Suggestions for problem set 5

This problem set brings together supply and demand to address **the price and quantity of each good in the short run** and the factors that cause the price and quantity to change in the short run.

If there are no constraints on price and output, they are determined by the market demand and supply curves. The prior topic focused on the determinants of the market supply curve. What determines the supply curve for each firm in the short run? By now, it should be ingrained that the** firm short-run supply curve is the marginal cost curve above the average variable cost curve**. The market supply curve is simply the sum of the quantity supplied by each firm at each possible price. It is the aggregation of the individual firm marginal cost curves above their average variable cost curves. Problem 1 provides a numerical example which requires you in part a to derive the supply schedule of each firm and in part b to derive the market supply schedule. You are given the firm’s cost schedule, from which you should be able to derive the relevant cost curves to derive the firm supply schedule. You are told there are 50 identical firms in the market. Given the firm supply schedule, how much will the 50 identical firms supply at each price? This defines the market supply schedule. Part c asks you to compute the price. The price is expected to occur where the quantity supplied and quantity demanded are equal, so it requires bringing together the market supply and demand curves on the same graph. Where do they cross, which defines the equilibrium price and output? Part d asks you to compute the quantity supplied by each firm, which follows directly from the firm supply curve given the price. Part e asks you whether firms earn positive or negative profits, which requires you to compute each firm’s profits. Profits equal total revenue, which is price times quantity, minus total costs. You have previously derived both price and firm quantity. You are given the firm’s total cost schedule, and thus based on its quantity you can simply read off its total costs from the total cost schedule and thus compute its profits.

Problems 2 and 3 deal with factors that could **shift either supply or demand and thus affect the market price and output**. To derive the effect of an event on price and output, first determine how the event shifts either the demand or supply curve. Then represent the shift on a graph and compare the price and output where the supply and demand curves originally crossed with where they cross after the event. Following this process will provide a reliable way to determine the effect of an event on the market price and output. The key is to determine how the event shifts the supply or demand curve. The factors shifting these curves (in the short run) are developed in detail on pages 171-179 of the textbook. Review these to make sure you are comfortable with them. Problem 2 provides you with an event and asks you to trace through the effects of the event on market supply and demand curves and prices and outputs, which you should be able to do following the above reasoning. Problem 3 reverses the problem, reporting the historical change in price and output in one market and asking for events that could explain these changes. First ask what kind of demand and/or supply shifts are required to generate the observed price and output changes, and then ask which events would give rise to the required shifts.

Problem 4 addresses four possible programs that might affect the market for new homes. You are asked questions about how each program would affect the market quantity and price. To analyze this, consider how each program would affect the market demand and/or supply curve and then trace through the effects of the shifts in these curves on the market price and output. The first three events shift either the market supply or demand curve. The fourth constrains the way the market operates. The effects of a ceiling price on the market price and output are developed in the textbook on pages 192-194.

Problem 5 requires a precise analysis of how changing the tax treatment of interest shifts the market supply and demand curves, particularly part c. You need to exploit the following idea. Suppose a good sells at some price and in addition to the price you pay to sellers, you have to pay an additional amount to the government in the form of a tax of say $50 for each unit of the good you purchase. The effective price to you of the good is then the price plus $50. So if the price of the good is $100, the effective price to you is $150, and the quantity of the good you demand at a (sale) price of $100 is based on how much of the good you want to purchase at a total price of $150. If the tax were eliminated and the sale price were $100, the effective price would only be $100, which is $50 lower than the old effective price. At the unchanged sale price of $100, you would then demand a greater quantity than you demanded at this price before the elimination of the tax. Indeed, at a sale price of $100 after the elimination of the tax, you would demand the same amount you demanded at a sale price of $50 before the elimination of the tax since the effective price to you at a sale price of $50 before the elimination of the tax was $100. Thus, with the elimination of the tax, the amount you would demand at $100 is equal to the amount you previously demanded at $50 (before the elimination of the tax). The same reasoning applies to how imposing or doing away with a subsidy would affect the quantity demanded and quantity supplied if the subsidy were provided to sellers.

Quiz 5 tests your understanding of what events shift the market demand and supply curves and how in turn such shifts affect price and output in the short run.