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EXERCISE Question 1 (Chapter 9 - Policy and Scenario Analysis with IS-LM-FE/AD-AS Framework) Suppose the economy is initially in its general equilibrium at full-employment output. Use the "Baseline" IS-LM-FE/AD-AS framework to graphically and qualitatively explain the following policies and scenarios. 1) "Short-run gain at a long-run pain" - An increase in government spending can only lead to a short-run increase in output, but ineffective in boosting the economy in the long run at the price of inflation. 2) "Money neutrality" - An increase in nominal money supply is effective only in the short run, but ineffective in boosting the economy in the long run. 3) A permanent negative long-run supply shock 4) A temporary negative supply shock 5) An increase in total factor productivity Suppose the economy is initially in its short-run equilibrium below the full-employment output. Draw the IS-LM-FE/AD-AS diagrams to the following stimulus policy to bring about full-employment output: 6) An increase in money supply (you can think of the recent quantitative easing) 7) An increase in government expenditure Question 2 (Chapter 10 - Temporary vs. Permanent Increase in Government Expenditure in Classical Analysis) CAUTION: Notice the differences between "Baseline" IS-LM and "Classical/RBC-styled" IS-LM! 1) Under the RBC framework, what is the channel by which an increase in government expenditure leads to an increase in full-employment level of output? Explain graphically and algebraically. 2) In RBC fashion, graphically explain the effects of temporary increase in government spending under the demand-supply in labor market, IS-LM-FE curves, and AD-AS curves. 3) Outline the main differences if the government expenditure increases permanently. (Hint: Chapter 3) Question 3 (Chapter 10 - Unanticipated vs. Anticipated Change in Money Supply in Classical Analysis) Assume the misperception theory in SRAS curve. 1) Graphically analyze the effect of an unanticipated increase in nominal money supply in IS-LM-FE and AD-AS diagrams. 2) Graphically analyze the effect of an anticipated increase in nominal money supply in IS-LM-FE and AD- AS diagrams. Question 4 (Chapter 10 - Deriving an AD Curve) Suppose the IS and LM curves are respectively given by: Y = 800 - 2000r 50000 Y = 100 + - P + 1000r Derive the equation for AD curve.1. NStar produces and distributes electricity to residential customers in the Boston metropolitan area. This monopoly firm is regulated, as are other investor owned electric companies. Suppose that the company faces the following demand for electricity: P = 6 - Q and has a marginal cost of MC = 1.25 + 0.75Q, where Q is in millions of kilowatt hours and P is cents per kilowatt hour. a) Under regulation, the firm must set P=MC. Find the regulation equilibrium price and quantity in this market. Calculate consumer and producer surplus. b) Suppose that NStar is allowed to operate as a profit-maximizing firm. What is equilibrium price and quantity for electricity now? Calculate consumer and producer surplus. c) What is the deadweight loss that would result if NStar is allowed to behave like a monopolist? 2. Acme and Becme are the only two widget manufacturers in the world. Each firm has a cost function given by: C(q) = 10q + q', where q is number of widgets produced. The market demand for widgets is represented by the inverse demand equation: P = 100 - 3Q where Q = q, + q2 is total output. Suppose that each firm maximizes its profits taking its rival's output as given (i.e. the firms behave as Cournot oligopolists). a) What will be the equilibrium quantities selected by each firm? What is total output, and what is the market price? What are profit levels for each firm? b) It occurs to the managers of Acme and Becme that they could do a lot better by colluding. If the two firms were to collude, what would be the profit-maximizing choice of output? What is the industry price? What are the output and profits for each firm in this case? c) What discount rate is required for firms to find it worthwhile to collude? (You can assume that widgets are perishable, i.e. one period's output must be sold in the same period). d) Suppose Acme can set its output level before Becme does. How much will the companies produce in this case? What is the market price, and the profits of each firm? Is Acme better off by choosing its output first (why or why not)?3. You and your competitor are both about to introduce similar products, and you will both have to announce your prices. The demand for your product is: Q1 = 24 - 6P, + 3P, and your competitor's demand is Q, = 24 - 6P2 + 2P, where P, is your price and P2 is your competitor's price. You both have costs equal to 3+2Q;. a) Suppose you must both announce your prices at the same time. What price will you announce, and what price could you expect your competitor to announce? How much profit will each of you make? b) Suppose you must announce your price first. What price will you choose? What price would you expect your competitor to choose? How much profit will each of you make? Is there an advantage to going first? Why or why not? c) Suppose you and your competitor can collude in setting price. What price will each of you set, and how much profit will each of you make? 4. Suppose there is an industry with an incumbent monopolist facing the possible entry of a new competitor. The incumbent must choose whether to invest in lots of capacity (in an attempt to scare off the competitor). After seeing the incumbent's investment level, the competitor decides to enter the market or not, incurring a cost of K if it does. The pay-offs are 20 to the incumbent if the competitor does not enter when investment was high and 25 when investment was low. If the competitor does not enter she gets nothing. If she enters then payoffs for the incumbent and the competitor respectively are {9, 5-K) if investment was high, and { 10, 10-K) if investment was low. a) If the cost of entry is low (K=1), what will the competitor do if the monopolist chooses high investment? What if investment is low? Knowing this, what should the monopolist do? b) If the cost of entry is moderate (K=6), what happens? c) If the cost of entry is high (K=11), what happens? d) Can you think of real industries where firms may over-invest to deter entry? Justify you answer briefly.1. A natural monopolist has total costs C(Q) = 400 + 250 and faces market demand Q = 200 - 2P. Solve for monopolist's profits, output, and consumer surplus when: (a) Price is set equal to marginal cost. (b) Price is set equal to average cost. (c) There is two-part pricing. Now the monopolist sets price equal to marginal cost and charges a fixed participation fee per consumer. Assume that the de- mand comes from 10 identical consumers. What participation fee would a profit- maximizing monopolist set? 2. Suppose a company providing cable TV and broadband is a natural monopolist in some city. It has a fixed operation cost of $1 million per day regardless of the number of households that subscribe to either service. The number of households subscribing to cable TV is Q1 = 2- Pi and the number of households subscribing to broadband is Q2 = 1 - :P2. Here Q is measured in millions and P in dollars per day. (a) Find the inverse demand curves and the total consumer surplus as a function of the prices. (b) Find the Ramsey prices and the associated consumer surplus. (c) What are the prices and consumer surplus if a regulator forces the company to charge prices such that the fixed cost is divided equally between the two products and that the company makes zero profits? 3. The demand for electricity is Q" = 10-PP in peak periods and Q" = 4-Po in off-peak periods. Both periods take up half of each day. Variable cost is 0.2 per unit of output per period and capital costs capacity are 0.3 per unit of capacity per day. Capacity costs are sunk and can not be adjusted between periods. (a) Find the optimal capacity, peak price, and off-peak price. (b) With price constrained to be the same all through the day, what price and capacity would maximize social surplus? (c) Compare consumer surplus in the two cases. 4. The cost of producing two types of products is described by the cost function C(r, y). Is there a natural monopoly (why or why not) when (a) C(r, y) = rty (b) C(1, y) = vry (c) C(x, y) = Vay + 1
