Problem Set 3

Hard copies of your answers are due at the beginning of your section, either on
Thursday, October 13, or Friday, October 14. For example, if your section
starts at 10:00am on Friday, you should submit your answers to your TA in your
section classroom at 10:00am on Friday, October 14. Late problems earn zero
points.

Note: you can work on these problems or your own, or in a small group with
other current Econ 1 students. If you choose to work in a group, each student
needs to hand in a separate, individual copy to his/her TA.

1. Fill out the following table for a competitive firm that can sell its product
for $13 a unit.

Quantity Total Fixed Variable Average Average Marginal Total Marginal Profit
Cost Cost Cost Total Variable Cost Revenue Revenue
Cost Cost
0
1 $27.00 $9.00
2 $16.00
3 $5.00
4 $5.50
5 $8.40

a. What quantity will this firm produce? Why?

b. How much profits or losses will this firm be making at that quantity
level?
c. Is this market in long-run equilibrium? Why or why not?
d. In the short run, at what price would this firm break even? At what price
would the firm shut down? Explain briefly.

2. There are two kinds of polio vaccines: oral and injectable. The oral form—
made from live viruses—is more popular since it is cheaper and easier to
administer than the injectable version, which is made from dead viruses. A
study that appeared in the April 2002 issue of Science reports a mutation in the
oral vaccine that can actually propagate polio instead of preventing it.

Assume that the markets for oral and injectable vaccines are competitive.

a. Draw two graphs, one for each market (oral and injectable). Make sure your
graphs include demand and supply curves, and equilibrium price and quantity.
b. Verbally explain the short-run effects of the mutation report on both
markets, and show those graphically.
3. A study published by the Canadian Cancer Society in January 2002 shows
that the graphic warning labels on cigarette packages in Canada have been
effective in discouraging smoking. Verbally and graphically show how the
introduction of graphic warning labels would affect the market for cigarettes in
the short and long run (assuming that this market is competitive). As always be
careful and precise in your explanations—verbal and graphical.

4. Three months ago a farmer paid $20,000 in seed, fertilizer and labor costs.
Now the crop is ready to be harvested and—given current market prices—the
potential revenue is $35,000. Last year the same farmer paid $30,000 in labor
costs to have the crop harvested. If the farmer pays the same amount in wages
this year, the total cost for the crop would be $50,000, with a loss of $15,000.

The farmer meets with the workers and proposes to lower their wages to a
total of $15,000. The farmer adds, “After this compromise I’m just going to
break even! If I pay you one more cent I’ll be losing money. If you don’t agree
to the lower payment, then I’ll just let the crop rot where it is.”

The labor union hires you as its economic advisor. Should the workers accept a
reduced payment or not? Explain carefully—using economic analysis and
terminology, of course.

5. As an economic wizard, evaluate the following statement: “The theory of

perfect competition claims that economic profits will disappear in the long run.
This assumption is incorrect because I know a family that has a farm that earns
more than $1 million per year.”

6. After the state of Texas raised the price of personalized license plates, the
state’s revenue from personalized license plates fell. From this information,
what can you say about the price elasticity of demand for personalized plates?

7. The government of Firmland wants to favor firms, and it is considering

implementing a maximum wage. As an economic advisor to the government of
Firmland, explain (verbally and graphically) the consequences of the maximum
wage in the competitive labor market. Make sure your explanation includes the
gains or losses to firms, workers, and the people of Firmland as a whole.
Extra practice problems (completely optional; no points awarded)

A. (a) Fill out the following table for a competitive firm that can sell its
product for $90 a unit.

Average Average
Total Fixed Variable Marginal Total Marginal
Quantity Total Variable Profit
Cost Cost Cost Cost Revenue Revenue
Cost Cost
0 -$30
1 $0
2 $50
3 $60
4 $50
5 $20
(b) What quantity will this firm produce? Why?
(c) In the short run, at what price would this firm break even? At what price
would the firm shut down? Explain briefly.

B. Answer the following questions using the production function information in

the following table. Assume that 1 unit of labor costs $5 and 1 unit of capital
costs $10.
(a) Derive the marginal product (MP) schedule. Does it obey the law of
diminishing returns?
(b) Derive the short-run cost schedules (fixed cost, variable cost, total cost,
and marginal cost).
(c) Derive the MP and short-run cost schedules if labor productivity doubles
(with 1 labor unit, for example, being used to produce an output of 10 units
instead of 5 units).
(d) Explain why the short-run cost curves shift if the amount of capital input
changes.

Labor(units) Capital(units) Output(units)

0 2 0
1 2 5
2 2 15
3 2 20
4 2 23
5 2 24

C. Taylor (fourth edition), chapter 13, page 340, problem 2.

D. In the year 2000, economist Jeffrey K. Sarbaum reported on the Northeast
Interstate Dairy Compact (NIDC), “a price floor system that guarantees
Northeastern dairy farmers a minimum price for their milk, typically above
what the equilibrium market price would bring them if the NIDC were not in
place. Regional price supports such as the NIDC have resulted in an over
production of milk that, historically, has been purchased by the Federal
Government at a cost, in the 1980's, of over two billion dollars a year. More
recently, Congress has been attempting to eliminate regional milk price
supports by initiating a federal program that will gradually reduce milk prices
to their fair market value. One consequence of this move has been increased
volatility in the price of milk across the country as some regions of the nation,
such as the Midwest, embrace the new regulations while others, like the NIDC,
fight in court to maintain their current system. For example, in October of
1999 a gallon of milk in Dallas sold for $2.34 on average while a gallon of milk
in New York sold for $3.03 on average, an increase of almost 30%.”

(a) Graphically show how the Northeast Interstate Dairy Compact increases the
price of milk and creates a production surplus.
(b) Show the consumer surplus, producer surplus, and the deadweight loss
caused by the Northeast Interstate Dairy Compact. Your answer should take
into account what the government may do with the surplus milk.
(c) Opinion: if economic analysis shows that price floors have negative welfare
effects for society, why do you think they still exist?

E. Imagine that a major freeze destroys this year’s crop of oranges in Florida.
(a) What are the short-run effects on the orange juice market?
(b) In the absence of other freezes or external effects, what will happen in the
long run?
For both parts, your verbal and graphical explanations should include the
effects on equilibrium price and quantity, as well as any shifts in demand,
supply, and cost curves, changes in levels of profits for the typical firm, and
number of firms in the market. You can assume that the orange juice market
was at a long-run equilibrium before the freeze hit Florida.
Problem Set 3 Answer Key

1.

Quantity Total Fixed Variable Average Average Marginal Total Marginal Profit
Total Variable
Cost Cost Cost Cost Cost Cost Revenue Revenue
0 18 18 0 -- -- -- 0 -- -18
1 27 18 9 27 9 9 13 13 -14
2 32 18 14 16 7 5 26 13 -6
3 33 18 15 11 5 1 39 13 6
4 40 18 22 10 5.5 7 52 13 12
5 60 18 42 12 8.4 20 65 13 5

a. The firm will produce 4 units because that is where Profit is maximized.
b. Profit=12
c. The market is not in long term equilibrium because the firm is making profits. In
the long term, firms in a competitive market make 0 economic profits. Also, in the
long run, competitive firms produce at the minimum point of the Average Total
Cost which is not the case here.
d. Breakeven Price=10 since minimum ATC is 10
e. Shutdown Price=5 since minimum AVC is 5

2
a) The general graphical setup for the problem is shown below. Note that the initial
equilibrium price for the oral vaccine should be less than the initial equilibrium
price for the injected vaccine. Similarly, the initial equilibrium quantity for the
oral vaccine should be greater than the equilibrium quantity for the injected
vaccine.

Price Price Sinjected

($) ($)
Soral

P*injected

P*oral
Dinjected
Doral

Q*oral Quantity of Oral Q*injected Quantity of Injected

Vaccine Vaccine
 b) The report will cause some consumers to reduce their demand for the oral
vaccine for fear of possibly contracting polio—that is demand shifts down
and to the left because of negative information. Note that demand for the oral
vaccine does not fall to zero or become completely elastic—the oral vaccine was
not shown to cause polio with 100% certainty; it only increases the chance that a
patient may contract the disease from the vaccine. At the lower price shown in
the oral vaccine graph, some patients may be willing to take on the extra risk of
contracting the disease rather than pay the higher price for the injected form of the
vaccine. The equilibrium price and quantity of oral vaccine both decline due to
the new information.

The new information also affects the market for the injected vaccine. This
vaccine now appears to be relatively safer and therefore demand for it will
increase at every price. Thus, the demand curve shifts up and to the right
because the new information is positive in the injected vaccine market. Note
however that since the two vaccines are substitutes, the fact that the price of the
oral vaccine declined should cause the demand for the injected vaccine to decline
as well (it is relatively more expensive). We do not have enough information to
determine which of these effects (the substitution effect or the “safety” effect) will
be larger. If the demand shift due to the increased relative safety is larger than the
shift due to the increase in relative price, the net effect is a shift of the demand
curve up and to the right. We will assume this is the case (although full credit
was given if you showed a shift down and to the left and explained your reasoning
correctly). Finally, note that the total quantity of vaccine used (oral plus injected)
could decrease—people might find the cost of the injected too high and the risk of
the oral too high such that they prefer not to vaccinate at all.

Price Price Sinjected

($) ($)
Soral
P**injected
P*injected

P*oral

P**oral Dinjected
Doral

D’oral

Q**oral Q*oral Quantity of Q*injected Q**injected Quantity of

Oral Vaccine Injected Vaccine
 3
Short Run
In the short run, the labels will reduce demand for cigarettes, thereby shifting the demand
curve down and to the left because of this new negative information about smoking. As
shown in the market graph below, this reduces the price of cigarettes and therefore causes
economic losses (i.e., negative profits) at individual firms. For this question we only
asked for the effects in the market (not individual firms); hence, the firm graph was not
necessary to receive full credit.
Price MC Price
($) S
($)
ATC
Losses
P*

P**

D2 D1

q** q* Quantity Q** Q* Quantity

Individual Firm Market
Long Run
Because firms are making negative profits, firms will exit the industry in the long run.
They will do so until economic profits are equal to zero—that is, until a competitive long
run equilibrium is reached. Therefore, the supply curve for the market shifts up and to
the left until the equilibrium price returns to the original equilibrium price (P*). The
equilibrium price returns to P* because there have been no changes in the cost structure
of the industry (no curves have shifted in the firm graph). Again, the individual firm
graph was not required for full credit, but some discussion of economic profits return to
zero was necessary to know when firms stop exiting the industry.

S2
Price MC Price
($) S1
($)
ATC

P* = P***

P**

D2 D1

q** q* = q*** Quantity Q*** Q** Q* Quantity

Individual Firm Market
4
From the perspective of the workers, accepting the reduced payment does not make
sense. This is because the farmer’s threat to let the crop rot is not credible. If the farmer
lets the crop rot, he will end up with net loss of $20,000. This loss exceeds $15,000, the
amount he would lose by harvesting the crop and paying the workers the same amount as
last year. This is illustrated in the table below:

Farmer’s Decision and Payoffs

Pay Full Wage and Harvest Let the Crop Rot
Planting (Sunk Costs) -$20,000 -$20,000
Labor Cost -$30,000 0
Revenue $35,000 0
Profit -$15,000 -$20,000

This is a good example of the economic concept of sunk costs. The farmer’s $20,000
expenditure three months ago is “sunk” because it can no longer be recovered. Like the
fixed costs for a firm, such costs do not impact short-run production decisions. The
farmer is still interested in maximizing profits (or minimizing losses in this case). Thus,
the workers have no reason to concede to the farmer’s demands.

(Another way to see this problem is to note that while the farmer would be below his
breakeven point if he harvests, he is still above his shutdown point, which is -$20,000.
So long as he can walk away with something better than -$20,000, the farmer has an
incentive to harvest the crop, even at a loss).

5. Correct Answer 1: The claim is not correct because the person confuses accounting
profits with economic profits. The opportunity cost must be subtracted from accounting
profits to obtain economic profits. If the opportunity cost is $1 million, then the family is
indeed making zero economic profits.

Correct answer 2: The claim is not necessarily correct because the industry may be in
the short-run, or subject to demand fluctuations. Economic profits may be earned in the
short-run but will disappear with the entry of new firms, which may be the situation of
the family. Demand fluctuations may cause firms to have profits in some years and
losses in others, but zero profits on average. Long-run perfectly competitive model is
then a good approximation of this industry.

6. It may seem counterintuitive that as one raises prices, revenues fall. However, an
economics wizard knows that revenues are PxQ, thus an increase in price may not always
lead to an increase in revenues, since quantity demanded is likely to change when prices
increase.
The demand curve tells us the relationship between any price and the amount that all
consumers in the market will consume. Since we have shown that all normal demand
curves slope downward, we know that consumers will consume fewer license plates
when the price goes up. How much fewer depends on the price elasticity of the demand
curve. If the curve is unit elastic (i.e., the elasticity is 1) where the market equilibrium is,
the change will produce the same amount of revenues. Since the change under discussion
produced lower revenues, we may say that the demand for personalized license plates in
Texas is relatively price elastic. A percentage change in price leads to a larger percentage
change in consumption. As the name suggests, “vanity” plates aren’t exactly a necessity.
Therefore, if price goes up a little people would be likely to drop their consumption
quickly.

A maximum wage is a price ceiling on the price of labor—the wage.

One might presume, first, that if Firmland is implementing a maximum wage, that the
equilibrium wage in the market exceeds the mandatory maximum wage (otherwise, there
would be no need for the law).1

If the equilibrium is indeed above the maximum wage, when we turn to our supply and
demand model (here, the laborers are “suppliers” and the firms are consumers), we will
find a shortage of labor (see diagram) in response to this effective price ceiling. Firms
will demand a great deal more work than the labor market is willing to supply.

Notice an important subtlety to the logic here (not necessary for a correct answer). When
we map the market “supply” curve for labor, we are looking at workers’ marginal cost of
supplying labor. As we have seen in so many cases, that cost is defined by the workers’
opportunity cost—their next-best alternative. Since every firm in Firmland must pay the
same wages, you could argue that a laborer’s opportunity cost is constant once it reaches
the maximum wage, and thus that there would be no shortage. However, first, as you
may remember from our economics case example in class, for some people, the next-best
alternative is leisure, not work. These people will choose to, say, go to the beach instead
of working. Also, the people of Firmland may emigrate to Laboria, where workers are
more appreciated! Knowing that the that opportunity of emigration exists means the
opportunity cost is still there. We might expect both of these factors to cause the labor
supply curve to still be upward sloping above the maximum wage.

Now we know that there is a shortage, that there will be less employment, and that firms
will hire fewer people at equilibrium, but this alone doesn’t tell us who is better or worse
off. The only way to know who is better or worse off as a result of the wage ceiling is to
look at producer (workers) and consumer (firms) surplus.

1
If you assume otherwise, you do not get the question wrong, BUT to get credit using this alternative
assumption, your answer must be consistent. Since the outcome is very straightforward when we assume
that the maximum wage is above the market equilibrium wage (answer: there is no effect), partial credit
was very difficult to give for any wrong answers.
Workers
We can be sure that, on the whole, workers are worse off. Some chose not to work at all
and lose the surplus of working that they would have at an equilibrium wage. Those who
continue to work (far left on the labor supply curve) lose a great deal of surplus in the
difference between the equilibrium wage and the maximum wage. The result in terms of
surplus is that workers overall begin with C+D+F and end up with only F; they are worse
off.
Firms
Firms may or may not be better off, depending on the geometry of the curves. While
they gain some of the surplus that would have gone to workers under the equilibrium
wage (this gain is represented by rectangle C), they lose the deadweight loss triangle of
B. If B < C, as it would probably be in most cases, the firms are better off.
Society
We measure losses to society in terms of deadweight loss (DWL). Here, the resulting
DWL is represented by regions B and D. Its very existence shows us that society is
worse off, because it lost the potential surplus.

As a result, we may tell the government that

• Firms will face labor shortages, but will probably make more surplus even at lower
levels of production;
• Many workers will choose not to work at all, but will spend their days at the beach
and many others will earn a lot less than they used to in surplus, which may mean
higher poverty even among those who have chosen to work; and
• Firmland will probably see a flight of workers—especially those most in demand in
a healthy economy, since Laboria and other countries will snap them up quickly. In
addition to the “brain drain”, Firmland will lose a great deal of economic surplus as a
result of the artificially low wage.

Wage
E Supply of Labor2

A B
Equil. Wage
C D
Max. Wage
F

Demand for Labor

Units of Labor

2
Note, of course, that the demand for leisure would make the upper register of this supply curve slope
backwards.
Before maximum wage is implemented
Firm Surplus = E + A + B
Worker Surplus = C + D + F

After maximum wage is implemented

Firm surplus = E + A + C
Workers’ Surplus = F

∆Firm Surplus = C-B

∆Worker Surplus = - C-D
∆Society Surplus (Deadweigh Loss) = - B – D
Problem Set 3 Practice Problems

A. (a)

Quantity Total Fixed Variable Average Average Marginal Total Marginal Profit
Total Variable
Cost Cost Cost Cost Cost Cost Revenue Revenue
0 30 30 0 -- -- -- 0 -- -30
1 90 30 60 90 60 60 90 90 0
2 130 30 100 65 50 40 180 90 50
3 210 30 180 70 60 80 270 90 60
4 310 30 280 77.5 70 100 360 90 50
5 430 30 400 86 80 120 450 90 20

(b) This firm will produce 3 units. This is the quantity that leads to the highest profits for
the firm.
(c) Breakeven Price=65. This is the minimum ATC.
Shutdown Price=50. This is the minimum AVC.

B.

(a) MP Schedule
Labor Capital Output Marginal
(units) (units) (units) Product
0 2 0 --
1 2 5 5
2 2 15 10
3 2 20 5
4 2 23 3
5 2 24 1

Yes the MP schedule obeys the Law of diminishing returns. As more labor is added, the
MP of labor declines i.e. the increase in output due to a unit increase in lahor declines
with increasing labor input.

(b) Short-run Cost Schedule

Labor Capital
Labor Capital Output Cost Cost Total Marginal
(units) (units) (units) (VC) (FC) Cost Cost
0 2 0 0 20 20 --
1 2 5 5 20 25 5
2 2 15 10 20 30 5
3 2 20 15 20 35 5
4 2 23 20 20 40 5
5 2 24 25 20 45 5
(c) MP and Short-run Cost Schedule if Labor Productivity doubles
Labor
Labor Capital Output Marginal Cost Capital Cost Total Marginal
(units) (units) (units) Product (VC) (FC) Cost Cost
0 2 0 -- 0 20 20 --
1 2 10 10 5 20 25 5
2 2 30 20 10 20 30 5
3 2 40 10 15 20 35 5
4 2 46 6 20 20 40 5
5 2 48 2 25 20 45 5

Only the MP schedule changes. The cost schedules remain the same because productivity
has changed, not the cost of labor.

(d) Each short-run cost curve or schedule is based on a particular amount of capital. As
capital changes, the cost structure of the firm as well as its output producing capabilities
change which causes the short-run cost curves to shift.

C.

The interaction of supply and demand for labor determines the wage rate. For the
moment, presume that the supply of labor in Mexico and the U.S. are relatively inelastic
and identical. Since the demand for labor is based on the marginal product of labor, a
higher marginal product in the U.S. than in Mexico would mean that there is a higher
demand for U.S. labor than Mexican labor. Thus, according to the supply and demand
model, differences in marginal product will be seen as differences in labor demand,
ceteris paribus. One factor that might cause this difference in marginal product is the
overall higher level of investment in human capital that takes place in the U.S. relative to
Mexico. If higher education makes workers more productive, one has only to compare
the distribution of education in the U.S. to that in Mexico to see why there is a higher
worldwide demand for skilled workers in the U.S. relative to Mexico, an therefore a
higher wage. Another factor that might explain the higher marginal product of labor in
the U.S. is the higher level of capital investment in the U.S. relative to Mexico.
 Mexican Labor Market US Labor
W
Market W
SM SU

Wus
Wus

Wmx
Wmx

DU

DM

QL QL

D.

The welfare loss of price controls: The Northeast Interstate Dairy Compact (NIDC)

a) The price floor in the Northeast is illustrated in figure 1. The non-intervention free
market equilibrium is revealed by the intersection of the standard supply and demand
curves for milk in the Northeast, with suppliers selling all their production of milk,
Qni, to consumers at a price Pni. Imposing a price floor Pf guarantees a price of milk
we are told is “typically above what the equilibrium market price would bring”. This
means Pf > Pni , as shown by the red line in figure 1. (Remember a price floor can be
set below the market equilibrium price, in which case it does not affect the natural
equilibrium. This could be used to reduce the volatility of prices for example).
As the price is increased to the guaranteed price floor Pf, demand for milk falls to Qd
whilst supply of milk increases to Qs, created a production surplus equal to Qs -Qd
that is bought by the government at price Pf.
 Price

SMilk
Surplus
Pf
Price floor

Pni

DMilk

Qd Qni Qs Quantit
Figure 1. The Northeast milk
k t

b) Determining the deadweight loss of the price floor is important to estimate the cost to
society of intervening in the Northeast dairy market1. To make things obvious, the
process can be broken down into two parts. Figure 2 shows the changes to consumer
and producer surplus after introducing a price floor. There is a reduction in consumer
surplus and an increase in producer surplus. Overall, there is a gain in the triangle F,
as shown by the thick red line.

1
The crucial simplifying assumption is that consumer surplus, producer surplus and government
expenditure are directly comparable.
 Without price floor With price floor
Price

SMilk SMilk
A
Pf
B F
D
Pni
E
C

DMilk DMilk

Qd Qni Qs Qd Qni Qs Quantit

Consumer surplus
Producer surplus

Figure 2 Change in Consumer and Producer Surpluses

Without price floor With price floor

Consumer Surplus A+B+D A
Producer Surplus C+E B + D + F + C +E

In a second step, we are told the suppliers can produce a surplus and sell it because the
government has agreed to buy the entire surplus. Since consumers are only buying Qd, the
government buys the difference Qs – Qd at a total cost of (Qs – Qd) x Pf , or the shaded
area DEFGI in figure 3 below.
Government intervention
Price

SMilk

Pf
F
D
Pni I
E

DMilk

Qd Qs
Government expenditure
Figure 3 The government
i t
The net effect depends on what the government does with all the milk it has bought. At
the extremes, it can:
1. Destroy the milk
This sounds completely crazy and it is. Nevertheless, Europe did this on numerous
occasions to protect its price floor! The European Common Agricultural Policy was
the cause of many an infamous “beef and butter mountain”, or “wine and milk lake”
in the 80s. In this case, the gain in consumer and producer surplus F is offset by
government expenditure of DEFGI, leaving a deadweight loss to society of DEGI, as
shown in figure 4.

Government destroys Government gives the milk

the milk

SMilk SMilk
A
Pf
B F F
D B D
E I I
E
C
G G
DMilk DMilk
Qd Qs Qd Qs
Deadweight loss Deadweight loss
Extra consumer surplus
Figure 4 The deadweight loss

2. Give the milk. The government can give the surplus to those who most value it,
but can’t afford to pay price Pf. Since they get it for free, the extra consumer
surplus is the whole area under the demand curve from Qd to Qs, represented by
the blue area DEG in figure 4. The gains and losses are summarised in the
following table. The difference between the total losses and total gains is I, the
triangular area shaded on the right hand graph above. This deadweight loss is the
same as the one portrayed in Taylor’s book on p174.

Loss Gain
Government D+E+F+G+I
Change in consumer and D+E+F+G
producer surplus
Net deadweight loss I
 These two deadweight losses are the maximum and minimum amounts of deadweight
loss that will be caused by the price floor. The cost to society will ultimately depend
on how much milk is not destroyed and how it is distributed to consumers. What is
clear in this analysis is that a price floor is always detrimental to social welfare.

c) There are unfortunately plenty of reasons why economically bad policies permeate
society. Here are just some reasons why price floors still exist:
i. The political process: Small, well organised and well funded groups often
wield more political power than apathetic majorities. Agricultural groups such
as the NIDC are particularly successful at influencing national policy.
Consumers lose from having to pay higher prices for foodstuffs and from
having to pay higher taxes to finance the Federal government’s purchase of
surplus produce. However, consumers are often ill informed and too
disorganised to launch an effective counter-strike.
ii. Lack of information/ignorance: Politicians may truly believe they are acting
in the best interest of the nation, but lack the economic training and the
information necessary to choose the economically optimal policy.
iii. Income distribution: What if dairy farmers were all earning a pittance, despite
working 12 hour long shifts milking their beloved cows to provide milk to the
nation’s children? A price floor could be used to rectify this “injustice” as a
form of income redistribution based on the beliefs of the elected party. As an
economist, you could suggest other forms of income support be used to prop up
dairy farmers incomes instead of distorting the market.
iv. Volatility: Uncertainty is often seen as a cost in economics and clouds rational
decision making. Agricultural products are open to supply shocks such as
weather and crop diseases that make it difficult to predict yields, the quantity
supplied and final prices. Furthermore, the quantity supplied is slow to react to
changes in price, since it takes many months to plant crops and years to raise
cattle. The volatility of prices thus harms consumers and producers. Setting a
price floor is one way of reducing this volatility and a potentially beneficial
reason to intervene in the market.
E
a)
Destruction of the orange crop will presumably cause an increase in the price of oranges.
Assuming that oranges are an input into the production of orange juice (hopefully a
reasonable assumption), the increase in the price of oranges will cause the marginal cost
curve for each orange juice producing firm to increase. Since oranges are a variable cost
as well as being proportional to the amount of orange juice that is produced, we can
imagine this as a marginal cost curve shifting up. For the purposes of exposition here, let
me just suppose that the increase in the price of oranges causes the marginal cost of
orange juice to increase by 30 cents per gallon. In that case, we would get the following
diagram for the firm’s cost.

Price

ATC1

P1
ATC0
P0
MC1

MC0

Q* Quantity

Notice that the ATC curve shifts up by EXACTLY the same amount as the MC curve.
This makes sense because if, for instance, the marginal cost of each unit increased by 30
cents, this would mean that the average total cost would increase by exactly 30 cents as
well. This implies that the breakeven point also increases by 30 cents, but stays at
exactly the same quantity. In the market, the supply curve will also shift up by 30 cents
(for any unit of production the cost will be 30 cents more.) Combining this with the
supply diagram, we get the following:2

2
Even though it may not appear so, the MC1 is the same curve as MC0, shifted up by an equal amount at all
points.
 Orange Juice Firm Orange Juice Market
Price Price
MC1

MC0 S1

ATC1 S0

P1 ATC0
P*
P0
Demand

Q1 Q0 Quantity Quantity

Since the demand curve is downward sloping, the new intersection of demand and supply
will occur at P*, which is a price that is above the original breakeven point, but BELOW
the new breakeven point. Assuming that firms are identical, all firms will lose profits in
the short-run.
The equilibrium price will increase and the equilibrium quantity will go down. The
number of firms in the market will be the same, assuming that price is above shutdown,
so that firms won’t exit the market in the short-run.

b)
In the long run, we assume that the marginal cost curves shift back to their original
places, and therefore the ATC and AVC shift back to its original location. Assuming that
no firms were run out of the market, we also have the supply curve go back to its original
location. We will then have exactly the same equilibrium price and quantity that we had
before, as well as the same number of firms in the market.