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##### ECON 104 HOMEWORK #7 Assignment Solution

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solution

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Question;Part 1: (60 points total)Pretend that you have a lemonade stand and that the demand for lemonade in your neighborhood isestimated to be:Q = 60 - 100 PJust like in the lecture, you get all the materials to make the lemonade for free so we assume that the costsof production are zero. Your goal, your objective, is to maximize profits which is the same asmaximizing total revenue given the zero cost assumption.a) (5 points) What is the profit (revenue) maximizing price and quantity (in cups) of lemonade andthe corresponding maximum profit.Suppose that there was a demand shock so that the new estimated demand function for lemonade in yourneighborhood changes to:Q = 100 - 100 Pb) (5 points) Name and support two reasons why demand would change like this.c) (5 points) Solve for the new profit (revenue) maximizing price and quantity (in cups) of lemonadeand the corresponding profit.d) (5 points) Compare your quantity sold and your profit in part c) to the quantity sold and profit ifyou kept 'sticky' lemonade prices - that is, what would be the quantity sold and profit if you didnot change prices?GRAPHICS (30 points total for a correct and completely labeled diagram)Just like in the lecture on the lemonade stand, draw a demand curve in your top diagram and atotal revenue function below making sure that you exploit the fact that the horizontal axis is thesame in the top and bottom diagrams. Label the initial equilibrium points according to youranswer in part a) as points A. Then, label on both diagram as points B, the answer you gave inpart c). We can think of this as the long run since you will increase price in the long run. Then,label as point C, the quantity sold and profit if you did not change price (i.e., your work from partd).e) (5 points) On a separate diagram, draw a supply curve that pertains to your behavior from pointsA to B and another supply curve that pertains to points A and C. Pretending that these are shortrun aggregate supply curves, under which curve would macroeconomic (demand side) policieshave the most effect on output? On prices? In other words, which supply curve is more Keynesianand which is more Classical?1f)(5 points) Suppose that in order to change prices, you need to make a new sign which costs you$5, these are referred to as menu costs. Is it worth it for you to change prices, why or why not?Explain.Part 2: True/ False Questions (2 points each 40 points total) Answer T for True and F for False1) A fall in the tax rate on capital will cause the aggregate expenditure curve to shift up and theaggregate demand curve to shift to the left, all else constant.2) One reason that the aggregate demand curve slopes downward is that when prices rise, say in theUS, the relative price of imports fall and thus, US citizens substitute away from domesticallyproduced goods toward imported goods and thus, GDP in the US will fall (all else constant).3) Suppose the value of the US dollar changes from $1 = 1.2 euros to $1 = 1.30 euros. This beingthe case, imports from the US to Europe, have become more expensive to European citizens, allelse constant.4) One reason the aggregate demand curve slopes downward is due to the fact that if the price levelfalls, real money balances rise, all else constant, interest rates will fall causing an increase inconsumption and investment.5) Assuming that natural gas for firm X is an important input to the production process, an increasein the availability of natural gas that lowers the price of natural gas, will result in a leftward shiftof firm X's supply curve.6) According to the lecture on the cyclical properties of the aggregate supply curve, I argued thataggregate demand side policy works better, in terms of influencing output, when the economy isoperating at near full employment output relative to when the economy is operating at levels ofoutput well below full employment.7) If labor markets become loose and wages fall, all else constant, the short run aggregate supplycurve will shift to the left.8) The more 'sticky' nominal wages and other input costs are, the steeper the slope of the aggregatesupply curve and therefore, the less effective demand side policies in terms of effecting realoutput.9) If the US economy is growing faster that the rest of the world, then we would expect a surge inUS exports.10) Suppose that expected inflation is 5% and thus, nominal wages rise, along with all other inputprices by 5%. Suppose also, that actual inflation over this period was only 2%. In terms of thebehavior of the short-run aggregate supply curve, it would shift up given the expectations ofhigher inflation and then shift downward to adjust for the actual rate of inflation.11) The more sensitive consumption is to real wealth, the steeper the aggregate demand curve.212) During the Great Recession, we argued that the aggregate expenditure curve shifted downwardand the short-run aggregate supply curve and the aggregate demand both shifted to the left.13) Anything that shifts the investment demand curve to the right will also shift the aggregatedemand curve to the right.14) The Obama administration in 2013 let a tax holiday expire which effectively increases incometaxes for all workers who pay into social security. The effect of this increase in taxes, all elseconstant, would shift the consumption function down, the aggregate expenditure curve down, andthe short-run aggregate supply curve to the left.15) Given that the working age population is shrinking in Japan, our discussion about thedeterminants of the potential growth rate of the economy suggests that this demographic realitywould lower the potential growth rate of the economy for Japan, all else constant.16) One reason the short-run aggregate supply curve slopes upward is due to the 'stickiness' of inputprices relative to output prices. We saw this in the plastering example when we let output pricesrise and kept nominal wages constant. This being the case, the firm's profit maximizing outputrises with the rise in prices, all else constant.17) According to our discussion about the cyclicality of the aggregate supply curve, the closer theeconomy is to potential output, the more Keynesian the world and thus, the more effectiveaggregate demand side policies are in terms of effecting real GDP.18) If output prices rise without the nominal wage rising, then real wages rise and workers are willingto work more. This is one of the main reasons that the short-run aggregate supply curve slopesupward.19) When we discussed the stagflation of the 1970s, we argued that policymakers should have actedmore aggressively with expansionary policies the fight the recession that occurred during thattime.20) The more flexible wages and prices, the steeper the short-run aggregate supply curve. In fact, ifprices and wages (and other inputs costs) are perfectly flexible then we are in a 'classical' world,where the short-run aggregate supply curve is vertical.

Paper#55762 | Written in 18-Jul-2015

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