Question 1

Assume that the market for beach towels is perfectly competitive. The demand is captured by the equation P = 30 - Q and the supply is described by the equation P = 10 + Q, where P stands for price and Q stands for quantity.

a) Compute equilibrium price and quantity. Compute consumer surplus (CS), producer surplus (PS), total welfare (TW) defined as CS + PS, and deadweight loss (DWL).

b) Suppose that the government imposes that the maximum price for beach towels is $15. How does this regulate change the market? That is, (i) compute the new equilibrium quantity, and

(ii) compare CS, PS, TW, and DWL before and after the regulation.

c) Suppose that there is no more maximum price but the government imposes the specific tax of $4. How does this regulate change the market? That is, (i) compute the new equilibrium quantity, (ii) compute how much consumers pay and how much producers receive, (iii) compute the total government revenue and tax burden of consumers and producers, and (iv) compare CS, PS, TW, and DWL before and after the regulation.

Question 2

Fancy Shirt Inc. is a company with market power that sells shirts in two markets. In one market, the shirts carry Fancy's popular label and receive a substantial price premium. The other market is targeted toward more price conscious consumers who buy the shirts without a breast logo, and the shirts are labeled with the name Cool. The retail price of the shirts carrying the Fancy label is $42.00 while the Cool shirts sell for $25. Market research indicates a price elasticity of demand for the higher priced shirt of -2.0, and the elasticity of demand for the Cool shirts is -4.0. Moreover, the research suggests that both elasticities are constant over broad ranges of output.

a) Are current prices optimal?

b) Management considers the $25 price to be optimal and necessary to meet the competition. What price should the firm set for the Fancy label to achieve an optimal price ratio?