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Pretend that you have a lemonade stand and that the demand for lemonade in your neighborhood is estimated to be:

Q = 60 – 100 P

Just like in the lecture, you get all the materials to make the lemonade for free so we assume that the costs of production are zero. Your goal, your objective, is to maximize profits which is the same as maximizing total revenue given the zero cost assumption.

a) (5 points) What is the profit (revenue) maximizing price and quantity (in cups) of lemonade and the corresponding maximum profit.

Suppose that there was a demand shock so that the new estimated demand function for lemonade in your neighborhood changes to:

Q = 100 – 100 P

b) (5 points) Name and support two reasons why demand would change like this.

c) (5 points) Solve for the new profit (revenue) maximizing price and quantity (in cups) of lemonade and the corresponding profit.

d) (5 points) Compare your quantity sold and your profit in 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 (30 points total for a correct and completely labeled diagram)

Just like in the lecture on the lemonade stand, draw a demand curve in your top diagram and a total revenue function 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) (5 points) 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) (5 points) 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.

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