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Problem Set 1 1. (25 points) For each of the following scenarios, use a supply and demand diagram to illustrate the effect of the given shock on the equilibrium price and quantity in the specified competitive market. Explain whether there is a shift in the demand curve, the supply curve, or neither. (a) (5 points) An unexpected temporary heat wave hits the East Coast. Show the effect in the ice cream market in New England. (b) (5 points) The government introduces a tax on ice cream which is paid by producers. What is the effect in the ice cream market? (c) (5 points) China and Mexico are major producers of textiles. Workers in Mexico decide to go on strike. Show the effect on the market for Mexican textiles. (d) (5 points) Show the effect of the situation described in (c) on the market for Chinese textiles. (e) (5 points) Suppose the government imposes a price cap on bottled water. Show the effect in the bottled water market. Problem 1 courtesy of William Wheaton. Used with permission. 2. (20 points) For each of the following pairs of goods, identify which one you would expect to have more own-price elastic demand. Please explain your reasoning. (a) (5 points) Computers (generally) vs. Apple MacBook Pro laptops. (b) (5 points) Stereo headphones (generally) vs. hearing aids. For each of the following goods, identify whether you would expect demand to be more (own-price) elastic in the short run or the long run. As above, please briefly explain your reasoning. (c) (5 points) Retail gasoline in the suburbs of Chicago. (d) (5 points) Air conditioning units in Miami Beach, Florida. Problem 2 courtesy of Luke Stein. Used with permission. 3. (30 points) Consider the market for apple juice. In this market, the supply curve is given by Qs = 10Py -5PA and the demand curve is given by Qp = 100-15Py + 10Py, where J denotes apple juice, A denotes apples, and T denotes tea. (a) (7 points) Assume that PA is fixed at $1 and Py = 5. Calculate the equilibrium price and quantity in the apple juice market. (b) (7 points) Suppose that a poor harvest season raises the price of apples to PA = 2. Find the new equilibrium price and quantity of apple juice. Draw a graph to illustrate your answer. (c) (8 points) Suppose PA = 1 but the price of tea drops to Pr = 3. Find the new equilibrium price and quantity of apple juice. (d) (8 points) Suppose PA = 1, Pr = 5, and there is a price ceiling on apple juice of Py = 5. What is the excess demand for apple juice as a result? Draw a graph to illustrate your answer. Problem 3 courtesy of William Wheaton. Used with permission. 4. (25 points) You have been asked to analyze the market for steel. From public sources, you are able to find that last year's price for steel was $20 per ton. At this price, 100 million tons were sold on the world market. From trade association data you are able to obtain estimates for the own price elasticities of demand and supply on the world markets as -0.25 for demand and 0.5 for supply. Assume that steel has linear demand and supply curves throughout. (a) (10 points) Solve for the equations of demand and supply in this market and sketch the demand and supply curves. (b) (15 points) Suppose that you discover that the current price of steel is $15 per ton and the current level of worldwide sales of steel is 150 million tons. The most recent elasticity estimates from the trade association this year are -0.125 for demand and 0.25 for supply. Describe the change in the supply and demand curves over the past year using your diagram from part (a). What sort of event(s) might explain the change?credit. 1. (5 points) According to the Coase theorem, agents will always reach a Pareto efficient bargain to internalize an externality if property rights over that externality are complete and bargaining is costless. One policy implication is that all agents should be indifferent among all allocations of property rights over externalities since the final outcome will always be Pareto efficient.2. (5 points) A second policy implication of the Coase Theorem is that the allocation of property rights has no effect on the amount of the externality produced. [Hint: Consider the ownership of "mineral" rights on private property. Mineral rights allow a person or company to drill for oil and gas on a given property. In many U.S. states, homeowners own the "surface" rights to their properties while the state owns the mineral rights. In other states, homeowners own both surface and mineral rights. If oil or gas is discovered in the area, extraction firms may offer substantial payments to mineral rights-holders for permission to drill on all or part of their land.]4. (5 points) The Second Welfare Theorem says that any Pareto efficient allocation can be attained as a market equilibrium by making appropriate transfers, assuming of course that the four necessary conditions for efficient markets are satisfied. Starting from the initial endowment E, the policymaker would like the economy to reach the point X*, which lies on the contract curve. Absent transfers, however, the economry would reach the point X", which is also on the contract curve but not the policymaker's preferred point. Having taken 14.03/003, the policymaker decides to implement a proportional tax f* (10 percent, for example) on all goods purchased. Note that if the initial price ratio is P = p1/p2, then the taxed initial price ratio will be P = p (1+#*) /p2 (1+ #*) = P. The tax revenue will be used to make the lump-sum transfers needed to reach X*. Will the policymaker's scheme satisfy the Second Welfare Theorem? Explain.2 International trade (22 points) Suppose Cheese (C) and Watches (W) in Switzerland are produced using only labor and the production functions Are: C = 10,Le W=OL Le and L. represent labor devoted to the production of cheese and watches, respectively, and a > 0 is a constant. Suppose labor supply in the country is fixed at L = 400, and the utility function of the representative Swiss consumer is U(C, W) = VCW. Note that this utility function implies that the marginal utility of a Swiss consumer from one extra unit of watch consumption is higher if she has more cheese to consume, which is a natural assumption about Swiss preferences for Cheese and Watches. 1. (5 points) Suppose a = 1. That is, one unit of labor can produce one watch. Derive and draw the Swiss production possibility frontier for watch and cheese production.2. (5 points) Now make no assumptions on the value of a. Suppose Switzerland didn't sell or buy any Cheese or Watches to other countries. What would be the equilibrium price ratio and equilibrium quantities of Cheese and Watches in the Swiss domestic market? [Note: Your answers will depend on a, which you should treat as an unknown for now. Of course, the solution will require finding the point of tangency between the PPF and the highest feasible indifference curve.]3 Externalities (28 points) There are 150 hunters in a community. They each choose whether to hunt in the forest or on the plains. The plains are so large that each hunter can catch 0.05 tons of game no matter how many other hunters are there. The forest can get crowded, however. If there are r hunters in the forest, each of them catches fri tons of game (so, in total, x* r" = $ri tons of game are hunted in the forest). Forest game and plains game are perfect substitutes in consumption and there are no other costs associated with hunting in the forest or the plains. The demand for game is perfectly elastic at price $5 per ton. (Note: You can ignore discreteness throughout the question.) 1. (5 points) If each hunter is free to choose whether to hunt in the forest or the plains, how many hunters will