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1. Understanding changes in equilibrium price and quantity Suppose you are an analyst in the oil refinery industry and are responsible for estimating the equilibrium price and quantity of home heating oil. To do so, you must consider factors that can affect the supply of and demand for heating oil. Determinants of the demand for heating oil include household income, the price of an oil furnace (a complementary good for heating oil), and the price of natural gas (a substitute good for heating oil). Determinants of the supply of heating oil include the cost of crude oil and the cost of refining crude oil into home heating oil. Use the graph input tool to help you answer the following questions. You will not be graded on any changes you make to the graph parameters. ( Note : Once you enter a value in a white field, the graph and any corresponding amounts in each grey field will change accordingly.) Initially, the price of natural gas is $10 per 1,000 cubic feet, the price of an oil furnace is $2,000, the average annual household income is $40,000, the cost of crude oil is $25 per barrel of heating oil, and the cost of refining oil is $15 per barrel of heating oil. The equilibrium quantity in this market is 80 thousand barrels of heating oil per day, and the equilibrium price is $40.00 per barrel. Explanation: The market for heating oil is in equilibrium when the price of heating oil is such that the quantity of heating oil demanded equals the quantity of heating oil supplied. In this case, when the price of heating oil is $40 per barrel, the quantity demanded and quantity supplied both equal 80,000 barrels of heating oil per day. Suppose that the cost of refining oil increases from $15 to $25 for each barrel of heating oil produced. Assuming that the rest of the determinants of supply and demand for heating oil remain equal to their initial values, the market will eventually reach a new equilibrium price of $46.00 per barrel. Explanation: The increase in the cost of refining oil increases the cost of producing heating oil. As the cost of producing heating oil increases, firms are willing and able to produce less heating oil at any given market price. This is represented by a leftward shift of the supply curve. If you enter 25 into the Cost of Refining Oil box, you can see this shift. At the initial equilibrium price of $40, consumers still demand 80,000 barrels of heating oil per day, while producers are willing to supply 56,000 barrels per day. This results in a shortage of 24,000 barrels per day, exerting upward pressure on prices. As the price rises, the quantity supplied increases, but the quantity demanded decreases. The new equilibrium is achieved at a price of $46 per barrel and a quantity of 68,000 barrels per day.

In the graph input tool, reset the price of heating oil to its equilibrium value that you found in the first question. Then reset the cost of refining oil to its initial value. ( Hint : When you click in the box, you will see a circular arrow to the left of the box that enables you to reset numbers to their initial values.) Suppose that instead of a change in the cost of producing heating oil, there was a decrease in average annual income from $40,000 to $35,000. If the price of heating oil were to remain at the initial equilibrium price you found in the first question, there would be a surplus of heating oil, which would exert downward pressure on prices. Explanation: A decrease in average annual income leads to a decrease in the demand for heating oil, which is a normal good. On the graph, the demand curve shifts to the left. You can enter 35,000 into the Average Annual Income box to see exactly how demand changes. If you enter the initial equilibrium price of $40 per barrel for the price of heating oil, you can see that at this price, consumers will demand 60,000 barrels of heating oil per day. Because heating oil producers still supply 80,000 barrels of heating oil per day at this price (because the supply curve has not shifted), a surplus of 20,000 barrels of heating oil per day will result. This would exert downward pressure on prices until the market reaches a new equilibrium with 70,000 barrels of heating oil per day at a price of $35 per barrel. 2. Price controls in the Florida orange market The following graph shows the annual market for Florida oranges, which are sold in units of 90-pound boxes. Use the graph input tool to help you answer the following questions. You will not be graded on any changes you make to this graph. Note : Once you enter a value in a white field, the graph and any corresponding amounts in each grey field will change accordingly. In this market, the equilibrium price is $25 per box, and the equilibrium quantity of oranges is 450 million boxes. Explanation: The equilibrium price and quantity of oranges occur at the intersection of the demand and supply curves. Using the graph input tool, you can see that this occurs at a price of $25 per box, which is where the quantity of oranges that producers are willing to supply is equal to the quantity consumers demand (450 million boxes). For each price listed in the following table, determine the quantity of oranges demanded, the quantity of oranges supplied, and the direction of pressure exerted on prices in the absence of any price controls. Price Quantity Demanded Quantity Supplied Pressure on Prices (Dollars per box) (Millions of boxes) (Millions of boxes) 30 225 486 Downward

Price Quantity Demanded Quantity Supplied Pressure on Prices (Dollars per box) (Millions of boxes) (Millions of boxes) 20 675 414 Upward Explanation: At a price of $20 per box, consumers demand 675 million boxes of oranges, but producers supply only 414 million boxes. Therefore, there is a shortage of 261 million boxes. In the absence of a price ceiling, a shortage exerts upward pressure on prices until the shortage no longer exists. At a price of $30 per box, consumers demand 225 million boxes of oranges, but producers supply 486 million boxes. Therefore, there is a surplus of 261 million boxes. In the absence of a price floor, a surplus exerts downward pressure on prices until the surplus no longer exists. True or False: A price ceiling below $25 per box will not prevent the market from reaching equilibrium. True False Explanation: In order for a price ceiling to be effective—that is, for it to prevent the market from reaching equilibrium —it must be set below the equilibrium price. In this case, you found that the equilibrium price was $25 per box. Therefore, any price ceiling below $25 per box would be effective, and any price ceiling set at or above $25 per box would have no effect. 3. Minimum wage legislation The following graph shows the labor market in the fast-food industry in the fictional town of Supersize City. Use the graph input tool to help you answer the following questions. You will not be graded on any changes you make to this graph. Note : Once you enter a value in a white field, the graph and any corresponding amounts in each grey field will change accordingly. In this market, the equilibrium hourly wage is $10 , and the equilibrium quantity of labor is 450 thousand workers. Explanation:

The equilibrium hourly wage and quantity of workers occur at the intersection of the demand and supply curves. Using the graph input tool, you can see that this occurs at a wage of $10 per hour, which is where the quantity of labor that workers are willing to supply is equal to the quantity of labor firms demand (450,000 workers). Suppose a senator introduces a bill to legislate a minimum hourly wage of $12 per hour. This type of price control is called a price floor . Explanation: A legislated minimum price is called a price floor , while a legislated maximum price is called a price ceiling . Because a wage is a kind of price, a minimum wage law is one example of a price floor. For each of the wages listed in the following table, determine the quantity of labor demanded, the quantity of labor supplied, and the direction of pressure exerted on wages in the absence of any price controls. Wage Labor Demanded Labor Supplied Pressure on Wages (Dollars per hour) (Thousands of workers) (Thousands of workers) 12 225 486 Downward 8 675 414 Upward Explanation: At a wage of $8 per hour, firms demand 675,000 workers, but only 414,000 workers want to work. Therefore, there is a shortage of 261,000 workers. In the absence of a price ceiling, a shortage exerts upward pressure on wages until there is neither a surplus nor a shortage. At a wage of $12 per hour, firms demand 225,000 workers, but 486,000 workers want to work. Therefore, there is a surplus of 261,000 workers. In the absence of a price floor, a surplus exerts downward pressure on wage until there is neither a surplus nor a shortage. True or False: A minimum wage below $10 per hour would not prevent the labor market from reaching equilibrium. True False Explanation: In order for a minimum wage to be effective—that is, for it to prevent the labor market from reaching equilibrium—it must be set above the equilibrium wage. In this case, you found that the equilibrium

wage rate was $10 per hour. Therefore, any minimum wage above $10 per hour would be effective, and any minimum wage set at or below $10 per hour would have no effect. 4. Externalities - Definition and examples An externality arises when a firm or person engages in an activity that affects the well-being of a third party, yet neither pays nor receives any compensation for that effect. If the impact on the third party is beneficial , it is called a positive externality. The following graph shows the demand and supply curves for a good with this type of externality. The dashed drop lines on the graph reflect the market equilibrium price and quantity for this good. Shift one of the curves to reflect the presence of the externality. If there are external costs of production, then you should shift the supply curve to reflect the social costs of producing the good; similarly, if there are external benefits from production, then you should shift the demand curve to reflect the social benefits from consuming the good. With this type of externality, in the absence of government intervention, the market equilibrium quantity produced will be less than the efficient quantity. Explanation: A positive externality is a benefit that a third party receives from someone else's economic activity. Graphically, with a positive externality, the demand curve inclusive of external benefits lies above the market demand curve. In the presence of a positive externality, the market equilibrium quantity produced is less than the efficient quantity. The reason for this inefficiency is that the market equilibrium reflects only the private value to each consumer. It doesn’t take into account the fact that some benefits spill over, making other members of society better off. Which of the following generate the type of externality previously described? Check all that apply. The local airport has doubled the number of runways, causing additional noise pollution for the surrounding residents. A microbiology lab has published its breakthrough in swine flu research.

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