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"input substitution"

1. Interferences such as rent controls and farm price supports reduce the efficiency of markets. In terms of the balance of Qd and Qs, how/why do they do this? Draw a supply & demand graph (or graphs) to illustrate your answer.

2. What is consumers surplus? Why does it exist? Why is consumers surplus at a maximum when the consumer purchases the quantity of a good at which P = MU.

3. Describe carefully what "input substitution" means in terms of different possible combinations of inputs capable of producing a given quantity of output. How does the rule MPPa/PRICEa = MPPb/PRICEb serve to guide a producer to the "correct" input combination?

4. In terms of the relationship between price and marginal revenue, what does it mean to say that the perfectly competitive firm is a "price taker"? Why is the profit-maximizing "price taking" perfectly competitive firm the ideal or standard of economic efficiency?

Solution Preview

1. Rent controls (and other price ceilings) are problematic because they introduce a price that is lower than that which the market demands. If Q*, the equilibrium quantity, normally occurs where Qd intersects Qs. With a price ceiling in effect, the quantity will never be allowed to reach Q*--the naturally occuring equilibrium. If the price is set to P1 rather than P* (and P1 will be less than P*), supply will be significantly lower than demand.

Since demand is greater than supply, there is a shortage. There will, however, be no incentive for producers to supply more of a good, since the price is fixed and the supply curve does not change. How do you suspect that an equilibrium is reached?

Often what happens is demand for substitutes for the good increases, and the demand curve for the good itself moves inward (decreases). Eventually an equilibrium will be reached at the fixed market price.

I leave it to you to determine an appropriate graph... be sure to include a horizontal line at some price point where P is less than the natural equilibrium, to ...

Solution Summary

In terms of the relationship between price and marginal revenue, what does it mean to say that the perfectly competitive firm is a "price taker"? Why is the profit-maximizing "price taking" perfectly competitive firm the ideal or standard of economic efficiency?

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