Homework 3-

1. Finlandia is a small closed economy. Finlandia produces canned sardines and the domestic demand for sardines in Finlandia is a downward sloping linear line. When the price of sardines is $100 a unit, 50 units of sardines are demanded. When the price increases to $200 a unit, 25 units of sardines are demanded. The domestic supply of sardines in Finalandia is upward sloping with a constant slope of 1. Domestic suppliers are willing to supply 100 units of sardines at a price of $100 per unit.

a. Find the domestic demand and the domestic supply curves for sardines in Finlandia.

b. What is the equilibrium price and quantity in the domestic market for sardines?

c. What is the value of consumer surplus, producer surplus, and total surplus in the domestic market for sardines? Draw a sketch of the domestic market for sardines and label the areas of consumer surplus and producer surplus.

d. Finlandia decides to open the market for sardines. Suppose the world price of sardines is $20 per unit. Describe what will happen in this market. In your answer identify whether or not Finlandia imports or exports sardines, the numerical level of imports or exports, the new value of consumer surplus, the new value of producer surplus, and the new value of total surplus. Is trade beneficial to the citizens of Finlandia? Explain your answer.

e. Domestic producers of sardines in Finlandia are successful in getting a quota on sardines enacted. The government of Finalandia passes a law limiting the amount of imported sardines to 20 units. What is the new price of sardines? What is the value of consumer surplus, producer surplus, license holder revenue, and deadweight loss equal to when this quota is imposed on the market for sardines? Who benefits from the imposition of a quota in this market?

2. Senators McCain, Obama, and Clinton have finally all agreed that rather than reducing taxes on gasoline there is a need to increase taxes on gasoline so that the United States can decrease their consumption of gasoline. The senators also think that an increase in the excise tax on gasoline will lead alternative energy to be more fully developed.

a. Suppose that the increase in the excise tax will double the price of gasoline from $4.00 per gallon to $8.00 per gallon. Assume that the average American household spends 10% of their gross income on gasoline each year. How might a typical American household adjust to this price increase? Do you think that the consumption of gasoline for this household will remain at its original level? If yes, explain how the household will adjust their budget so that they can continue to purchase the same number of gallons of gasoline as they did initially. If no, explain how the household will adjust their lifestyle if they cut their consumption of gasoline in half (this cut will result in the household spending exactly the same amount on gas as they did last year, but only getting ½ as much gas).

Suppose the demand for gasoline can be represented by the demand equation P = 20 - 0.00008Q and the supply of gasoline can be represented by the supply equation P = 0.00004Q - 4.

b. What is the initial equilibrium price and quantity in the market for gasoline?

c. The Senators agree that the price of gasoline should be raised through the imposition of an excise tax to $8 a gallon. How large will the excise tax per gallon be in order to reach this goal?

d. Calculate the value of tax revenue and deadweight loss from the imposition of the tax in part (c).

e. Suppose the aides to the Senators report that to really make a difference in energy habits, the use of gasoline needs to fall by 100,000 gallons from its initial level. What would the excise tax per gallon need to be in order to reduce consumption by 100,000 from its original level?

3. The chart below describes Henry's preferences for books and meals.  Henry makes $18 per week, while books cost $3 each and meals cost $2 each.

a) Find the equation for Henry's budget line.

b) Graph these three indifference curves and Henry's budget line with books on the horizontal axis and meals on the vertical axis.

c) Which indifference curve represents the highest level of utility for Henry?  Why?

d) What bundle of books and meals will Henry choose to consume?  Why?

e) Find Henry's marginal rate of substitution between books and meals when he is consuming his optimal bundle.  Be sure to show your work and use the appropriate units.

4. The following table provides some information about the production and cost functions for a perfectly competitive firm. The table uses the following abbreviatons:

K is capital

L is labor

Q is output

MPL is the marginal product of labor

FC is fixed cost and AFC is average fixed cost

VC is variable cost and AVC is average variable cost

TC is total cost and ATC is average total cost

MC is marginal cost

a. Please fill in the open squares given the information provided, and answer the related questions below.  Assume that labor is paid a constant wage, i.e. our firm is a price-taker in the labor market.

b. At what quantity of output is average total cost at its minimum?

c. At what quantity of output is average variable cost at its minimum?

d. At what quantity of output is marginal cost at its minimum?

e. What must be true about average total cost and marginal cost as long as ATC is decreasing as output increases?  Why?

5.  The market for bicycles is characterized by perfect competition.  This characterization implies that firms and consumers are price-takers.  Furthermore, there is free entry and exit into the market in the long run and all firms are identical in terms of their technological capabilities.  Thus the cost function as given below for a representative firm can be assumed to be the cost function faced by each firm in the industry.

TC = Q_s² + 10Qs + 400

MC = 2Q_s + 10

Aggregate demand in this market is given by

P = 990 - Q_d

a. What will be the long-run equilibrium price in this market?

b. What will be the output of each firm?

c. How many firms will exist in the long-run?

Now, suppose that the popularity of bicycles falls. (Hint: You don't need that new demand curve to answer these questions (d) through (f).)

d. In the short-run will the firms in the market earn profits, earn losses, or break even?  Why?

e. In the long-run will the number of firms in the market increase or decrease?

f. What will be the long-run equilibrium price now?

Consider an alternative scenario where the technology available for producing bicycles improves.  This causes a change in the cost functions.  The new cost functions are given by,

TC = Q_s² + 5Q_s + 400

MC = 2Q_s + 5

g. What will be the new equilibrium price?

h. How much will each firm produce?