14.01 Fall 2010 Problem Set 1 Solutions

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1 14.01 Fall 2010 Problem Set 1 Solutions 1. (25 points) For each of the following scenarios, use a supply and demand diagram to illustrate the effect of the given shock on the equilibrium price and quantity in the specified competitive market. Explain whether there is a shift in the demand curve, the supply curve, or neither. (a) (5 points) An unexpected temporary heat wave hits the East Coast. Show the effect in the ice cream market in New England. The temporary heat wave shifts the demand curve to the right from D to D. As a result, equilibrium price and quantity both go up. (b) (5 points) The government introduces a tax on ice cream which is paid by producers. What is the effect in the ice cream market? The supply curve shifts up from S to S by the amount of the tax. As a result, the equilibrium price increases and the equilibrium quantity decreases. However, the rise in the equilibrium price from P to P is smaller than the tax. (c) (5 points) China and Mexico are major producers of textiles. Workers in Mexico decide to go on strike. Show the effect on the market for Mexican textiles. The supply curve for Mexican textiles shifts to the left. This results in a higher equilibrium price and lower equilibrium quantity in the market for Mexican textiles. (d) (5 points) Show the effect of the situation described in (c) on the market for Chinese textiles. The demand curve for Chinese textiles shifts to the right. This results in a higher equilibrium price and higher equilibrium quantity in the market for Chinese textiles. (e) (5 points) Suppose the government imposes a price cap on bottled water. Show the effect in the bottled water market. 1

2 If the price ceiling P is set below the equilibrium price P, then there will be a shortage of bottled water in the amount of Q 1 Q 2 and bottled water will be rationed. If the price ceiling is above the equilibrium price, then there is no effect. Problem 1 solution courtesy of William Wheaton. Used with permission. 2. (20 points) For each of the following pairs of goods, identify which one you would expect to have more own-price elastic demand. Please explain your reasoning. (a) (5 points) Computers (generally) vs. Apple MacBook Pro laptops. Apple MacBook Pro, because it is a specific brand and has more substitutability. (b) (5 points) Stereo headphones (generally) vs. hearing aids. Stereo headphones, since they tend to be less of a necessity good than hearing aids. For each of the following goods, identify whether you would expect demand to be more (own-price) elastic in the short run or the long run. As above, please briefly explain your reasoning. (c) (5 points) Retail gasoline in the suburbs of Chicago. More price elastic in the long run, because people cannot effectively adjust to necessity goods like gasoline in the short run, while in the long run, people can substitute it with electricity (hybrid cars), diesel, public transportation, etc. (d) (5 points) Air conditioning units in Miami Beach, Florida. More price elastic in the short run, because there are other good substitutes in the short run, such as fans. If there were a sudden increase in the price of A/C units, people could delay their purchase of a unit for a few days or weeks. But in the long run, there is no good substitute for A/C. Problem 2 solution courtesy of Luke Stein. Used with permission. 3. (30 points) Consider the market for apple juice. In this market, the supply curve is given by Q S = 10P J 5P A and the demand curve is given by Q D = P J + 10P T, where J denotes apple juice, A denotes apples, and T denotes tea. (a) (7 points) Assume that P A is fixed at \$1 and P T = 5. Calculate the equilibrium price and quantity in the apple juice market. We have the system of equations Q = 10P J 5 1 and Q = P J Solving for P J and Q we get that P J = 6.2 and Q = 57. (b) (7 points) Suppose that a poor harvest season raises the price of apples to P A = 2. Find the new equilibrium price and quantity of apple juice. Draw a graph to illustrate your answer. 2

3 We now have to solve the system: Q = 10P J 10 Q = P J Solving for P J and Q we get that P J = 6.4 and Q = 54. In a supply and demand graph, the supply curve shifts to the left, resulting in the higher equilibrium price and lower equilibrium quantity. (c) (8 points) Suppose P A = 1 but the price of tea drops to P T = 3. Find the new equilibrium price and quantity of apple juice. Q = 10P J 5, Q = P J P J = 5.4, Q = 49. (d) (8 points) Suppose P A = 1, P T = 5, and there is a price ceiling on apple juice of P = 5. What is J the excess demand for apple juice as a result? Draw a graph to illustrate your answer. Note that the price ceiling will be binding, since the equilibrium price from (a) is P J = 6.2. Plugging the price ceiling level into the supply and demand equations we get that Q S = 45 and Q D = 75. Hence, there will be excess demand for apple juice of Q E = 30. The graph in Question 1(e) shows the identical case as the one here. Problem 3 solution courtesy of William Wheaton. Used with permission. 4. (25 points) You have been asked to analyze the market for steel. From public sources, you are able to find that last year s price for steel was \$20 per ton. At this price, 100 million tons were sold on the world market. From trade association data you are able to obtain estimates for the own-price elasticities of demand and supply on the world markets as 0.25 for demand and 0.5 for supply. Assume that steel has linear demand and supply curves throughout. (a) (10 points) Solve for the equations of demand and supply in this market and sketch the demand and supply curves. Assume that this is a competitive market and assume that demand and supply are linear. Thus, X d = a bp and X s = c + dp. We know from the equation for own-price elasticity of demand that dx d P X P X 20 = = b = b = 0.25 dp X X d X d 100 Solving for b, then, we have b = Substituting back into the equation for demand, X d = a 1.25P or 100 = a 1.25(20). Solving for a we have a = 125. Hence, the equation for last year s demand is X d = P. We know that the price elasticity of supply is dx s P X 20 = = d = 0.5 dp X X s 100 3

4 Solving for d, then, we have d = 2.5. Substituting back into the equation for supply, X s = c+2.5p or 100 = c + 2.5(20). Solving for c, we have c = 50. Hence, the equation for last year s supply is X s = P. (b) (15 points) Suppose that you discover that the current price of steel is \$15 per ton and the current level of worldwide sales of steel is 150 million tons. The most recent elasticity estimates from the trade association this year are for demand and 0.25 for supply. Describe the change in the supply and demand curves over the past year using your diagram from part (a). What sort of event(s) might explain the change? Using the same functional forms as in the first part of the answer, with the new data we find that X d = a bp becomes 150 = a b(15). Our equation for elasticity of demand yields dx d P X P X 15 = = b = b = dp X X d X d 150 Solving for b yields b = Substituting this value for b into the equation for (linear) demand, we have 150 = a 1.25(15) or a = Hence, X d = P. For supply, we have X s = c + dp or 150 = c + d(15). The equation for elasticity yields dx s P X 15 = = d = 0.25 dp X X s 150 Solving for d yields d = 2.5. Substituting this value for d into the equation for linear supply, we have 150 = c + 2.5(15) or c = Thus, X s = P. The demand and supply have kept the same slope as last year, but the intercepts have changed for both curves: demand and supply have shifted out. The demand shift could occur with any number of factors that increase the willingness to pay for steel at any given price, such as an increase in income, an increase in the price of other (substitute) materials, or the increase in demand for a good that requires steel as an input, like cars. The supply shift could occur with any of a number of factors that increase the willingness to produce steel for the markets at a given price, such as an increase in the number of firms that sell steel, or a decrease in the prices of inputs required to produce steel (such as steel workers wages). Problem 4 solution courtesy of Luke Stein. Used with permission. 4

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