Since the cross price elasticity is positive, the two goods are substitutes.

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1 Exam 1 AGEC 210 The Economics of Agricultural Business Spring 2013 Instructor: Eric Belasco Name Belasco KEY 1. (15 points, 5 points each) The following questions refer to different elasticity measures we ve discussed in class a. If the quantity demanded of tea increases by 2% when the price of coffee increases by 8%, what is the cross price elasticity? Does your answer suggest that coffee and tea are substitutes, complements, or unrelated?, % %. Since the cross price elasticity is positive, the two goods are substitutes. b. If the quantity demanded of coffee increases by 2% when the price of coffee creamer decreases from $1.50 to $1.44, what is the cross price elasticity? Does your answer suggest that coffee and coffee creamer are substitutes, complements, or unrelated?, % % /. Since the cross price elasticity is negative, the two goods are complementary. c. If the quantity demand of coffee increases by 3% when incomes increase by 9%, what is the income elasticity? Does your answer suggest that coffee is a normal or inferior good? % %. Since the income elasticity is positive, coffee is a normal good. 1

2 2. (15 points, 5 points each) The figure below refers to the cost structure for a hay producer. Refer to this figure to answer the subsequent parts. a. What is this farmer s profit maximizing output level? Where MR=MC, which occurs where Q = 500 b. At the profit maximizing output level, what is farmer s profit? Profit = TR TC = P*Q ATC*Q = (P ATC)*Q = (24 20)*500 = $2,000 c. At what price level does the farmer earn exactly zero economic profits? Would you suggest the farmer continue to operate or shut down? Explain. The breakeven point (where profits are equal to zero) occurs where P=18. At this point, the firm maximizes profits (albeit at zero) by continuing to operate. Profits would be less (assuming there are fixed costs) if the firm shut down. 2

3 3. (20 points, 5 points each) Show graphically, the impact on the market equilibrium price and quantity for bananas from the following changes. a. A decrease in household incomes (bananas are a normal good) Equilibrium price and quantity fall b. An increase in the price of apples (apples and bananas are substitutes) Equilibrium price and quantity increase c. New research shows that bananas help to fight off the common cold Equilibrium price and quantity increase d. Wage rates increase in regions where banana production occurs S1 Equilibrium price increases and quantity decreases 3

4 ESSAY. Select three of the questions below to answer. Write your answer in the space provided. Clearly indicate which question you are answering with each response. Also, if you provide more than three responses, only the first three will be graded. (10 points each) 4. Over the past 20 years, U.S. agricultural production has shifted toward using fewer labor hours per planted acre on farms, while the average acreage per farm has grown. Explain what economic concepts are driving these changes. The use of fewer labor hours per planted acre has come as a result of capital to labor substitution. As capital has become more productive per dollar (relative to labor inputs per dollar), substitution has occurred to replace labor inputs with capital inputs. The average acreage has grown as a result of average cost savings realized for larger scales. Larger scale productions are also more conducive to capital inputs, relative to labor inputs. 5. Using a commodity of your choosing (e.g., beef/meat, wheat/grain, cotton, etc..), identify and characterize the players involved in the different segments of the supply chain: (i) input sector, (ii) producer sector, and (iii) processing/manufacturing sector. Input sector includes seed and fertilizer sales, feed for livestock, etc. Production sector includes farmers and ranchers Processing/manufacturing sector includes transportation, retail, and food preparation for convenience 6. Apples and Oranges are close substitutes. A recent freeze in Florida destroys a good portion of oranges. What is expected happen to the prices of oranges and apples? (In your response, be sure to draw a supply/demand graph with clearly labeled axis and curves. Be as specific as possible.) The freeze reduces the supply of oranges. This is shown in the figure to the left as supply is reduced, resulting in higher prices and lower quantity of oranges sold in equilibrium. Since apples are a substitute, the demand for apples shifts out as the price of oranges increase. This is shown in the figure to the right. The increased demand leads to an increase in price and quantity. Thus, both prices are expected to increase. 4

5 Oranges S1 Apples 7. A headline in the paper reads A recent increase in the price of milk and falling incomes both lower revenue for Starbucks coffee. Show whether this statement is valid or not. (Note: Assume coffee and milk are complements and that coffee is a normal good.) If coffee and milk are complements and the price of milk increases, then we would expect a decrease in the demand for coffee. At the same time falling incomes would result in reduced demand (since coffee is a normal good). Thus, Starbucks would experience a downward demand shock from these two reasons, resulting in lower price and quantity sold. This would result in lower revenue. 8. A lawsuit brought against the US through the World Trade Organization claims that subsidies to U.S. cotton producers have led to an increased amount cotton production. Is there any validity to their claim? Show and/or explain why or why not. (Hint: Assume cotton is a perfectly competitive industry and that subsidies effectively shift marginal costs lower at all output levels for an individual firm.) Since cotton producers sell into a perfectly competitive market, they are considered price takers. If a subsidy results in a lower marginal cost at all output levels, then this would effectively increase the profit maximizing quantity for each farm. The aggregate effect would be a supply shift outward, leading to a higher quantity produced at a lower price. The lower price aspect is what other countries are concerned about enough to bring a lawsuit to the WTO against the United States. 5