Question

III. Graphs (10 points each, 20 points) 1. Draw indifference curves that reflect the following preferences. a. Tony thinks a cup of coffee and a cup of tea provide the same utility: b. Mary loves potatoes and hates rice. Suppose the industry for Vitamin C is a constant-cost industry (ie the production cost will not change with the number of firms in the industry) and the market for Vitamin C is perfectly competitive, illustrate what happens to the market both in the short run and long run when there is a positive demand shock (for example, Rew scientific evidence show that Vitamin C is good for health).

Answer 1

1. a.As Tony thinks that a cup of coffee and tea provide the same utility, hence according to Tony, tea and coffee are perfect substitutes, Hence he will be indifferent between a cup of coffee and a cup of tea. In this case his utility function will be U= aX1+bX2 where X1 and X2 are the consumption of tea and coffee respectively. Here the we will get the straight line indifference curve(refer to the figure) IC1.

IO Scanned with CamScanner

b. As Mary loves potatoes and hate rice, according to her, Potatoes is a good commodity and rice is a bad commodity. Hence marginal utility of potatoes will be positive and marginal utility of rice will be negative. Hence the slope of the indifference curve is marginal rate of substitution(MRS) which is the ratio of marginal utility of potatoes and rice and we can write

MRS= -(Marginal utility of potatoes)/ (Marginal utility of rice )

As marginal utility of rice is negative, sign of MRS will be positive and hence we will get concave indifference curve.

The diagram below represent the following situation a positive demand shock in a perfectly competitive market in short run and long run

Rice TICH - potatoes Scanned with CamScanner

The constant cost industry is where raising the output levels do not affect the cost of the production which is shown by the horizontal supply curve (LRS). In the short run, the market is in equilibrium, where market demand D1 intersects supply S at a price level P and quantity q1. In the long run this situation is described where the price=average revenue=marginal revenue becomes tangent to both long run marginal and long run average cost curves. Here the firm earns zero economic profit. Now due to the positive demand shock, the short run demand curve shifts rightward from D1 to D2 and equilibrium price P1 and q2 becomes higher than the initial equilibrium price and quantity P and q1 respectively. Here in the long run as a result of this positive demand shock, all the firms in the market will earn supernormal profit shown by the shaded area.

puce fat puice I MC y Supu noma probita AR=MR cs Scanned with q1 q2 "oucher o ห Output น,