an existing demand curve.

The same is true of supply. "Supply" or "level of supply" which refers to the entire curve while "Quantity supplied" refers to movements along the curve.

In this question all we know for sure is that the price has changed and there is no indication that the curves have shifted so the answers referring to "Level" of demand or supply don't apply. Of course, since the price has risen the answer "an increase in quantity demanded" is wrong which leaves "quantity supplied to increase" as the only possible answer.

What has happened here could be a government imposed price floor in which a law is passed making it illegal to sell below a certain price and that price has been set above equilibrium. Or it could be a cartel (a group of suppliers coming together to agree not to sell below a certain price - this is illegal in the U.S.) like OPEC and the new agreed upon price is above equilibrium.

Finally, it could be a shift in the supply and/or demand curve which results in a new, higher equilibrium price. Any one of these will result in an increase in the quantity supplied as explained in the first paragraph. However, there is nothing in the question that indicates this, so all we have to go on in selecting an answer is the fact that the price has risen.

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