Demand, Supply and Elasticity: Question 2
Syllabus 2.1, 2.4
A small dairy farm sells unhomogenised whole milk directly to a local grocery co-operative. The table below shows the quantity of milk that the co-operative's customers demand each week, and the quantity that the farm is willing and able to supply each week, at different prices.
| Price ($ per litre) | Quantity demanded (litres per week) | Quantity supplied (litres per week) | New quantity supplied (litres per week) |
|---|---|---|---|
| 1.00 | 800 | 200 | 500 |
| 1.50 | 650 | 350 | 650 |
| 2.00 | 500 | 500 | 800 |
| 2.50 | 350 | 650 | 950 |
| 3.00 | 200 | 800 | 1100 |
The "new quantity supplied" column shows quantity supplied after a sharp fall in the cost of cattle feed, which allows the farm to profitably supply more milk at every price than before.
(a) At a price of $1.00 per litre, calculate the size of the excess demand in the market for milk (using the original "quantity supplied" column), and explain, using the concepts of rationing and signalling, how the price mechanism would be expected to move the market toward equilibrium. [3]
(b) State the original equilibrium price and quantity of milk (using the original "quantity supplied" column). [2]
(c) State whether the fall in the cost of cattle feed causes a movement along the supply curve for milk or a shift of the supply curve, giving a reason for your answer, and state the direction of this change. [2]
(d) Using the "new quantity supplied" column, state the new equilibrium price and quantity of milk, and describe the overall change in equilibrium price and quantity caused by the fall in the cost of cattle feed. [3]
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Worked solution
Part (a): Excess demand at $1.00 per litre and the price mechanism
At a price of $1.00 per litre, quantity demanded is 800 litres per week and (original) quantity supplied is 200 litres per week. Excess demand is the difference:
This shortage of 600 litres per week signals to the farm that the current price is below the market-clearing level. Buyers want far more milk than is currently available. This excess demand puts upward pressure on price. As price rises toward equilibrium, it performs two functions:
- Rationing: some buyers, at the margin, are no longer willing or able to pay the higher price, so the limited milk available is shared out among those who value it most.
- Signalling: the rising price tells the farm that milk can now be sold more profitably, incentivising it to supply more.
Both effects continue (quantity demanded falling as price rises, quantity supplied rising as price rises) until the shortage is eliminated at the equilibrium price of $2.00.
Part (b): The original equilibrium
Checking each row of the table for where quantity demanded equals original quantity supplied:
| Price | Qd | Original Qs |
|---|---|---|
| $1.00 | 800 | 200 |
| $1.50 | 650 | 350 |
| $2.00 | 500 | 500 |
| $2.50 | 350 | 650 |
| $3.00 | 200 | 800 |
Only at $2.00 do the two quantities match, both at 500 litres per week. This is the original equilibrium price and quantity.
Part (c): Why this is a shift, not a movement
The price of milk itself has not changed anywhere in this scenario. What has changed is the cost of cattle feed, an input used to produce milk. A change in a cost of production is a non-price determinant of supply, so it shifts the whole supply curve; it does not simply move the farm to a different point on the same curve.
Reasoning through the effect: cattle feed becomes cheaper, so the cost of producing each litre of milk falls. At any given selling price, milk is now more profitable to produce than before, so the farm is willing and able to supply more milk at every price. This means the supply curve for milk shifts to the right: supply has increased. This matches the table. At every price row, “new quantity supplied” is higher than “quantity supplied”.
Part (d): The new equilibrium after the shift
Equilibrium after the cost fall occurs where quantity demanded equals the new quantity supplied. Checking the table:
| Price | Qd | New Qs |
|---|---|---|
| $1.00 | 800 | 500 |
| $1.50 | 650 | 650 |
| $2.00 | 500 | 800 |
| $2.50 | 350 | 950 |
| $3.00 | 200 | 1100 |
Only at $1.50 do the two quantities match, both at 650 litres per week. This is the new equilibrium.
Comparing the two equilibria:
- Equilibrium price falls, from $2.00 to $1.50.
- Equilibrium quantity rises, from 500 to 650 litres per week.
This is exactly what is expected from a rightward shift of the supply curve with demand unchanged: the extra milk the farm is now willing to supply at every price can only be sold by moving down the (unchanged) demand curve, so price falls and quantity rises.
Final answers
- (a) Excess demand 600 litres per week; the shortage raises price, which rations the limited milk and signals the farm to supply more, until equilibrium is reached.
- (b) Original equilibrium: price $2.00, quantity 500 litres per week.
- (c) The supply curve shifts right (supply increases), because the fall in the cost of cattle feed makes milk more profitable to supply at every price. This is a shift, since milk’s own price never changed.
- (d) New equilibrium: price $1.50, quantity 650 litres per week. Overall, equilibrium price falls and equilibrium quantity rises.