Demand = 60 100P

P
Q
TR
0.05 55 2.75
0.1 50
5
0.15 45 6.75
0.2 40
8
0.25 35 8.75
0.3 30
9
0.35 25 8.75
0.4 20
8
0.45 15 6.75
0.5 10
5
0.55 5 2.75
0.6
0
0

Demand =
100P
P
Q
0.05 95
0.1
90
0.15 85
0.2
80
0.25 75
0.3
70
0.35 65
0.4
60
0.45 55
0.5
50
0.55 45
0.6
40
0.65 35
0.7
30
0.75 25
0.8
20
0.85 15
0.9
10
0.95
5
1
0

100 TR

Lemonade Stand Problem

4.75
Pretend that you have a lemonade stand and that the
9
demand for lemonade in your neighborhood is
12.8
estimated to be:
Q = 60 - 100 P
16
We assume that you get all the materials to make the
18.8
lemonade for free so we assume that the costs of
21
production are zero. Your goal, your objective, is to
22.8
maximize profits which is the same as maximizing
24
total revenue given the zero cost assumption.
24.8
a) What is the profit (revenue) maximizing price
25
and quantity (in cups) of lemonade and the
corresponding maximum profit?
24.8
Suppose that there was a demand shock so that the
24
new estimated demand function for lemonade in your
22.8
neighborhood changes to:
21
Q = 100 - 100 P
18.8
b) Name and support two reasons why demand
16
would change like this.
12.8
c) Solve for the new profit (revenue) maximizing
9
price and quantity (in cups) of lemonade and
the corresponding profit.
4.75
d) Compare your quantity sold and your profit in
0
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
Draw a demand curve in your top diagram and a profit = total revenue function
(given zero cost assumption) 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) 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 short-run 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?
f) 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.

American, Norwegian Win Nobel

By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL

October 12, 2004; Page A2

An American and a Norwegian were awarded the Nobel Prize in economics for research that laid the intellectual foundation
for modern central banking and for their somewhat controversial work that redefined how some economists think about the
causes of economic booms and busts.
The award went to Edward C. Prescott, 63 years old, an economics professor at Arizona State University and longtime
researcher with the Federal Reserve Bank of Minneapolis, and his frequent collaborator Finn E. Kydland, 60, a Norwegianborn economist now on faculty at Carnegie Mellon University in Pittsburgh and at the University of California at Santa
Barbara. Mr. Prescott has long been seen as a favorite to win the award; Mr. Kydland has received less attention.
The Royal Swedish Academy of Sciences said the men's work has "profoundly influenced the practice of economic policy in
general and monetary policy in particular." The reforms that central banks around the world undertook in part as a result of
their work "are an important factor underlying the recent period of low and stable inflation."
The main insight came in a paper called "Rules Rather than Discretion: The Inconsistency of Optimal Plans," written
in 1977. In that paper, the authors examined how government policy makers invited long-term trouble when they
strayed from their goals to address short-run problems. They applied the theory to everything from patent enforcement to
federal disaster assistance, but it was in the area of central banking that the ideas in the paper struck a chord. At the time,
inflation was running rampant and economic growth was stagnant -- a phenomenon called "stagflation."
Most central bankers around the world typically espoused a commitment to contain inflation, but in practice central
bankers would shift policy to tolerate a little more inflation in the short run as a trade-off for stronger economic
growth and rising employment. THEY ACT DOVISH - THEY CAN'T HELP THEMSELVES! The professors showed
how these short-term shifts in policy had long-term consequences and could push up inflation expectations of
households and businesses, leading to long-running bouts of rising prices.
"Kydland and Prescott's analysis provided an explanation for the failure to combat inflation in the 1970s," the
academy said. The key to any policy, they argued, was to make a commitment and stick to it. Central bankers
responded by demanding more independence, so that they would be less prone to interference by elected officials who
were concerned about short-term fluctuations in the economy. It also led many central banks -- such as those of New
Zealand, Sweden and the U.K. -- to adopt formal inflation targets to underline the commitment to low inflation. "You
should not think in terms of controlling the economy," Mr. Prescott says. "That leads to bad outcomes. You should
think in terms of committing to good policy rules."
Their research into business cycles has been more contentious. Before the authors took up the subject in a 1982 paper,
many economists believed that economic booms and busts were caused by changes in demand by consumers and
businesses, a point espoused by John Maynard Keynes, whose views dominated economic thought after the Great
Depression. Mr. Keynes prescribed government stimulus when consumer spending or business investment softened.
But Messrs. Prescott and Kydland, who were the forefront of a broad shift away from the teachings of Keynes, argued
that other factors, most notably a nation's productivity, were critical driving forces in short-term shifts in the business
cycle. They theorized that supply-side shocks, such as a new technological innovation or a surge in the price of oil,
could alter productivity patterns and cause a recession or an economic boom. Before their work, economists thought
productivity of a nation's work force mainly affected long-term economic performance.
Those views about the business cycle may seem straightforward, but they remain contentious even today, in part
because they undercut arguments for the government to act to stimulate demand when the economy weakens.
Lawrence Summers, the president of Harvard and the former U.S. Treasury secretary, once wrote that the work of
Messrs. Prescott and Kydland on business cycles had "nothing to do with the business-cycle phenomena observed in
the United States or other capitalist economies."SO, LAWRENCE SUMMER IS MOST DEFINITELY A ___________
In an e-mail yesterday, Mr. Summers said the two professors "richly deserve" the prize because of the economic
methods they introduced, even though "I like many others find their particular theories [about business cycles]
implausible."
Messrs. Prescott and Kydland will share an award of 10 million Swedish kronor, or $1.4 million. The award is officially
called the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. It is the last of six prizes announced by
the Royal Swedish Academy of Sciences; the others were all announced last week.

Two majors points to emphasize: 1) Prescott and Kydland won noble prize for hands off policy
prescription; and 2) their work on real Business cycle analysis is contentious.
Applications to the Aggregate Supply / Aggregate Demand Model