Question

Consider the retail market for bananas in Australia in 2020. The market is in equilibrium with 20,000 tonnes being bought and sold per year at a price of $4 per kg.

a. Explain why $5 per kg for bananas is not an equilibrium price. Given the current demand and supply, if the price was temporarily $5 per kg, explain how the market would return to equilibrium.

b. Explain why the production/consumption of 20,000 tonnes of bananas is the socially efficient level of production (assuming there are no externalities).

c. Suppose that in 2021 price of diesel increases, increasing the transportation costs for banana farmers in getting their bananas to market. Explain why there would be any movement in the demand or supply curve and any change in the equilibrium price and quantity for bananas after the increase in the price of diesel.

Answer 1

a) As given the Equilibrium Price is $4. At Equilibrium Price Quantity Demanded and Supplied are equal. If price rise to $5 then Quantity Demanded will decrease, due to law of demand. Supply still being more than demand, will result in Surplus. As a result price will again reduce, following law of demand. Again Equilibrium Price of $4 will be attained.The equilibrium price is the market price where the quantity of goods supplied is equal to the quantity of goods demanded. This is the point at which the demand and supply curves in the market intersect. Economic equilibrium is a situation in which economic forces such as supply and demand are balanced and in the absence of external influences the values of economic variables will not change. ( For reference, law of demand states that, conditional on all else being equal, as the price of a good increases, quantity demanded decreases; conversely, as the price of a good decreases, quantity demanded increases ).

b) The socially efficient level of output is that quantity that maximizes the sum of the consumer and producer surpluses. It is the most efficient output level because the marginal social benefit of producing and consuming another unit equals the marginal social cost. Consumer surplus is the excess benefit consumers get from paying less than what they are willing and able to pay. Producer surplus is the excess benefit producers get from producing at a cost less than what consumers pay for the product. Welfare is maximized at the equilibrium where Quantity Demanded equals Quantity Supplied. This is because, the incremental benefit consumers get from consumption is equal to the incremental cost producers take to produce the good. Total surplus is maximized when the price equals the market equilibrium price.

c) With the increase in the transportation costs the cost of production of bananas will increase. This will result in making the supply expensive thus reducing the supply. As a result supply curve of bananas will shift Upward denoting a reduction in supply. Since the supply has decreased but demand remains the same, as a result demand will exceed supply. This will result in rise in price of bananas due to law of demand. This will also result in upward movement along demand curve.Upward movement along a demand curve implies reduced quantity demanded. This generally occurs due to price increase of the commodity. As a result Equilibrium Quantity Demanded and Supplied will reduce and Equilbrium Price will rise.