Economic Theory Assignment

Questions: 1. Explain using a diagram what would happen in the market for car tires if at the same time there was an increase in the prices of rubber used in the production of tires and a decrease in the price for cars. Explain the effects on price and quantity. 2. In a perfectly competitive market for apples explain would happen in the shortrun to the market and to individual producers if the price for pears went up. Demonstrate your answer using a diagram. With reference to the same diagram show what would happen to the market and individual producers in the long-run. Answers: 1. Rubber is an input into tires. A rise in rubber prices means rise in input costs. This will cause supply to fall. The supply curve shifts from S1 to S2. This raises price , but reduces quantity of tires Cars and tires are complementary goods. As cars become cheaper the demand for cars will rise, causing demand for tires to rise. The demand curve shifts from D1 to D2. This increases price and quantity of tires. Considering both events it is clear that price will rise , but the effect on quantity is uncertain. If demand effect supply effect then quantity will rise. If demand effect supply effect then quantity will fall. If demand effect = supply effect then quantity will stay unchanged. as shown 2. Apples and pears are substitutes for each other. A rise in pear prices will reduce demand for pears( as per demand law) . this will increase demand for apples, shown as shift of D1 to D2. The industry price (P2) and quantity will rise. At firm level, let us assume that we start at long run equilibrium at E1. The rise in apple prices will cause abnormal profits as shown. This is short run effect. Over long run, new firms will enter apple industry. This will cause supply to rise to S2, . If there is no change in costs of production of apples then in the long run prices will fall to old level of P1. The only difference in two long run situations is that now we have more producers.