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Market Substitutes and Term Structure (Yield Curve)

1. The IPAD 2 replaced the IPAD 1 and we can assume they are substitutes. RIM recently introduced the PLAYBOOK and we can assume it is also a substitute for both IPADs.

a) Explain what will happen to the equilibrium prices and quantities of the IPAD 2 and the PLAYBOOK if the price of touch screens rises as a result of the devastation in Japan.

b) Proposed copyright legislation will force PLAYBOOK users to pay a fee to copy electronic media between devices because their format changes, whereas there will be no impact on IPAD (1 or 2) users since there is no format change when moving between devices (Mac computers and IPADs, for example).

If this legislation is adopted what impact will it have on the equilibrium prices and quantities of the PLAYBOOK and the IPAD2. Will there be an impact on the IPAD 1 market? Why?

c) What is more likely to explain an increase in equilibrium IPAD 2 prices and a reduction in equilibrium PLAYBOOK output: an increase in the number of IPAD 2 apps or an increase in the number of PLAYBOOK apps? Be sure to explain why you did not choose the other option.

2. This question requires to do a bit of math, and you must include graphs in your answers.

a) If monetary policy is expected to tighten over the next few years, does that suggest the term structure will be upward sloping? Why?

b) What does that imply for the distribution of current and future consumption?

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Solution Preview

1. a) The increase in production cost will cause the supply curves of both computers to decrease, i.e. shift to the left. Consequently, both prices will increase and both quantities will decrease.

b) Demand for Playbooks will shift to the left, causing both price and quantity to decrease. Because both Ipads are substitutes for the Playbook, demand for both Ipads will shift to the right, increasing price and quantity.

c) Scenario 1: An increase in the number of of Ipad2 apps will shift the ...

Solution Summary

This solution shows the effects of market shifts in demand and supply on the equilibrium price and quantity of a pair of substitues: the IPAD and the PLAYBOOK.
The solution also shows the expected shape of the term structure (yield curve) and the distrubution of current and future consumption if money policy is expected to tighten in the near future.