Suggestions for problem set 6

 

This problem set develops the factors that determine price and output in the long run, when the time interval for production is long enough that all inputs to production can be variedói.e., there are no fixed costs.

 

The process of long-run adjustment through entry and exit of firms is developed on pages 230-234 of the textbook. The process of long-run adjustment is depicted graphically in Figure 15-4 on page 232. Review this figure carefully. What does the price have to equal in the long run, in terms of the firm cost curves, in order for firms to be earning zero pure profits? If firms are not earning zero pure profits, there will be entry or exit and hence the market will not be in long-run equilibrium. Thus, the key to long-run equilibrium is that the price is such that firms earn zero pure profits. To reiterate, based on Figure 15-4, what does the price have to equal in terms of firm costs, in order for the firm to be earning zero pure profits. This is the long-run equilibrium price.

 

Problem 1 involves a numerical example in which you are required to compute the long-run equilibrium price. You first need to compute the firmís average total curve. Then you are asked to compute the equilibrium price assuming 50 firms in the market. To do this, compute the market supply curve as in problem set 5 and see where it intersects the market demand curve, which defines the equilibrium price. Part b asks whether the market would be in long-run equilibrium at the price that would prevail with 50 firms in the market. What must be true about firm profits for the market to be in long-run equilibrium? Compute whether this condition is satisfied at the price that would prevail with 50 firms in the market? Part c asks what the price would be in the long run, which is equivalent to asking what the long-run equilibrium price will be. What does it equal generally, and what will it equal for this numerical problem? Once you have determined the long-run equilibrium price, you should be able to compute the answers to parts d and e from the market demand curve and the firm total cost schedules.

 

Problem 2 gives you a price and asks how much will be supplied at this price in the short run by two firms with different cost schedules. You should be quite familiar with how firms make short-run supply decisions and thus should be able to compute how much each firm will supply in the short run. Part b asks about the price in the long run. Recall that the long-run equilibrium price requires all firms that remain in the market to earn zero pure (i.e., economic) profits. At what price will Locklin supply at an output at which it earns zero economic profits? At what price will Jones supply an output at which it earns zero economic profits? If the higher of these two prices prevails, will both firms remain in the market? Will both earn zero economic profits? If the lower of the two prices prevails, will both firms remain in the market? If not, what is the level of economic profits earned by the firm that remains in the market? Which of the these two situations satisfies the conditions for a long-run equilibrium? Use your answer to this question to answer parts b and c of Problem 2.

 

Problem 3 requires you to analyze how two different types of taxes on producers affect price in the short run and in the long run. For each type of tax, to analyze its short-run impact you need to consider how it would affect each firmís short-run supply curve and in turn the market supply curve. Again, you should be familiar with the determinants of the firmís short-run supply curve and how different kinds of taxes affect the curve. You should also be familiar with how you would graphically analyze the effect of any change in the market supply curve in the short run on the equilibrium price. To analyze the impact of each kind of tax on the long-run equilibrium price, you need to consider what determines the price in the long run and how each type of tax would affect the relevant factor(s). Quiz 6 probes your understanding of the factors that cause changes in supply, demand, and price and output in the long run.

 

Problem 4 requires you to analyze the effect of an import quota on Japanese cars on the U.S. automobile market. First, what will happen to the quantity supplied of cars at the pre-import quota price for Japanese cars as a result of the quota? How would this be expected to affect the price of imported Japanese cars? If Japanese cars are imperfect substitutes for U.S. cars, how will this affect the demand for U.S. cars and how in the short run will it affect firm supply curves for U.S. cars? In addressing the latter question, reflect on the basis for the short-run firm supply curve and whether the ramifications of the import quota on Japanese cars will affect the basis for the firm short-run supply curve. After considering the short-run effects of the import quota, you are then asked to consider the long-run effects. Entry and exit occur in the long run if the conditions for a long-run equilibrium do not prevail. You are told that prior to the import quota the U.S. automobile industry was in long-run equilibrium, which means that all firms were earning zero economic profits. Part c asks you to consider whether firms will continue to earn zero economic profits in the short run after the imposition of the quota. If not, you need to analyze whether entry or exit will occur in the long run after the imposition of the quota and how the price that will prevail after entry and exit cease compares to the price before the imposition of the import quota.

 

Problem 5 requires a similar kind of analysis to problem 4, except the event that you must consider is the elimination of a tax on producers.