rephrase economic problem set

In short, it is likely that lowering prices at lunch and on weekend will not lead to a significant increase in the quantity demanded of drinking during those times. (demand for alcohol is inelastic)

Demand for alcohol in the evening on work days may be price elastic. People are generally more willing to drink in the evenings than at lunch during weekdays and therefore will be more sensitive to changes in price.

Therefore, a price discount could increase total revenues associated with alcohol after work (since lowering prices with an elastic demand increases revenues), but probably would not have a positive impact on total revenues at lunch or on weekends (since lowering prices with an inelastic demand decreases revenues).

You could also have discussed the cross price elasticity between drinks and food. This relationship is probably stronger at dinner time than at lunch time. So, discounts on drinks may lead you to higher revenues because it will lead to someone staying for dinner.

So, yes, this policy does make sense!

2. (20 pts) The Commerce Department is considering lifting the ban on the import of Brazilian oranges (the world’s largest producer of oranges) into the United States. If a significant number of Brazilian oranges are allowed to be imported into the United States, show the impact on the following: (You can use demand and supply curves. In your explanation, be sure to distinguish between a change in demand and a change in quantity demanded and between a change in supply and a change in the quantity supplied.)

a. The equilibrium quantity and price of oranges in the US

b. The equilibrium quantity and price of orange juice in the US

c. The equilibrium quantity and price of tangerines in the US (assuming tangerines are a substitutes for oranges)

ANSWER to #2

a. Allowing Brazilian oranges into the United States increases the supply of oranges and the supply curve shifts rightward. The equilibrium price of an orange falls and the equilibrium quantity increases. The quantity of oranges demanded increases and there is a movement along the demand curve.

b. Oranges are an input used in the production of orange juice. When the price of an orange falls, it costs less to produce orange juice. At every quantity, orange juice manufacturers are willing to sell orange juice at a lower prices, since their costs of producing orange juice has gone down. The supply curve thus shifts rightward and the equilibrium price of orange juice falls and the equilibrium quantity increases. The quantity of orange juice demanded increases and there is a movement down along the demand curve.

c. If tangerines are considered a substitute for oranges, and the price of oranges has declined, consumers will switch from buying tangerines to oranges (holding everything else constant). At every price of tangerines, consumers will be willing to buy less tangerines (since they are now buying oranges). The demand curve will move to the left and the equilibrium price and quantity of tangerines will decrease. The quantity demanded of tangerines will go down and there will be a movement down along the demand curve for tangerines,

As an aside, note that the price of all of these goods go down as a result of allowing more Brazilian oranges – benefitting consumers and harming business, especially if the imported good has an inelastic demand (lower prices for business with an inelastic demand means lower revenues). Restrictions on imports, such as tariffs and quotas almost always benefit business (protectionism) and hurt consumers.

3. (10 pts) Imagine you are an author of a book who gets a royalty payment of 10% of the total revenues from the sale of the book. You get a phone call from your publisher telling you they are increasing the price of your book from $25 to $30. Should you be happy about this? Why or Why not?

What assumptions are you making about the change in quantity demanded of the book in your answer?

What elements/characteristics of the book will determine whether your assumption is valid?

ANSWER to #3

You would be happy about the price increase if you believed that the demand for your book was price inelastic, meaning that demand for your book was not sensitive to price. If the demand for the book is inelastic, the revenues from the book would go up and so would your royalty payments.

In particular, the price of the book has gone up by 25%. If the quantity demanded of the book goes down by less than 25% - meaning demand is inelastic – revenues (Price x quantity from the book will go up and royalty payments would go up. If quantity demanded goes down by more than 25% (demand is elastic), revenues from the book would go down and your royalty payments would go down.

Some characteristics of your book that might determine elasticity include the availability of substitute books, whether you were a best selling author, whether your book was a necessity (such as a textbook for schools), etc.

4. (15 pts) Market approval in the US for new pharmaceutical products is a long, arduous, and expensive process. Once approved, patent protection keeps close substitute products from entering for some years.

a. If the demand for a particular product is stable, what would you predict for the profitability after approval and prior to patent expiration? Why?

b. What would you predict for the profitability of pharmaceuticals products after the patent expires? Why?

ANSWER to #4

a. The prices and profits should be relatively constant over this period. There may be an initial period when the drug maker must inform the potential customers of the benefits of this product that will make demand and prices lower. But, after that, these firms enjoy a stable monopoly without any competition. There will be no entry of firms so demand and profits will be stable.

b. After patent expiration, the barrier to entry are lifted and firms will be able to copy the product and enter the market. Demand and prices for the incumbent should decrease significantly. As prices and demand for the incumbent firm go down due to the entry of other firms and the arrival of substitute goods, profitability of the incumbent firms will decrease.

5. (15 pts) Between World War I and World War II, the cotton textile industry was one of the most competitive industries in the US. Cotton textiles were a homogenous product, there were many buyers and sellers and free entry and exit.

Research showed that the return on investments in the cotton textile industry was about 6% in the South and 1% in the North (due to higher labor costs). The average rate of return for ALL manufacturing industries was around 8%.

a. What would you expect to happen to the number of firms in the cotton textile industry in the long run? Would firms in the South or the North be equally affected? Why?

After World War II, the US put restrictions on the import of cheaper textile imports.

b. What would you expect to happen to the profitability and number of firms in the US cotton textile industry in the long run? Explain why.

In the early 1990’s these trade restrictions were lifted.

c. What would you expect to happen to the profitability and number of firms in the US cotton textile industry in the long run? Explain why.

ANSWER to #5

a. Given that the cotton textile firms are earning less than other firms and therefore less than the opportunity cost of capital, it is likely that the number of firms in the cotton textile industry will decrease. And you would expect that the number of firms in the North, where returns are a lot lower, would decrease more than firms in the South. And this is exactly what happened: capacity in the US textile industry decreased by 33% between the Wars, with the decline being larger in the North than in the South

b. The restriction on the importation of cheaper textile imports acts as an entry barrier. Prices remain higher than otherwise would be the case (since importation of textile would increase supply and lower price), profitability of US textile firms are maintained and you would expect that the number of firms in the US textile industry would not change that much. That is, historically, exactly what happened.

c. With the lifting of the entry barrier, US textile firms have become under increasing pressure. Supply of textiles would increase, lowering price and decreasing economic profits of US textile firms. You would expect that the economic profits of the most inefficient textile firms would drop below zero and the number of textile firms would begin to decline in the long run.

6. (30 pts)

a. Why are clothes with designer labels so much more expensive than ‘own brand’ clothes from a chain store, even though they may cost a similar amount to produce?

b. Why do the prices of fresh vegetables fall when they are in season?  Could an individual farmer prevent the price from falling?

c. If the price of frozen yogurt falls, the price of ice cream is likely to rise. True or False? Why?

a. Because fashion is an important determinant of demand. The more fashionable a product, the higher will be the demand, and the less elastic will be the demand, at any given price. In short, raising prices for fashionable designer label products will not affect their demand to a significant extent. Demand for designer label products are price inelastic and raising prices will increase revenues. Thus, shops attempt to maximize profits by charging higher prices for fashion products than for own brand products.

b. Because supply is at a high level. The increased supply creates a surplus which pushes down the price. Individual farmers could not prevent the price falling. If they continued to charge the higher price, consumers would simply buy from those farmers charging the lower price – assuming there are many farmers selling a similar product or a competitive market exists.

c. False. Frozen yogurt and ice cream are substitutes. When the price of yogurt falls, people substitute frozen yogurt for ice cream. The demand for ice cream decreases and the demand curve shifts leftward. The equilibrium quantity of ice cream decreases but the equilibrium price of ice cream falls. There is a decrease in the quantity of ice cream supplied and a movement down along the supply curve.