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test3_solns

# test3_solns - Department of Economics University of Toronto...

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Page 1 of 9 Department of Economics Prof. Gustavo Indart University of Toronto February 10, 2006 ECO 100Y – L0101 INTRODUCTION TO ECONOMICS Midterm Test #3 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS : 1. The total time for this test is 50 minutes. 2. Answer all questions in the space provided (if space is not sufficient, continue on the back of the previous page). 3. Aids allowed: a simple , non-programmable calculator. 4. Use pen instead of pencil . DO NOT WRITE IN THIS SPACE 1. /8 4. /12 2. /8 5. /9 3. /8 6. /5 TOTAL /50 SOLUTION

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Page 2 of 9 Question 1 (8 marks) Assume that a perfectly competitive industry, with “n” identical firms, is initially in long-run equilibrium. The industry has a constant cost long-run supply curve. The product is a normal good. Disposable income increases as a result of a tax cut. Statement: In the new long-run equilibrium, the industry price will increase; the industry output will also increase; each firm will produce a larger output; and the number of firms in the industry will remain unchanged. Position: Do you agree with the statement? Draw the proper diagram to explain your answer. In the initial long-run equilibrium, price is P 1 , industry output is Q 1 , and each of the n 1 firms in the industry is producing output q 1 (and thus Q 1 = n 1 q 1 ). Note that since the industry is in long-run equilibrium, firms’ economic profits are zero. Since the product this industry produces is a normal good, the increase in disposable income increases the demand for this good. The demand curve shifts to D’ and equilibrium price increases to P 2 and industry output increases to Q 2 in the short-run. At this new price, each firm produces an output q 2 in the short-run (and thus Q 2 = n 1 q 2 ). Firms make now positive economic profits since P 2 is greater than average cost at the level of output q 2 . The firm’s profit is shown by the blue area in the right-hand side diagram. The economic profits firms are making attract more firms into the industry in the long-run. As more firms enter the industry, the short-run supply curve starts shifting to the right, price starts to fall, and economic profits start to decrease. This process continues until the price level falls back to P 1 and all firms make normal profits once again (i.e., a new long-run equilibrium is reached). Industry output increases to Q3, but each firm is producing the same output as before (i.e., Q 3 = n 2 q 1 ) Therefore, I disagree with the statement: price doesn’t change in the long-run; industry output does increase; each firm produces the same output as before; and the number of firms increases. P \$ P 1 P 1 P 2 P 2 Q 2 Q 1 Q 3 q 2 q 1 q S S’ LRS D D’ Q LRAC SRAC SRMC
Page 3 of 9 Question 2 (8 marks) A perfectly competitive industry is initially in long-run equilibrium with a constant cost long-run supply curve.

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