04 Jun Question Part 1: (60 points total) Pretend that you have a lemonade stand and that the
Question
Part 1: (60 points total)
Pretend that you have a lemonade stand and that the demand for lemonade in your neighborhood is
estimated to be:
Q = 60 – 100 P
Just like in the lecture, you get all the materials to make the lemonade for free so we assume that the costs
of production are zero. Your goal, your objective, is to maximize profits which is the same as
maximizing total revenue given the zero cost assumption.
a) (5 points) What is the profit (revenue) maximizing price and quantity (in cups) of lemonade and
the corresponding maximum profit.
Suppose that there was a demand shock so that the new estimated demand function for lemonade in your
neighborhood changes to:
Q = 100 – 100 P
b) (5 points) Name and support two reasons why demand would change like this.
c) (5 points) Solve for the new profit (revenue) maximizing price and quantity (in cups) of lemonade
and the corresponding profit.
d) (5 points) Compare your quantity sold and your profit in part c) to the quantity sold and profit if
you kept ‘sticky’ lemonade prices – that is, what would be the quantity sold and profit if you did
not change prices?
GRAPHICS (30 points total for a correct and completely labeled diagram)
Just like in the lecture on the lemonade stand, draw a demand curve in your top diagram and a
total revenue function below making sure that you exploit the fact that the horizontal axis is the
same in the top and bottom diagrams. Label the initial equilibrium points according to your
answer in part a) as points A. Then, label on both diagram as points B, the answer you gave in
part c). We can think of this as the long run since you will increase price in the long run. Then,
label as point C, the quantity sold and profit if you did not change price (i.e., your work from part
d).
e) (5 points) On a separate diagram, draw a supply curve that pertains to your behavior from points
A to B and another supply curve that pertains to points A and C. Pretending that these are shortrun aggregate supply curves, under which curve would macroeconomic (demand side) policies
have the most effect on output? On prices? In other words, which supply curve is more Keynesian
and which is more Classical?
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f)
(5 points) Suppose that in order to change prices, you need to make a new sign which costs you
$5, these are referred to as menu costs. Is it worth it for you to change prices, why or why not?
Explain.
Part 2: True/ False Questions (2 points each 40 points total) Answer T for True and F for False
1) A fall in the tax rate on capital will cause the aggregate expenditure curve to shift up and the
aggregate demand curve to shift to the left, all else constant.
2) One reason that the aggregate demand curve slopes downward is that when prices rise, say in the
US, the relative price of imports fall and thus, US citizens substitute away from domestically
produced goods toward imported goods and thus, GDP in the US will fall (all else constant).
3) Suppose the value of the US dollar changes from $1 = 1.2 euros to $1 = 1.30 euros. This being
the case, imports from the US to Europe, have become more expensive to European citizens, all
else constant.
4) One reason the aggregate demand curve slopes downward is due to the fact that if the price level
falls, real money balances rise, all else constant, interest rates will fall causing an increase in
consumption and investment.
5) Assuming that natural gas for firm X is an important input to the production process, an increase
in the availability of natural gas that lowers the price of natural gas, will result in a leftward shift
of firm X’s supply curve.
6) According to the lecture on the cyclical properties of the aggregate supply curve, I argued that
aggregate demand side policy works better, in terms of influencing output, when the economy is
operating at near full employment output relative to when the economy is operating at levels of
output well below full employment.
7) If labor markets become loose and wages fall, all else constant, the short run aggregate supply
curve will shift to the left.
8) The more ‘sticky’ nominal wages and other input costs are, the steeper the slope of the aggregate
supply curve and therefore, the less effective demand side policies in terms of effecting real
output.
9) If the US economy is growing faster that the rest of the world, then we would expect a surge in
US exports.
10) Suppose that expected inflation is 5% and thus, nominal wages rise, along with all other input
prices by 5%. Suppose also, that actual inflation over this period was only 2%. In terms of the
behavior of the short-run aggregate supply curve, it would shift up given the expectations of
higher inflation and then shift downward to adjust for the actual rate of inflation.
11) The more sensitive consumption is to real wealth, the steeper the aggregate demand curve.
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12) During the Great Recession, we argued that the aggregate expenditure curve shifted down
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