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ECON 310-1: Microeconomic Theory Professors James A. Hornsten and Ronald R. Braeutigam

Northwestern University, Winter 2016

Problem Set #1: Comparative Statics, S&D Analysis, and Elasticity

Instructions: This problem set will not be collected, but we encourage you to work on the problems, both individually and with a group. During the upcoming week’s discussion sections, the teaching assistants will go over some of the solutions and present similar problems from old exams.

1. Consider the example of the comparative statics problem with an equilibrium discussed in class.

The supply curve P S = 2Qw, where P S is the price on the supply curve at a quantity of Q, and w is the wage

rate producers must pay. The demand curve is P d = 210 – Q, where P d is the price on the demand curve at a quantity of Q. Find the comparative statics derivatives that show how a small change in the exogenous wage rate affects the two endogenous variables, the equilibrium quantity and the equilibrium price.

In other words, find dQ dw

dP

dw .

and

2.

and Q d is the quantity demanded. The market supply curve is described by Q S = 5 P .

supply curve is described by Q S = 5 P . The demand for shoes in

The demand for shoes in a market is Q d = (100 2 P ) Y , where Y is the level of income, P the price,

a) On a graph show the demand curve for each of the following levels of income:

Y = 100, Y = 400. How does the choke price change as the level of income varies?

b) Show that the demand curve has a constant income elasticity of demand, and find the numerical value of that elasticity. In words summarize what this tells us about the impact on the quantity that would be demanded when the level of income in the market rises by 1%.

3. Continue using the supply and demand curves from the previous problem about the market for shoes.

Let’s examine the effects on the equilibrium price as income changes from 100 to 400.

a) If the level of income is 100, find the equilibrium price and show the equilibrium in the graph you

have drawn in part (a).

b) What is the value of the own price elasticity of demand at the equilibrium price you found in part (a)? What does this value tell us?

c) If the level of income is 400, find the equilibrium price and show the equilibrium in the graph you have drawn in part (a).

4. Using the supply and demand curves from the previous two problems, let’s now examine how the

equilibrium price will change for any level of income.

a) Find the reduced form relationship that shows how the equilibrium price depends on the level of income.

b) Verify that the reduced form predicts the same equilibrium prices you found in in question 2 for Y=100 and Y=400.

c) Use the reduced form to infer how the equilibrium price will change as the level of the income continues to rise. Will the price always rise when income increases?

5. Do Problem 2.17 in B&B’s 4 th or 5 th edition. Because it is very early in the quarter and you may have not

obtained the textbook, here is the problem: Consider the following demand and supply relationship in the

market for golf balls: Q d = 90 – 2P – 2T and Q S = –9 + 5P – 2.5R, where T is the price of titanium, a metal used to make golf clubs, and R is the price of rubber.

a) If R = 2 and T = 10, calculate the equilibrium price and quantity of golf balls.

b) At the equilibrium values, calculate the price elasticity of demand and the price elasticity of supply.

c) At the equilibrium values, calculate the cross-price elasticity of demand for golf balls with respect to the price of titanium. What does the sign of this elasticity tell you about whether golf balls and titanium are substitutes or complements?

Profs James A. Hornsten & Ronald R. Braeutigam ECON 310-1: Microeconomic Theory Northwestern University Winter 2016

Problem Set #1 SOLUTIONS Comparative Statics, S&D Analysis, Elasticity Discussed in Sections in Week 2

Instructions: This problem set need not be handed in. The teaching assistants will go over it in sections.

1. Consider the example of the comparative statics problem with an equilibrium discussed in class. The supply curve P S = 2Qw, where P S is the price on the supply curve at a quantity of Q, and w is the wage rate producers must pay. The demand curve is P d = 210 – Q, where P d is the price on the demand curve at a quantity of Q.

Find the comparative statics derivatives that show how a small change in the exogenous wage rate affects the two endogenous variables, the equilibrium quantity and the equilibrium price.

In other words, find dQ dw

dP

dw .

and

Answer to 1.

If Supply given by P S = 2Qw and Demand given by P d = 210 Q , then in equilibrium

we require P S = P d . Thus, 2Qw = 210 Q .

To find the comparative statics effect of a change in the wage rate on the equilbrium quantity,

we need to find the reduced form equation that tells us how Q depends on the exogenous variable w .

Solving for the endogenous variable Q as a function of exogenous variable w , we find

we find that Q =

210 +1 . Thus dQ

w

dw

420

2

(2 w +1) 2

=

. This tells us how much the equilibrium

quantity will fall as the wage rate rises by a little. Note that the derivative is not a constant because

it depends on w .

To find the comparative statics effect of a change in the wage rate on the equilibrium price,

we need to find the reduced form equation that tells us how P depends on the exogenous variable w .

Since the price equilbrium price P is the same as P S and P d , we substitute the equilibrium quantity

Q =

210

2 w +1

(as determined above) into either the structural supply equation P S = 2Qw

or the structural demand equation P d = 210 Q. Either way we find that P = 420 w

2 w +1 .

Thus

dP =

dw

420

(2 w + 1) 2

. This tells us how much the equilibrium price will rise as the wage rate

rises by a little. Note that the derivative is not a constant because it depends on w .

Final comment : Note that the effects of a small change of w on P and Q have the same magnitude,

but opposite signs. This is because the demand curve has a slope of - 1. When w rises,

Q goes down by a certain amount, and P thus goes up by the same amount.

2. The demand for shoes in a market is Q d = (100 2 P ) Y , where Y is the level of income, P the price,

and Q d is the quantity demanded. The market supply curve is described by Q S = 5 P .

supply curve is described by Q S = 5 P . c) On a graph show

c) On a graph show the demand curve for each of the following levels of income:

Y = 100, Y = 400. How does the choke price change as the level of income varies?

d) Show that the demand curve has a constant income elasticity of demand, and find the numerical value of that elasticity. In words summarize what this tells us about the impact on the quantity that would be demanded when the level of income in the market rises by 1%.

Answer to 2. a)

P

50

44.44

40

S D when Y = 100 D when Y = 400 200 1000 2000 222.2
S
D when Y = 100
D when Y = 400
200 1000
2000
222.2

When Y = 100, the horizontal intercept is

When Y = 400, the horizontal intercept is Q d = [100 2 ( 0 )] 400 = 2000 .

Q d = [100 2 ( 0 )] 100 = 1000

− 2 ( 0 ) ] 1 0 0 = 1 0 0 0 The choke

The choke price will be the price at which the quantity demanded becomes zero. Setting Q d =0 for the demand curve, then at the choke price 0 = (100 2 P ) Y . When income is positive, the choke price (the vertical intercept of the demand curve) is always 50. In other words, the choke price is the same for all levels of positive income.

choke price is the same for all levels of positive income. b) The income elasticity of

b) The income elasticity of demand at any price and income is E Q . Y = dQ

Y

dY Q .

The derivative of Q with respect to Y is: dQ dY

= 100 2 P

2 Y
2 Y

.

Y = 100 − 2 P Y Thus E Q . Y = dQ (
Y = 100 − 2 P
Y
Thus E Q . Y = dQ
(
2 P ) Y ) = 0.5 . So the income elasticity of demand is a constant
dY Q
2 Y
(100 −

(0.5), for all levels of P and Y. Interpretation: Given any price, when income rises by 1%, the quantity demanded increases by 0.5%.

3. Continue using the supply and demand curves from the previous problem about the market for shoes. Let’s examine the effects on the equilibrium price as income changes from 100 to 400.

d) If the level of income is 100, find the equilibrium price and show the equilibrium in the graph you have drawn in part (a).

e) What is the value of the own price elasticity of demand at the equilibrium price you found in part (a)? What does this value tell us?

f) If the level of income is 400, find the equilibrium price and show the equilibrium in the graph you have drawn in part (a).

Answer to 3. a) In equilibrium, Q S =Q d . When Y=100, 5 P = (100 2 P ) 100 . Thus, 5P=1000 – 20P, which tells us that the equilibrium price is P=40.

1 0 0 − 2 P ) 1 0 0 . Thus, 5P=1000 – 20P, which

Using the supply curve, we find the equilibrium quantity by Q*=5P =5(40) = 200.

b)

E Q . P = dQ

P

dP Q

The derivative of Q with respect to P is: dQ = 2 Y . Therefore,

dP

respect to P is: d Q = − 2 Y . Therefore, dP E Q .

E Q . P = dQ dP

P

Q = (2 Y ) Q = (2 100 )

P
P
40
40

200 = 4

Interpretation: Moving along the demand curve, an increase in price of 1% will lead to a decrease in quantity of about 4%.

c) In equilibrium, Q S =Q d . When Y=400, 5 P = (100 2 P )

Thus, 5P=2000 – 40P, which tells us that the equilibrium price is P=44.44. Using the supply curve, we find the equilibrium quantity by Q*=5P =5(44.44) = 222.2.

find the equilibrium quantity by Q*=5P =5(44.44) = 222.2. 4 0 0 . 4. Using the

400 .

4. Using the supply and demand curves from the previous two problems, let’s now examine how the equilibrium price will change for any level of income.

d) Find the reduced form relationship that shows how the equilibrium price depends on the level of income.

e) Verify that the reduced form predicts the same equilibrium prices you found in in question 2 for Y=100 and Y=400.

f) Use the reduced form to infer how the equilibrium price will change as the level of the income continues to rise. Will the price always rise when income increases?

Answer to 4.

a) To find the reduced form, use the equilibrium condition Q S =Q d .

Solving this to see how the endogenous variable P depends on the exogenous variable Y, we find that

P depends on the exogenous variable Y , we find that 5 P = ( 1

5 P = (100 2 P ) Y

5 + 2 Y .
5 + 2 Y .

P = 1 0 0 Y

When Y = 100 (as in 2(a)), we see that P = 1 0 0 1 0 0 5 + 2 1 0 0

= 1 0 0 0 2 5 4 0 0 = 2 0 0 0
= 1 0 0 0
2 5
4 0 0
= 2 0 0 0
5 + 2 4 0 0
4 5

b)

= 4 0 , the same as in 2(a).

= 4 4 . 4 4 , the same as in 2(c).

When Y = 400 (as in 2(c)), we see that P = 1 0 0

c) One way to see how the equilibrium price changes as income rises is to divide the numerator and

denominator of the reduced form by P = 1 0 0 Y = 1 0
denominator of the reduced form by
P = 1 0 0 Y = 1 0 0
5 + 2 Y
.
5
+ 2
Y
reduced form by P = 1 0 0 Y = 1 0 0 5 + 2

Y .

As Y increases, the denominator decreases, and thus P always increases. Note: Asymptotically the price approaches the choke price of 50 as income becomes very large.

5. Do Problem 2.17 in B&B’s 4 th or 5 th edition. Because it is very early in the quarter and you may have not obtained the textbook, here is the problem: Consider the following demand and supply relationship in the market for golf balls: Q d = 90 – 2P – 2T and Q S = –9 + 5P – 2.5R, where T is the price of titanium, a metal used to make golf clubs, and R is the price of rubber.

d) If R = 2 and T = 10, calculate the equilibrium price and quantity of golf balls.

e) At the equilibrium values, calculate the price elasticity of demand and the price elasticity of supply.

f) At the equilibrium values, calculate the cross-price elasticity of demand for golf balls with respect to the price of titanium. What does the sign of this elasticity tell you about whether golf balls and titanium are substitutes or complements?

Answer to 5.

a) Substituting the values of R and T, we get Demand: Q d = 70 – 2P, and Supply: Q S = –14 + 5P. In

equilibrium, 70 – 2P = –14 + 5P, which implies that P = 12. Substituting this value back, Q = 46.

b) PED = –2(12/46), or –0.52.

Price-Elasticity of Supply = 5(12/46) = 1.30.

c) CPED golf,titanium = (-2)(10/46) = –0.43. The negative sign indicates that titanium and golf balls are

complements, i.e., when the price of titanium goes up, the demand for golf balls decreases.