Prof. Gustavo Indart
Department of Economics
University of Toronto
ECO 100Y
INTRODUCTION TO ECONOMICS
Solution to Problem Set 7
1.a)
Note:
i) Supply intersects Demand at $10 and 10,000 units. No Supply below $6 (shutdown)
ii) minimum short-run AC is at $10 and 100 units
iii) minimum short-run AVC at $6
iv) MC through minimum AC and minimum AVC
b) Shift MC, AVC, and AC vertically up $2 for every unit of output.
Shift Supply up $2 vertically for every unit of output (supply is now 10,000 at $12,
and shutdown is now $8).
Supply, not equilibrium, shifts vertically up $2 -> equilibrium increases by less
than $2.
2. The statements that industry price will fall by $1, each firm will produce the same
output and more firms will enter the industry in the short-run is false (though true in
the long-run). In the short-run, capital - in particular, the number of firms - does not
change. A decline in costs of $1/unit causes a parallel shift down of Marginal Cost
and Average Cost of $1 so that the minimum of the new Average Cost (and
intersection with Marginal Cost) is at the same output as the minimum of the initial
Average Cost.
Because industry Supply is the Marginal Cost curve (above minimal Average
Variable Cost) of the firm times the number of firms, industry Supply shifts vertically
down by the same amount as Marginal Cost, i.e., exactly $1 per unit of output. This
is crucial to the analysis that short-run equilibrium price (Ps) does not fall by $1 since
the new Supply curve intersects downward sloping Demand between Po and Po-$1.
Find the equilibrium output (qs) of the firm from short-run Marginal Cost (MCs) at this
new price and the short-run average cost from the Average Cost curve (ACs). Shortrun average cost is not at minimum average cost which occurs at output qo. It is
true that each firm makes economic profits.
(The initial equilibrium P and Q are at long-run equilibrium - minimum average cost but this is not necessary. Short-run equilibrium implies only that the firm produces
the output where price - determined by the intersection of supply and demand equals Marginal Cost.]
3. The diagram shows an economic loss for the firm at initial short-run equilibrium (Po,
Qo). The quota restricts the industry and firm to 80% of equilibrium output (.8qo and
.8qo). MC = P still defines the profit maximizing output for the individual firm for the
quota price Ps but no firm can produce more than its .8qo quota. (A firm could
produce less than the quota but this would reduce profitability).
It is true that industry price (Ps) would increase, industry output (Qs = .8Qs) and firm
output (qs = .8Qs) would decrease, and economic profitability would increase. (The
above diagram happens to show zero economic profit but it could have been an
economic loss or economic profit depending on the curves; the important thing is that
profitability improves relative to the initial equilibrium).
It is false that firms enter the industry since this is the short-run.
4. The diagram shows an economic profit for the firm at initial short-run equilibrium (Po,
Qo, and qo). The increase in property taxes represents an increase in fixed tax
since it is invariant to output. A fixed tax increase shifts up Average Cost but not
parallel since Marginal Cost does not change; minimum Average Cost (intersection
with Marginal Cost) now occurs at greater output.
Supply does not shift since it is composed of the unchanged Marginal Cost (above
minimum Average Variable Cost) times the number of firms which does not change in
the short-run. Hence, equilibrium price and industry and firm output do not change in
the short-run. Average Cost does change, however, so that profitability declines
(whether the new equilibrium results in a lesser economic profit or actual economic
loss depends on the particular curves you drew).
Therefore an increase in price and a decrease in industry output are both false. It is
true that the firm output will not change and is true that profitability will decline though
not necessarily true that this will result in an economic loss.
5. The diagram shows an economic profit the firm at initial short-run equilibrium (Po,
Qo, and qo) since Price is greater than Average Cost at equilibrium.
A rise in Disposable income given negative income elasticity (inferior good) implies a
fall in Demand.
The statement is false that Industry price will rise, since it falls, but it is true that
industry output and firm output will fall. Profitability will fall but particular curves will
determine whether this will be a fall in economic profit or an economic loss.