MGEC: Lecture 1

Practice Problems Answer Key

Practice Problem 1
You are considering joining the PGP, when your company offers you a promotion to lead its newest
project in Manila, requiring you to move there. You won't be able to join the PGP if you are in Manila

a) What is the opportunity cost of taking the promotion?

Opportunity cost of a particular alternative is the payoff associated with the best of alternatives that are
not chosen. Therefore, opportunity cost of taking the promotion is whatever benefits you would have
enjoyed from joining the PGP since you will have to forego joining the PGP in order to take the
promotion.

b) How does the answer change if you have already paid the deposit for the PGP tuition?
The deposit paid for the PGP tuition has been explicitly incurred but it should not be factored into
decision making. These kinds of costs are known as sunk costs. Ideally, sunk costs should have no
bearing on future decisions.

c) You believe that the promotion is the better alternative for your career but are still hesitant to
accept the job because of the money you have paid towards the PGP tuition. Explain what
may be going on?
It is harder to let go of something once one has spent time, effort and money on it. In this case, you
know that promotion is the better alternative for your career but are still hesitant to accept the job
because of the money you have paid towards the PGP tuition. You fail to recognize that the deposit is a
sunk cost and it should not affect your future decisions. This is the sunk cost fallacy.

Practice Problem 2
A team consisting of three people is working on a big project, which involves manual entry of data in a
computer, with subsequent processing of these data and making a poster presentation. Naturally,
each member of the team has different abilities in performing either task. Amrit can make 1 poster or
400 data entries in a day. Hard-working Binita can make 2 posters or 1200 data entries in a day.
Artistic Chhavi can make 3 posters or 900 entries in a day.

a) As the time comes to start making posters, you decide to assign one member of the team to
this task. Whom would you choose? Explain why.
Opportunity cost of producing 1 extra
Posters Data Entries
poster in terms of data entries given up
Amrit 1 400 400
Binita 2 1200 600
Chhavi 3 900 300
Chhavi should be chosen to make posters as her opportunity cost is the lowest.
 b) What is the opportunity cost of a poster at the choice made by you?
If Chhavi makes the poster, the opportunity cost for each poster she makes is 300 data entries that she
wouldn’t be able do.
 Managerial Economics
Digital Headstart Module

◼ Questions for Review

1. A firm pays its accountant an annual retainer of $10,000. Is this an economic cost?
This is an explicit cost of purchasing the services of the accountant, and it is both an economic and an
accounting cost. When the firm pays an annual retainer of $10,000, there is a monetary transaction.
The accountant trades his or her time in return for money. An annual retainer is an explicit cost and
therefore an economic cost.

2. The owner of a small retail store does her own accounting work. How would you measure the
opportunity cost of her work?
The opportunity, cost of doing accounting work is measured by the monetary amount that the owner’s
time would be worth in its next best use. For example, if she could do accounting work for some other
company instead of her own, her opportunity or implicit cost is the amount she could have earned in
that alternative employment. Or if she is a great stand-up comic, her opportunity/implicit cost is what
she could have earned in that occupation instead of doing her own accounting work.

3. Please explain whether the following statements are true or false.

a. If the owner of a business pays himself no salary, then the accounting cost is zero, but the
economic cost is positive.
True. Since there is no monetary transaction, there is no accounting, or explicit, cost. However,
since the owner of the business could be employed elsewhere, there is an economic cost. The
economic cost is positive, reflecting the opportunity cost of the owner’s time. The economic cost
is the value of the owner’s time in his next best alternative, or the amount that the owner would
earn if he took the next best job.
b. A firm that has positive accounting profit does not necessarily have positive economic profit.
True. Accounting profit considers only the explicit, monetary costs. Since there may be some
opportunity/implicit costs that were not fully realized as explicit monetary costs, it is possible that
when the opportunity/implicit costs are added in, economic profit will become negative. This
indicates that the firm’s resources are not being put to their best use.
c. If a firm hires a currently unemployed worker, the opportunity cost of utilizing the worker’s
services is zero.
False. From the firm’s point of view, the wage paid to the worker is an explicit cost whether she
was previously unemployed or not. The firm’s opportunity cost is equal to the wage, because if
it did not hire this worker, it would have had to hire someone else at the same wage. The
opportunity cost from the worker’s point of view is the value of her time, which is unlikely to be
zero. By taking this job, she cannot work at another job or take care of a child or elderly person
at home.
If her best alternative is working at another job, she gives up the wage she would have earned.
If her best alternative is unpaid, such as taking care of a loved one, she will now have to pay
someone else to do that job, and the amount she has to pay is her opportunity cost.
 MGEC: Session 2

Practice Problems Answer Key

Practice Problem 1

The Dolan Corporation, a maker of small engines, determines that in 2008 the demand curve for its
product is P = 2000 - 50Q, where P is price (in dollars) of an engine and Q is the number of engines
sold per month.
a) To sell 20 engines per month, what price would Dolan have to charge?

Given, demand curve for small engines:

P = 2000 - 50Q ……………………………………………..………………………………………………………………..………(1)
At Q = 20, P can be found by plugging Q = 20 in the equation (1)
P = $1000

b) If managers set a price of $500, how many engines will Dolan sell per month?

To find the number of engines (Q) which Dolan will sell per month, plug P = $500 in equation (1).
Q = 30

c) What is the price elasticity of demand if price equals $500?

𝑑𝑄 𝑃
ϵd = ×
𝑑𝑃 𝑄

Demand Equation: P=2000-50Q. At price = $500, we can find the corresponding quantity by
plugging it into the demand equation:

500 = 2000 − 50𝑄

50𝑄 = 1500
𝑄 = 30

Also, the demand equation can be expressed in terms of Q;

𝑃 = 2000 − 50𝑄
50𝑄 = 2000 − 𝑃
𝑃
𝑄 = 40 −
50
𝑑𝑄 −1
Differentiating the demand function 𝑑𝑃 = 50

Now, we have to substitute the values in the elasticity formula:

𝑑𝑄 𝑃
ϵd =𝑑𝑃 × 𝑄

−1 500
ϵd = 50 × 30
 −1
ϵd = 3

d) At what price, if any, will demand for Dolan's engines be unitary elastic?

We know that ϵd = -1

𝑑𝑄 𝑃
Since, ϵd =𝑑𝑃 × 𝑄

−1 (2000−50𝑄)
-1 = 50 × 𝑄

Solve for Q, Q=20

To find Price, plug Q = 20 it into the demand function;

𝑃 = 2000 − 50𝑄
𝑃 = 2000 − 1000
𝑃 = $1000

Thus, demand for Dolan's engines will be unitary elastic at a price of $1000.
Practice Problem 2

After a careful statistical analysis, the Chidester Company concludes the demand function for its
product is Q = 500 - 3P + 2Pr + 0.1I where Q is the quantity demanded of its product, P is the price of
the product, Pr is the price of its rival's product, and I is per capita disposable income (in dollars). At
present, P = $10, Pr = $20 and I = $6000.

a) What is the price elasticity of demand for the firm's product?

Demand function:
Q = 500 - 3P + 2Pr + 0.1I
Plugging P = $10, Pr = $20 and I = $6000 into the demand function; Q=1110
Formula for price elasticity of demand:

𝑑𝑄 𝑃
ϵd = ×
𝑑𝑃 𝑄

10
ϵd = −3 × 1110

ϵd = -3/111 = -0.027

b) What is the income elasticity of demand for the firm's product?

Formula for income elasticity of demand:

𝑑𝑄 𝐼
ϵI = 𝑑𝐼
×𝑄

6000
ϵI = 0.1 × 1110

ϵI = 60/111 = 0.54

c) What is the cross-price elasticity of demand between its product and its rival's product?
Formula for cross elasticity of demand:

𝑑𝑄 𝑃𝑟
ϵxy = 𝑑𝑃𝑟 × 𝑄

20
ϵxy = 2 × 1110

ϵxy = 4/111 = 0.0360

d) What is the implicit assumption regarding the population in the market?

The population is assumed to be constant.
Practice Problem 3

From November 2007 to March 2008, the price of gold increased from $865 per ounce to over $1,000
per ounce. Newspaper articles during this period said there was no increased demand from the
jewelry industry but significantly greater demand from investors who were purchasing gold because
of the falling dollar. For each of the following demand curves, indicate whether the curve shifted
inwards, outwards, or did not shift at all.

a) Gold demand by jewelry industry: No shift in demand curve

b) Gold demand by investors: Demand curve shifts outwards

c) Aggregate demand for gold: Market demand curve shifts outward as it is horizontal summation
of gold demand by jewelry industry and investors.
Practice Problem 3

Given demand equation Q=40000-4P,

a. Find the revenue that the firm may earn if the price is Rs. 5000.
Revenue = Price * Quantity
At price of Rs. 5000, quantity demanded will be 20000 units. (Plug 5000 in the demand
equation)
Revenue = Price * Quantity
Revenue = 5000*20000 = Rs. 100,000,000
b. Graph the function and use the ‘area under the curve’ approach to do the above
computation.

Q = 40000-4P
Price

10000

5000

0 20000 40000 Quantity

Using ‘area under the curve’ approach, revenue will be the area (L*B) of the blue triangle.
Revenue = 5000*20000 = Rs. 100,000,000

c. Find the consumer surplus

Consumer surplus is given by the area of the triangle; above market price (P=5000) and below
1
the demand curve. We can use the formula for area of a triangle = 2 × base × height, to
calculate the consumer surplus. In this case the base of the triangle is 20000 and the height is
5000 (10000-5000), therefore

1
Consumer Surplus = × 20000 × 5000 = 50,000,000
2
 Q = 40000-4P
Price

10000

Consumer Surplus

5000

0 20000 40000 Quantity

d. Find change in revenue and change in consumer surplus if the price increases to Rs. 7500.
If price increase to Rs. 7500, the quantity demanded will be 10000 units.
New Revenue = 7500*10000 = Rs. 75,000,000
Revenue falls by Rs. 25,000,000
1
New Consumer Surplus = 2 × 10000 × 2500 = 12,500,000
Consumer surplus falls by 37,500,000.

Q = 40000-4P
Price

10000 New Consumer Surplus

7500 New Revenue

5000

0 10000 20000 40000 Quantity

 MGEC: Lecture 3

Practice Problems Answer Key

Problem 1

A survey indicated that chocolate is the most popular ice cream flavor. For each of the following,
indicate the possible effects on demand, supply, or both as well as equilibrium price and quantity of
chocolate ice cream.
a) A severe drought causes dairy farmers to reduce the number of milk-producing cattle in their
herds by a third. These dairy farmers supply cream that is used to manufacture chocolate ice
cream.
Effect on demand: No effect on demand curve
Effect on supply: Supply curve moves inwards; Supply decreases
Equilibrium price and quantity of chocolate ice cream: Equilibrium price increases and
equilibrium quantity decreases

b) Latest research suggests that chocolate does, in fact, have significant health benefits.
Effect on demand: Demand curve moves outwards; Demand increases
Effect on supply: Supply curve also moves inwards as the cost of chocolate will likely go up;
Supply decreases
Equilibrium price and quantity of chocolate ice cream: Equilibrium price increases and
equilibrium quantity is ambiguous. (It may remain the same, increase or decrease depending on
the extent to which the supply curve moves inwards.)

c) The discovery of cheaper synthetic vanilla flavoring lowers the price of vanilla ice cream.
Assuming vanilla ice cream is a substitute good, which has now become cheaper.
Effect on demand: Demand curve moves inwards. Demand decreases
Effect on supply: No effect on supply curve
Equilibrium price and quantity of chocolate ice cream: Equilibrium price decreases and
equilibrium quantity decreases

d) New technology for mixing and freezing ice cream lowers manufacturers' costs of producing
chocolate ice cream.
Effect on demand: No effect on demand curve
Effect on supply: Supply curve moves outwards; Supply increases
Equilibrium price and quantity of chocolate ice cream: Equilibrium price decreases and
equilibrium quantity increases

Problem 2

Consider a market where supply and demand are given as the following:
Demand Curve: QD = 20 - 2P
Supply Curve: QS = 2P
a) Calculate the market equilibrium price and quantity
Market equilibrium price and quantity can be found by equating the demand and supply
functions:
 QD = QS
20-2P = 2P, Solving for P,
P=5
To find Q, plug P = 5 in the demand function; QD = 20-2P; QD = 10
Thus, market equilibrium price = 5 and quantity = 10

b) Calculate the consumer surplus at equilibrium

At equilibrium, consumer surplus is given by the area of the triangle; above equilibrium price
(P=5) and below the demand curve. We can use the formula for area of a triangle = 1/2 × base ×
height, to calculate the consumer surplus. In this case the base of the triangle is 10 and the
height is 5 (10-5), therefore

𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 = 1/2 × 10 × 5 = 25

Price

10 Supply
Consumer Surplus

5 Equilibrium

Demand

0 10 20 Quantity

c) Calculate the producer surplus at equilibrium

At equilibrium, producer surplus is given by the area of the inverted triangle; below equilibrium
price (P=5) and above the supply curve. We can use the formula for area of a triangle = 1/2 ×
base × height, to calculate the producer surplus. In this case the base of the triangle is 10 and
the height is 5, therefore

𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑟 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 = 1/2 × 10 × 5 = 25

Price

10 Supply

5 Equilibrium

Producer
Surplus Demand

0 10 20 Quantity
 MGEC: Session 4

Practice Problems Answer Key

Practice Problem 1

The Lone Star Transportation Company hauls coal and manufactured goods. The demand curve for its
services by the coal producers is PC = 495 - 5QC where PC is the price (in dollars) per ton-mile of coal
hauled and QC is the number of ton-mile of coal hauled (in thousands). The demand curve for its
services by the producers of manufactured goods is PM = 750 - 10QM where PM is the price (in dollars)
per ton-mile of manufactured goods hauled and QM is the number of ton-mile of manufactured goods
hauled (in thousands). The firm's total cost function is TC = 410 + 8(QC + QM) where TC is total cost (in
thousands of dollars).

a) What price should managers charge to haul coal?

Given,
Demand curve by coal producers: PC = 495 - 5QC
Demand curve by producers of manufactured goods: PM = 750 - 10QM
Firm’s Total cost function: TC = 410 + 8(QC + QM)

The firm’s profit (𝜋) = (Revenue from coal producers + Revenue from producers of
manufactured goods) – Total Costs, or
𝜋 = (𝑃𝑐 𝑄𝑐 + 𝑃𝑚 𝑄𝑚 ) − 𝑇𝐶

𝜋 = 𝑄𝑐 (495 − 5𝑄𝑐 ) + 𝑄𝑚 (750 − 10𝑄𝑚 ) − (410 + 8(QC + QM))

𝜋 = −410 + 487𝑄𝑐 − 5𝑄𝑐 2 + 742𝑄𝑚 − 10𝑄𝑚2

To maximize profits with respect to QC and QM we need to find first derivatives of the above
equation with respect to QC and QM and set them equal to 0:
𝜕𝜋
= 487 − 10𝑄𝑐
𝜕𝑄𝑐

0 = 487 − 10𝑄𝑐

Solving for QC , QC = 48.7, and similarly

𝜕𝜋
= 742 − 20𝑄𝑚
𝜕𝑄𝑚

0 = 742 − 20𝑄𝑚
Solving for Qm , Qm = 37.1
 Now we can find the Prices (PC and PM) by substituting QC and QM in the respective demand
functions.
PC = 495 - 5Qc, plugging QC = 48.7, in the equation, PC = 251.5

PM = 750 - 10Qm plugging Qm = 37.1, in the equation, Pm = 379

Hence, the firm should charge $251.5 per ton-mile of coal hauled.

b) What price should managers charge to haul manufactured goods?

Please refer to the solution to part a.

The firm should charge $379 per ton-mile of manufactured goods hauled.

c) If a regulatory agency were to require managers to charge the same price to haul both coal
and manufactured goods, would this reduce the firm's profit? If so, by how much?

Profits of the firm with discriminatory pricing can be found by plugging the following values;
PC = 251.5, QC = 48.7, PM = 379 and Qm = 37.1, in the equation:
𝜋 = −410 + 487𝑄𝑐 − 5𝑄𝑐 2 + 742𝑄𝑚 − 10𝑄𝑚2

𝜋 = $25212.55

If the firm were to charge the same price to haul both coal and manufactured goods, then
PC = P M
Letting this common price be P, the demand functions can be re-written as;
𝑃
𝑄𝑐 = 99 −
5
𝑃
𝑄𝑚 = 75 −
10
Since Q = QC + QM
3𝑃
𝑄 = 174 −
10
10𝑄
𝑃 = 580 −
3

Profit = TR - TC

𝜋 = 𝑃. 𝑄 − 𝑇𝐶
10𝑄
𝜋 = (580 − ) 𝑄 − (410 + 8𝑄)
3

To maximize profits with respect to Q we need to find first derivative of the above equation with
respect to Q and set it equal to 0:
 𝜕𝜋 20
= 572 − 𝑄
𝜕𝑄 3

20
0 = 572 − 𝑄
3

Solving for Q , Q = 85.8

Now we can find the Price (P) by substituting Q = 85.8 in the demand function;
10𝑄
𝑃 = 580 −
3
𝑃 = 294
Also, we can find the profit by plugging this value (Q = 85.8) in the profit equation:
10𝑄
𝜋 = (580 − ) 𝑄 − (410 + 8𝑄)
3
𝜋 = $ 24128.8
Clearly, by giving up discriminatory pricing, the firm’s profit has reduced.
The profit has reduced by $1083.7 (25212.55-24128.8).
Practice Problem 2

The Burr Corporation's total cost function (where TC is the total cost in Rupees and Q is quantity) is TC
= 20 + 2Q + 2Q2

a) If the firm is perfectly competitive and the price of its product is Rs. 24, what is its optimal
output rate?
At a given price, optimal output for perfectly competitive firm will be the one where marginal
cost equals price.
Given, Price = Rs. 24 and marginal cost can be found as follows
𝑇𝐶 = 20 + 2𝑄 + 2𝑄 2

𝑑𝑇𝐶
𝑀𝐶 =
𝑑𝑄

𝑀𝐶 = 2 + 4𝑄

To find optimal output, Equate P = MC

24 = 2 + 4𝑄

𝑄 = 5.5

b) At this output rate, what is its profit?

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 – 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
𝜋 = P. Q − TC
𝜋 = (24 × 5.5) − (20 + 2Q + 2𝑄 2 )

𝜋 = 𝑅𝑠. 40.5

At output level of Q = 5.5, the firm makes a profit Rs. 40.5

Practice Problem 3

The White Company is a member of the lamp industry, which is perfectly competitive. The price of a
lamp is $50. The firm's total cost function is TC = 1000 + 20Q + 5Q 2 where TC is total cost (in dollars)
and Q is hourly output.

a) What output maximizes profit?

At a given price, optimal output for perfectly competitive firm will be the one where marginal
cost equals price.
Given, Price = $ 50 and marginal cost can be found as follows
𝑇𝐶 = 1000 + 20𝑄 + 5𝑄 2
𝑑𝑇𝐶
𝑀𝐶 =
𝑑𝑄

𝑀𝐶 = 20 + 10𝑄

To find optimal output, Equate P = MC

50 = 20 + 10𝑄

𝑄 = 3
b) What is the firm's economic profit at this output?
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 – 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
𝜋 = 𝑃. 𝑄 − 𝑇𝐶
𝜋 = (50 × 3) − (1000 + 20𝑄 + 5𝑄 2 )
𝜋 = −955

At output level of Q = 3, the firm faces a loss of $955.

c) What is the firm's average cost at this output?

Given firm’s Total Cost Function:
𝑇𝐶 = 1000 + 20𝑄 + 5𝑄 2

𝑇𝐶
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑠𝑡 (𝐴𝐶) =
𝑄

1000 + 20𝑄 + 5𝑄 2
𝐴𝐶 =
𝑄

At output of Q = 3, AC = $368.33

d) If other firms in the lamp industry have the same cost function as this firm, is the industry in
equilibrium? Why or why not?
A perfectly competitive firm is in equilibrium when it makes no economic profits (or losses). In
this case, at given price of $50, all firms are incurring losses (as other firms in the lamp industry
have the same cost function as this firm) Hence, the industry is not in equilibrium.
 Chapter 2
The Basics of Supply and Demand

◼ Questions for Review

1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the
right. Why will the price of ice cream rise to a new market-clearing level?
Suppose the supply of ice cream is completely inelastic in the short run, so the supply curve is
vertical as shown below. The initial equilibrium is at price P1. The unusually hot weather causes the
demand curve for ice cream to shift from D1 to D2, creating short-run excess demand (i.e., a temporary
shortage) at the current price. Consumers will bid against each other for the ice cream, putting
upward pressure on the price, and ice cream sellers will react by raising price. The price of ice cream
will rise until the quantity demanded and the quantity supplied are equal, which occurs at price P2.

2. Use supply and demand curves to illustrate how each of the following events would affect the
price of butter and the quantity of butter bought and sold:
a. An increase in the price of margarine.
Butter and margarine are substitute goods for most people. Therefore, an increase in the price of
margarine will cause people to increase their consumption of butter, thereby shifting the demand
curve for butter out from D1 to D2 in Figure 2.2.a. This shift in demand causes the equilibrium
price of butter to rise from P1 to P2 and the equilibrium quantity to increase from Q1 to Q2.

Figure 2.2.a

Page 1 of 31
b. An increase in the price of milk.
Milk is the main ingredient in butter. An increase in the price of milk increases the cost of
producing butter, which reduces the supply of butter. The supply curve for butter shifts from
S1 to S2 in Figure 2.2.b, resulting in a higher equilibrium price, P2 and a lower equilibrium
quantity, Q2, for butter.

Figure 2.2.b
Note: Butter is in fact made from the fat that is skimmed from milk; thus butter and milk are
joint products, and this complicates things. If you take account of this relationship, your answer
might change, but it depends on why the price of milk increased. If the increase were caused by
an increase in the demand for milk, the equilibrium quantity of milk supplied would increase.
With more milk being produced, there would be more milk fat available to make butter, and the
price of milk fat would fall. This would shift the supply curve for butter to the right, resulting in
a drop in the price of butter and an increase in the quantity of butter supplied.

c. A decrease in average income levels.

Assuming that butter is a normal good, a decrease in average income will cause the demand
curve for butter to decrease (i.e., shift from D1 to D2). This will result in a decline in the
equilibrium price from P1 to P2, and a decline in the equilibrium quantity from Q1 to Q2. See
Figure 2.2.c.

Figure 2.2.c

Page 2 of 31
 3. If a 3% increase in the price of corn flakes causes a 6% decline in the quantity demanded,
what is the elasticity of demand?
The elasticity of demand is the percentage change in the quantity demanded divided by the
percentage change in the price. The elasticity of demand for corn flakes is therefore
%Q −6
EPD = = = −2.
%P +3

4. Explain the difference between a shift in the supply curve and a movement along the supply
curve.
A movement along the supply curve occurs when the price of the good changes. A shift of the supply
curve is caused by a change in something other than the good’s price that results in a change in the
quantity supplied at the current price. Some examples are a change in the price of an input, a change
in technology that reduces the cost of production, and an increase in the number of firms supplying
the product.

5. Explain why for many goods, the long-run price elasticity of supply is larger than the short-
run elasticity.
The price elasticity of supply is the percentage change in the quantity supplied divided by the
percentage change in price. In the short run, an increase in price induces firms to produce more by
using their facilities more hours per week, paying workers to work overtime and hiring new workers.
Nevertheless, there is a limit to how much firms can produce because they face capacity constraints
in the short run. In the long run, however, firms can expand capacity by building new plants and
hiring new permanent workers. Also, new firms can enter the market and add their output to total
supply. Hence a greater change in quantity supplied is possible in the long run, and thus the price
elasticity of supply is larger in the long run than in the short run.

6. Why do long-run elasticities of demand differ from short-run elasticities? Consider two goods:
paper towels and televisions. Which is a durable good? Would you expect the price elasticity of
demand for paper towels to be larger in the short run or in the long run? Why? What about
the price elasticity of demand for televisions?
Long-run and short-run elasticities differ based on how rapidly consumers respond to price changes
and how many substitutes are available. If the price of paper towels, a non-durable good, were to
increase, consumers might react only minimally in the short run because it takes time for people to
change their consumption habits. In the long run, however, consumers might learn to use other
products such as sponges or kitchen towels instead of paper towels. Thus, the price elasticity would
be larger in the long run than in the short run. In contrast, the quantity demanded of durable goods,
such as televisions, might change dramatically in the short run. For example, the initial result of a
price increase for televisions would cause consumers to delay purchases because they could keep
on using their current TVs longer. Eventually consumers would replace their televisions as they wore
out or became obsolete. Therefore, we expect the demand for durables to be more elastic in the short
run than in the long run.

Page 3 of 31
 7. Are the following statements true or false? Explain your answers.

a. The elasticity of demand is the same as the slope of the demand curve.
False. Elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in the price of the product. In contrast, the slope of the demand curve is the
change in quantity demanded (in units) divided by the change in price (typically in dollars).
The difference is that elasticity uses percentage changes while the slope is based on changes
in the number of units and number of dollars.

b. The cross-price elasticity will always be positive.

False. The cross-price elasticity measures the percentage change in the quantity demanded of
one good due to a 1% change in the price of another good. This elasticity will be positive for
substitutes (an increase in the price of hot dogs is likely to cause an increase in the quantity
demanded of hamburgers) and negative for complements (an increase in the price of hot dogs is
likely to cause a decrease in the quantity demanded of hot dog buns).

c. The supply of apartments is more inelastic in the short run than the long run.
True. In the short run it is difficult to change the supply of apartments in response to a change in
price. Increasing the supply requires constructing new apartment buildings, which can take a
year or more. Therefore, the elasticity of supply is more inelastic in the short run than in the long
run.

11. Suppose the demand curve for a product is given by Q = 10 − 2P + PS, where P is the price of
the product and PS is the price of a substitute good. The price of the substitute good is $2.00.
a. Suppose P = $1.00. What is the price elasticity of demand? What is the cross-price
elasticity of demand?
Find quantity demanded when P = $1.00 and PS = $2.00. Q = 10 − 2(1) + 2 = 10.
P Q 1 2
Price elasticity of demand = = (−2) = − = −0.2.
Q P 10 10
P Q 2
Cross-price elasticity of demand = s = (1) = 0.2.
Q Ps 10

b. Suppose the price of the good, P, goes to $2.00. Now what is the price elasticity of demand?
What is the cross-price elasticity of demand?
When P = $2.00, Q = 10 − 2(2) + 2 = 8.
P Q 2 4
Price elasticity of demand = = (−2) = − = −0.5.
Q P 8 8
Ps Q 2
Cross-price elasticity of demand = = (1) = 0.25.
Q Ps 8

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◼ Exercises

7. In 2010, Americans smoked 315 billion cigarettes, or 15.75 billion packs of cigarettes. The
average retail price (including taxes) was about $5.00 per pack. Statistical studies have shown
that the price elasticity of demand is −0.4, and the price elasticity of supply is 0.5.
a. Using this information, derive linear demand and supply curves for the cigarette market.
Let the demand curve be of the form Q = a − bP and the supply curve be of the form Q = c + dP,
where a, b, c, and d are positive constants. To begin, recall the formula for the price elasticity of
demand
P Q
EPD = .
Q P
We know the demand elasticity is –0.4, P = 5, and Q = 15.75, which means we can solve for the
slope, −b, which is Q/P in the above formula.
5 Q
−0.4 =
15.75 P
Q  15.75 
= −0.4   = −1.26 = −b.
P  5 
To find the constant a, substitute for Q, P, and b in the demand function to get 15.75 = a −
1.26(5), so a = 22.05. The equation for demand is therefore Q = 22.05 − 1.26P. To find the
supply curve, recall the formula for the elasticity of supply and follow the same method as
above:
P Q
EPS =
Q P
5 Q
0.5 =
15.75 P
Q  15.75 
= 0.5   = 1.575 = d.
P  5 
To find the constant c, substitute for Q, P, and d in the supply function to get 15.75 = c + 1.575(5)
and c = 7.875. The equation for supply is therefore Q = 7.875 + 1.575P.

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 Chapter 4
Individual and Market Demand

3. Explain whether the following statements are true or false:

c. Engel curves always slope upward.
False. If the good is an inferior good, quantity demanded decreases as income increases, and
therefore the Engel curve slopes downward.

4. Tickets to a rock concert sell for $10. But at that price, the demand is substantially greater
than the available number of tickets. Is the value or marginal benefit of an additional ticket
greater than, less than, or equal to $10? How might you determine that value?
The diagram below shows this situation. At a price of $10, consumers want to purchase Q tickets, but
only Q* are available. Consumers would be willing to bid up the ticket price to P*, where the
quantity demanded equals the number of tickets available. Since utility-maximizing consumers are
willing to pay more than $10, the marginal increase in satisfaction (i.e., the value or marginal benefit
of an additional ticket) is greater than $10. One way to determine the value of an additional ticket
would be to auction it off. Another possibility is to allow scalping. Since consumers are willing to
pay an amount equal to the marginal benefit they derive from purchasing an additional ticket, the
scalper’s price equals that value.

7. Which of the following events would cause a movement along the demand curve for U.S.
produced clothing, and which would cause a shift in the demand curve?

a. the removal of quotas on the importation of foreign clothes

The removal of quotas will allow U.S. consumers to buy more foreign clothing. Because foreign
produced goods are substitutes for domestically produced goods, the removal of quotas will result
in a decrease in demand (a shift to the left) for U.S. produced clothes. There could be a smaller
secondary effect also. When the quotas are removed, the total supply (foreign plus domestic)
of clothing will increase, causing clothing prices to fall. The drop in clothing prices will lead
consumers to buy more U.S. produced clothing, which is a movement along the demand curve.

b. an increase in the income of U.S. citizens

When income rises, expenditures on normal goods such as clothing increase, causing the
demand curve to shift out to the right.

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 c. a cut in the industry’s costs of producing domestic clothes that is passed on to the market
in the form of lower prices
A cut in an industry’s costs will shift the supply curve out. The equilibrium price will fall and
quantity demanded will increase. This is a movement along the demand curve.

11. Explain which of the following items in each pair is more price elastic.
a. The demand for a specific brand of toothpaste and the demand for toothpaste in general
The demand for a specific brand is more elastic because the consumer can easily switch to
another brand if the price goes up. It is not so easy to switch to a different tooth brushing agent
(baking soda?).

b. The demand for gasoline in the short run and the demand for gasoline in the long run
Demand in the long run is more elastic since consumers have more time to adjust to a change in
price. For example, consumers can buy more fuel efficient vehicles, move closer to work or
school, organize car pools, etc.

◼ Exercises

7. The director of a theater company in a small college town is considering changing the way he
prices tickets. He has hired an economic consulting firm to estimate the demand for tickets.
The firm has classified people who go to the theater into two groups, and has come up with two
demand functions. The demand curves for the general public (Qgp) and students (Qs) are given
below:
Qgp = 500 − 5 P
Qs = 200 − 4 P
a. Graph the two demand curves on one graph, with P on the vertical axis and Q on the
horizontal axis. If the current price of tickets is $35, identify the quantity demanded by
each group.
Both demand curves are downward sloping and linear. For the general public, Dgp, the vertical
intercept is 100 and the horizontal intercept is 500. For the students, Ds, the vertical intercept
is 50 and the horizontal intercept is 200. When the price is $35, the general public demands
Qgp = 500 − 5(35) = 325 tickets and students demand Qs = 200 − 4(35) = 60 tickets.

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 b. Find the price elasticity of demand for each group at the current price and quantity.
P Q 35
The elasticity for the general public is  gp = = (−5) = −0.54, and the elasticity for
Q P 325
P Q 35
students is  S = = (−4) = −2.33. If the price of tickets increases by 10% then the general
Q P 60
public will demand 5.4% fewer tickets and students will demand 23.3% fewer tickets.

c. Is the director maximizing the revenue he collects from ticket sales by charging $35 for
each ticket? Explain.
No, he is not maximizing revenue because neither of the calculated elasticities is equal to −1.
The general public’s demand is inelastic at the current price. Thus the director could increase the
price for the general public, and the quantity demanded would fall by a smaller percentage,
causing revenue to increase. Since the students’ demand is elastic at the current price, the
director could decrease the price students pay, and their quantity demanded would increase by a
larger amount in percentage terms, causing revenue to increase.

d. What price should he charge each group if he wants to maximize revenue collected from
ticket sales?
To figure this out, use the formula for elasticity, set it equal to −1, and solve for price and
quantity. For the general public:
−5P
 gp = = −1
Q
5P = Q = 500 − 5P
P = 50
Q = 250.
For the students:
−4 P
s = = −1
Q
4 P = Q = 200 − 4 P
P = 25
Q = 100.
These prices generate a larger total revenue than the $35 price. When price is $35, revenue is
(35)(Qgp + Qs) = (35)(325 + 60) = $13,475. With the separate prices, revenue is PgpQgp + PsQs =
(50)(250) + (25)(100) = $15,000, which is an increase of $1525, or 11.3%.

15. Suppose that you are the consultant to an agricultural cooperative that is deciding whether
members should cut their production of cotton in half next year. The cooperative wants your
advice as to whether this action will increase members’ revenues. Knowing that cotton (C) and
soybeans (S) both compete for agricultural land in the South, you estimate the demand for
cotton to be C = 3.5 − 1.0PC + 0.25PS + 0.50I, where PC is the price of cotton, PS the price of
soybeans, and I income. Should you support or oppose the plan? Is there any additional
information that would help you to provide a definitive answer?

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If production of cotton is cut in half, then the price of cotton will increase, given that the equation
above shows that demand is downward sloping (since the sign on PC is negative). With price
increasing and quantity demanded decreasing, revenue could go either way. It depends on whether
demand is elastic or inelastic. If demand is elastic, a decrease in production and an increase in price
would decrease revenue. If demand is inelastic, a decrease in production and an increase in price would
increase revenue. You need a lot of information before you can give a definitive answer. First, you
must know the current prices for cotton and soybeans plus the level of income; then you can calculate
the quantity of cotton demanded, C. Next, you have to cut C in half and determine the effect that will
have on the price of cotton, assuming that income and the price of soybeans are not affected (which
is a big assumption). Then you can calculate the original revenue and the new revenue to see
whether this action increases members’ revenues or not.

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 Chapter 6
Production

◼ Questions for Review

1. What is a production function? How does a long-run production function differ from a short-run
production function?
A production function represents how inputs are transformed into outputs by a firm. In particular,
a production function describes the maximum output that a firm can produce for each specified
combination of inputs. In the short run, one or more factors of production cannot be changed,
so a short-run production function tells us the maximum output that can be produced with different
amounts of the variable inputs, holding fixed inputs constant. In the long-run production function,
all inputs are variable.

2. Why is the marginal product of labor likely to increase initially in the short run as more of the
variable input is hired?
The marginal product of labor is likely to increase initially because when there are more workers,
each is able to specialize in an aspect of the production process in which he or she is particularly
skilled. For example, think of the typical fast food restaurant. If there is only one worker, he will
need to prepare the burgers, fries, and sodas, as well as take the orders. Only so many customers can
be served in an hour. With two or three workers, each is able to specialize, and the marginal product
(number of customers served per hour) is likely to increase as we move from one to two to three
workers. Eventually, there will be enough workers and there will be no more gains from
specialization. At this point, the marginal product will begin to diminish.

3. Why does production eventually experience diminishing marginal returns to labor in the
short run?
The marginal product of labor will eventually diminish because there will be at least one fixed factor
of production, such as capital. As more and more labor is used along with a fixed amount of capital,
there is less and less capital for each worker to use, and the productivity of additional workers
necessarily declines. Think for example of an office where there are only three computers. As more
and more employees try to share the computers, the marginal product of each additional employee
will diminish.

11. Is it possible to have diminishing returns to a single factor of production and constant returns
to scale at the same time? Discuss.
Diminishing returns and returns to scale are completely different concepts, so it is quite possible to
have both diminishing returns to, say, labor and constant returns to scale. Diminishing returns to a
single factor occurs because all other inputs are fixed. Thus, as more and more of the variable factor
is used, the additions to output eventually become smaller and smaller because there are no increases
in the other factors. The concept of returns to scale, on the other hand, deals with the increase in output
when all factors are increased by the same proportion. While each factor by itself exhibits diminishing
returns, output may more than double, less than double, or exactly double when all the factors are
doubled. The distinction again is that with returns to scale, all inputs are increased in the same

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 proportion and no inputs are fixed. The production function in Exercise 10 is an example of a
function with diminishing returns to each factor and constant returns to scale.

◼ Exercises

2. Suppose a chair manufacturer is producing in the short run (with its existing plant and
equipment). The manufacturer has observed the following levels of production corresponding
to different numbers of workers:
Number of Workers Number of Chairs
1 10
2 18
3 24
4 28
5 30
6 28
7 25
a. Calculate the marginal and average product of labor for this production function.
q
The average product of labor, APL, is equal to . The marginal product of labor, MPL, is equal
L
q
to , the change in output divided by the change in labor input. For this production process we
L
have:
L q APL MPL
0 0 — —
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 28 4.7 −2
7 25 3.6 −3

b. Does this production function exhibit diminishing returns to labor? Explain.

Yes, this production function exhibits diminishing returns to labor. The marginal product of
labor, the extra output produced by each additional worker, diminishes as workers are added,
and this starts to occur with the second unit of labor.

c. Explain intuitively what might cause the marginal product of labor to become negative.
Labor’s negative marginal product for L  5 may arise from congestion in the chair manufacturer’s
factory. Since more laborers are using the same fixed amount of capital, it is possible that they
could get in each other’s way, decreasing efficiency and the amount of output. Firms also have
to control the quality of their output, and the high congestion of labor may produce products that
are not of a high enough quality to be offered for sale, which can contribute to a negative
marginal product.

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 Chapter 7
The Cost of Production

◼ Questions for Review

1. A firm pays its accountant an annual retainer of $10,000. Is this an economic cost?
This is an explicit cost of purchasing the services of the accountant, and it is both an economic and
an accounting cost. When the firm pays an annual retainer of $10,000, there is a monetary
transaction. The accountant trades his or her time in return for money. An annual retainer is an
explicit cost and therefore part of the economic cost.

2. The owner of a small retail store does her own accounting work. How would you measure the
opportunity cost of her work?
The opportunity cost of doing accounting work is measured by computing the monetary amount that
the owner’s time would be worth in its next best use. For example, if she could do accounting work
for some other company instead of her own, her opportunity cost is the amount she could have
earned in that alternative employment. Or if she is a great stand-up comic, her opportunity cost is
what she could have earned in that occupation instead of doing her own accounting work.

3. Please explain whether the following statements are true or false.

a. If the owner of a business pays himself no salary, then the accounting cost is zero, but the
economic cost is positive.
True. Since there is no monetary transaction, there is no accounting, or explicit, cost. However,
since the owner of the business could be employed elsewhere, there is an opportunity cost. The
opportunity cost is the value of the owner’s time in his next best alternative, or the amount that
the owner would earn if he took the next best job. Thus, the economic cost is positive.

b. A firm that has positive accounting profit does not necessarily have positive economic
profit.
True. Accounting profit considers only the explicit, monetary costs. Since there may be some
opportunity costs that were not fully realized as explicit monetary costs, it is possible that when
the opportunity costs are added in, economic profit will become negative. This indicates that the
firm’s resources are not being put to their best use.

c. If a firm hires a currently unemployed worker, the opportunity cost of utilizing the
worker’s services is zero.
False. From the firm’s point of view, the wage paid to the worker is an explicit cost whether she
was previously unemployed or not. The firm’s opportunity cost is equal to the wage, because if
it did not hire this worker, it would have had to hire someone else at the same wage. The
opportunity cost from the worker’s point of view is the value of her time, which is unlikely to be
zero. By taking this job, she cannot work at another job or take care of a child or elderly person
at home.
If her best alternative is working at another job, she gives up the wage she would have earned.

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 If her best alternative is unpaid, such as taking care of a loved one, she will now have to pay
someone else to do that job, and the amount she has to pay is her opportunity cost.

12. Distinguish between economies of scale and economies of scope. Why can one be present
without the other?
Economies of scale refer to the production of one good and occur when total cost increases by a
smaller proportion than output. Economies of scope refer to the production of two or more goods
and occur when joint production is less costly than the sum of the costs of producing each good
separately. There is no direct relationship between economies of scale and economies of scope, so
production can exhibit one without the other. For example, there are economies of scale producing
computers and economies of scale producing carpeting, but if one company produced both, there
would likely be no synergies associated with joint production and hence no economies of scope.

◼ Exercises

4. Suppose a firm must pay an annual tax, which is a fixed sum, independent of whether it
produces any output.

a. How does this tax affect the firm’s fixed, marginal, and average costs?
This tax is a fixed cost because it does not vary with the quantity of output produced. If T is
the amount of the tax and F is the firm’s original fixed cost, the new total fixed cost increases
to TFC = T + F. The tax does not affect marginal or variable cost because it does not vary with
output. The tax increases both average fixed cost and average total cost by T/q.
b. Now suppose the firm is charged a tax that is proportional to the number of items it
produces. Again, how does this tax affect the firm’s fixed, marginal, and average costs?
Let t equal the per unit tax. When a tax is imposed on each unit produced, total variable cost
increases by tq and fixed cost does not change. Average variable cost increases by t, and because
fixed costs are constant, average total cost also increases by t. Further, because total cost
increases by t for each additional unit produced, marginal cost increases by t.

9. The short-run cost function of a company is given by the equation TC = 200 + 55q, where TC is
the total cost and q is the total quantity of output, both measured in thousands.

a. What is the company’s fixed cost?

When q = 0, TC = 200, so fixed cost is equal to 200 (or $200,000).

b. If the company produced 100,000 units of goods, what would be its average variable cost?
With 100,000 units, q = 100. Variable cost is 55q = (55)(100) = 5500 (or $5,500,000). Average
VC 5500
variable cost is = = 55 (or $55,000).
q 100

c. What would be its marginal cost of production?

With constant average variable cost, marginal cost is equal to average variable cost, which is 55
(or $55,000).

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 d. What would be its average fixed cost?
FC 200
At q = 100, average fixed cost is = = 2 (or $2000).
q 100

14. A computer company produces hardware and software using the same plant and labor. The
total cost of producing computer processing units H and software programs S is given by
TC = aH + bS − cHS
where a, b, and c are positive. Is this total cost function consistent with the presence of
economies or diseconomies of scale? With economies or diseconomies of scope?
If each product were produced by itself there would be neither economies nor diseconomies of scale.
To see this, define the total cost of producing H alone (TCH) to be the total cost when S = 0. Thus
TCH = aH. Similarly, TCS = bS. In both cases, doubling the number of units produced doubles the
total cost, so there are no economies or diseconomies of scale.
Economies of scope exist if SC > 0, where, from equation (7.7) in the text:
C (q1 ) + C (q2 ) − C (q1 , q2 )
SC = .
C (q1 , q2 )
In our case, C(q1) is TCH, C(q2) is TCS, and C(q1, q2) is TC. Therefore,
aH + bS − (aH + bS − cHS ) cHS
SC = = .
aH + bS − cHS aH + bS − cHS
Because cHS (the numerator) and TC (the denominator) are both positive, it follows that SC > 0, and
hence there are economies of scope.

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 Chapter 8
Profit Maximization and Competitive Supply

◼ Review Questions

1. Why would a firm that incurs losses choose to produce rather than shut down?
Losses occur when revenues do not cover total costs. If revenues are greater than variable costs, but
not total costs, the firm is better off producing in the short run rather than shutting down, even
though it is incurring a loss. The reason is that the firm will be stuck will all its fixed cost and have no
revenue if it shuts down, so its loss will equal its fixed cost. If it continues to produce, however, and
revenue is greater than variable costs, the firm can pay for some of its fixed cost, so its loss is less than
it would be if it shut down. In the long run, all costs are variable, and thus all costs must be covered
if the firm is to remain in business.

2. Explain why the industry supply curve is not the long-run industry marginal cost curve.
In the short run, a change in the market price induces the profit-maximizing firm to change its optimal
level of output. This optimal output occurs where price is equal to marginal cost, as long as marginal
cost exceeds average variable cost. Therefore, the short-run supply curve of the firm is its marginal
cost curve, above average variable cost. (When the price falls below average variable cost, the firm
will shut down.)
In the long run, a change in the market price induces entry into or exit from the industry and may
induce existing firms to change their optimal outputs as well. As a result, the prices firms pay for inputs
can change, and these will cause the firms’ marginal costs to shift up or down. Therefore, long-run
supply is not the sum of the existing firms’ long-run marginal cost curves. The long-run supply
curve depends on the number of firms in the market and on how their costs change due to any
changes in input costs.
As a simple example, consider a constant-cost industry where each firm has a U-shaped LAC curve.
Here the input prices do not change, only the number of firms changes when industry price changes.
Each firm has an increasing LMC, but the industry long-run supply is horizontal because any change
in industry output comes about by firms entering or leaving the industry, not by existing firms
moving up or down their LMC curves.

3. In long-run equilibrium, all firms in the industry earn zero economic profit. Why is this true?
The theory of perfect competition explicitly assumes that there are no entry or exit barriers to new
participants in an industry. With free entry, positive economic profits induce new entrants. As these
firms enter, the supply curve shifts to the right, causing a fall in the equilibrium price of the product.
Entry will stop, and equilibrium will be achieved, when economic profits have fallen to zero.
Some firms may earn greater accounting profits than others because, for example, they own a superior
source of an important input, but their economic profits will be the same. To be more concrete, suppose
one firm can mine a critical input for $2 per pound while all other firms in the industry have to pay
$3 per pound. The one firm will have an accounting cost advantage and will report higher accounting
profits than other firms in the industry. But there is an opportunity cost associated with the company’s
input use, because other firms would be willing to pay up to $3 per pound to buy the input from the
firm with the superior mine. Therefore, the company should include a $1 per pound opportunity cost

Page 15 of 31
 for using its own input rather than selling it to other firms. Then, that firm’s economic costs and
economic profit will be the same as all the other firms in the industry. So all firms will earn zero
economic profit in the long run.

4. What is the difference between economic profit and producer surplus?

Economic profit is the difference between total revenue and total cost. Producer surplus is the
difference between total revenue and total variable cost. So fixed cost is subtracted to find profit but
not producer surplus, and thus profit equals producer surplus minus fixed cost (or producer surplus
equals profit plus fixed cost).

5. Why do firms enter an industry when they know that in the long run economic profit will be
zero?
Firms enter an industry when they expect to earn economic profit, even if the profit will be short-lived.
These short-run economic profits are enough to encourage entry because there is no cost to entering
the industry, and some economic profit is better than none. Zero economic profit in the long run
implies normal returns to the factors of production, including the labor and capital of the owner of
the firm. So even when economic profit falls to zero, the firm will be doing as well as it could in any
other industry, and then the owner will be indifferent to staying in the industry or exiting.

6. At the beginning of the twentieth century, there were many small American automobile
manufacturers. At the end of the century, there were only three large ones. Suppose that this
situation is not the result of lax federal enforcement of antimonopoly laws. How do you explain
the decrease in the number of manufacturers? (Hint: What is the inherent cost structure of the
automobile industry?)
Automobile plants are highly capital-intensive, and consequently there are substantial economies of
scale in production. So, over time, the automobile companies that produced larger quantities of cars
were able to produce at lower average cost. They then sold their cars for less and eventually drove
smaller (higher cost) companies out of business, or bought them to become even larger and more
efficient. At very large levels of production, the economies of scale diminish, and diseconomies of
scale may even occur. This would explain why more than one manufacturer remains.

14. A certain brand of vacuum cleaners can be purchased from several local stores as well as from
several catalogues or websites. Assuming that this industry is roughly perfectly competitive,
what will happen if:

a. If all sellers charge the same price for the vacuum cleaner, will they all earn zero economic
profit in the long run?
Yes, all earn zero economic profit in the long run. If economic profit were greater than zero for,
say, online sellers, then firms would enter the online industry and eventually drive economic profit
for online sellers to zero. If economic profit were negative for catalogue sellers, some catalogue
firms would exit the industry until economic profit returned to zero. So all must earn zero
economic profit in the long run. Anything else will generate entry or exit until economic profit
returns to zero.

Page 16 of 31
 b. If all sellers charge the same price and one local seller owns the building in which he does
business, paying no rent, is this seller earning a positive economic profit?
No this seller would still earn zero economic profit. If he pays no rent then the accounting cost
of using the building is zero, but there is still an opportunity cost, which represents the value of
the building in its best alternative use.

c. Does the seller who pays no rent have an incentive to lower the price that he charges for
the vacuum cleaner?
No he has no incentive to charge a lower price because he can sell as many units as he wants at
the current market price. Lowering his price will only reduce his economic profit. Since all firms
sell the identical good, they will all charge the same price for that good.

4. Suppose you are the manager of a watchmaking firm operating in a competitive market. Your
cost of production is given by C = 200 + 2q2, where q is the level of output and C is total cost.
(The marginal cost of production is 4q; the fixed cost is $200.)
a. If the price of watches is $100, how many watches should you produce to maximize profit?
Profits are maximized where price equals marginal cost. Therefore,
100 = 4q, or q = 25.

b. What will the profit level be?

Profit is equal to total revenue minus total cost:  = Pq − (200 + 2q2). Thus,
2
 = (100)(25) − (200 + 2(25) ) = $1050.

c. At what minimum price will the firm produce a positive output?

The firm will produce in the short run if its revenues are greater than its total variable costs. The
firm’s short-run supply curve is its MC curve above minimum AVC. Here, AVC =
VC 2q 2
= = 2q. Also, MC = 4q. So, MC is greater than AVC for any quantity greater than 0. This
q q
means that the firm produces in the short run as long as price is positive.

5. Suppose that a competitive firm’s marginal cost of producing output q is given by MC(q) = 3 +
2q. Assume that the market price of the firm’s product is $9.

a. What level of output will the firm produce?

The firm should set the market price equal to marginal cost to maximize its profits:
9 = 3 + 2q, or q = 3.

b. What is the firm’s producer surplus?

Producer surplus is equal to the area below the market price, i.e., $9.00, and above the marginal
cost curve, i.e., 3 + 2q. Because MC is linear, producer surplus is a triangle with a base equal to
3 (since q = 3) and a height of $6 (9 − 3 = 6). The area of a triangle is (1/2)  (base)  (height).
Therefore, producer surplus is (0.5)(3)(6) = $9.

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 c. Suppose that the average variable cost of the firm is given by AVC(q) = 3 + q. Suppose that
the firm’s fixed costs are known to be $3. Will the firm be earning a positive, negative, or
zero profit in the short run?
Profit is equal to total revenue minus total cost. Total cost is equal to total variable cost plus
fixed cost. Total variable cost is equal to AVC(q)  q. At q = 3, AVC(q) = 3 + 3 = 6, and
therefore
TVC = (6)(3) = $18.
Fixed cost is equal to $3. Therefore, total cost equals TVC plus TFC, or
C = $18 + 3 = $21.
Total revenue is price times quantity:
R = ($9)(3) = $27.
Profit is total revenue minus total cost:
 = $27 − 21 = $6.
Therefore, the firm is earning positive economic profits. More easily, you might recall that profit
equals producer surplus minus fixed cost. Since we found that producer surplus was $9 in part b,
profit equals 9 − 3 or $6.

10. Suppose you are given the following information about a particular industry:
Q D = 6500 − 100 P Market demand
Q S = 1200 P Market supply
q
2
C (q) = 722 + Firm total cost function
200
2q
MC (q) = Firm marginal cost function.
200
Assume that all firms are identical, and that the market is characterized by perfect
competition.
a. Find the equilibrium price, the equilibrium quantity, the output supplied by the firm, and
the profit of each firm.
Equilibrium price and quantity are found by setting market demand equal to market supply:
6500 − 100P = 1200P. Solve to find P = $5 and substitute into either equation to find Q = 6000.

Page 18 of 31
 2q
To find the output for the firm set price equal to marginal cost: 5 = so q = 500. Profit is total
200
 q2   5002 
revenue minus total cost or  = Pq −  722 +  = 5(500) −  722 + = $528. Notice that
 200   200 
since the total output in the market is 6000, and each firm’s output is 500, there must be
6000/500 = 12 firms in the industry.

b. Would you expect to see entry into or exit from the industry in the long run? Explain.
What effect will entry or exit have on market equilibrium?
We would expect entry because firms in the industry are making positive economic profits. As
new firms enter, market supply will increase (i.e., the market supply curve will shift down and to
the right), which will cause the market equilibrium price to fall, all else the same. This, in turn,
will reduce each firm’s optimal output and profit. When profit falls to zero, no further entry will
occur.

c. What is the lowest price at which each firm would sell its output in the long run? Is profit
positive, negative, or zero at this price? Explain.
In the long run profit falls to zero, which means price falls to the minimum value of AC. To find
the minimum average cost, set marginal cost equal to average cost and solve for q:
2q 722 q
= +
200 q 200
q 722
=
200 q
q 2 = 722(200)
q = 380
AC (q = 380) = 3.8.
Therefore, the firm will not sell for any price less than $3.80 in the long run. The long-run
equilibrium price is therefore $3.80, and at a price of $3.80, each firm sells 380 units and earns
an economic profit of zero because P = AC.

d. What is the lowest price at which each firm would sell its output in the short run? Is profit
positive, negative, or zero at this price? Explain.
The firm will sell its output at any price above zero in the short run, because marginal cost is above
average variable cost (MC = q/100  AVC = q/200) for all positive prices. Profit is negative if
price is just above zero.

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 Chapter 9
The Analysis of Competitive Markets

◼ Review Questions

2. Suppose the supply curve for a good is completely inelastic. If the government imposed a price
ceiling below the market-clearing level, would a deadweight loss result? Explain.
When the supply curve is completely inelastic, it is vertical. In this case there is no deadweight loss
because there is no reduction in the amount of the good produced. The imposition of the price ceiling
transfers all lost producer surplus to consumers. Consumer surplus increases by the difference
between the market-clearing price and the price ceiling times the market-clearing quantity.
Consumers capture all decreases in total revenue, and no deadweight loss occurs.

3. How can a price ceiling make consumers better off? Under what conditions might it make
them worse off?
If the supply curve is highly inelastic a price ceiling will usually increase consumer surplus because
the quantity available will not decline much, but consumers get to purchase the product at a reduced
price. If the demand curve is inelastic, on the other hand, price controls may result in a net loss of
consumer surplus because consumers who value the good highly are unable to purchase as much as
they would like. (See Figure 9.3 on page 321 in the text.) The loss of consumer surplus is greater
than the transfer of producer surplus to consumers. So consumers are made better off when demand
is relatively elastic and supply is relatively inelastic, and they are made worse off when the opposite
is true.

◼ Exercises

1. From time to time, Congress has raised the minimum wage. Some people suggested that a
government subsidy could help employers finance the higher wage. This exercise examines the
economics of a minimum wage and wage subsidies. Suppose the supply of low-skilled labor is
given by LS = 10w, where LS is the quantity of low-skilled labor (in millions of persons
employed each year), and w is the wage rate (in dollars per hour). The demand for labor is
given by LD = 80 − 10w.
a. What will be the free-market wage rate and employment level? Suppose the government
sets a minimum wage of $5 per hour. How many people would then be employed?
In a free-market equilibrium, LS = LD. Solving yields w = $4 and LS = LD = 40. If the minimum
wage is $5, then LS = 50 and LD = 30. The number of people employed will be given by the labor
demand, so employers will hire only 30 million workers.

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b. Suppose that instead of a minimum wage, the government pays a subsidy of $1 per hour
for each employee. What will the total level of employment be now? What will the
equilibrium wage rate be?
Let ws denote the wage received by the sellers (i.e., the employees), and wb the wage paid by the
buyers (the firms). The new equilibrium occurs where the vertical difference between the supply
and demand curves is $1 (the amount of the subsidy). This point can be found where
LD(wb) = LS(ws), and
ws − wb = 1.
Write the second equation as wb = ws − 1. This reflects the fact that firms pay $1 less than the
wage received by workers because of the subsidy. Substitute for wb in the demand equation:
LD(wb) = 80 − 10(ws − 1), so
LD(wb) = 90 − 10ws.
Note that this is equivalent to an upward shift in demand by the amount of the $1 subsidy. Now
set the new demand equal to supply: 90 − 10ws = 10ws. Therefore, ws = $4.50, and LD = 90 −
10(4.50) = 45. Employment increases to 45 (compared to 30 with the minimum wage), but wage
drops to $4.50 (compared to $5.00 with the minimum wage). The net wage the firm pays falls to
$3.50 due to the subsidy.

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 9. Among the tax proposals regularly considered by Congress is an additional tax on distilled
liquors. The tax would not apply to beer. The price elasticity of supply of liquor is 4.0, and the
price elasticity of demand is −0.2. The cross-elasticity of demand for beer with respect to the
price of liquor is 0.1.
a. If the new tax is imposed, who will bear the greater burden—liquor suppliers or liquor
consumers? Why?
ES
The fraction of the tax borne by consumers is given in Section 9.6 as , where ES is the
ES − E D
own-price elasticity of supply and ED is the own-price elasticity of demand. Substituting for ES
and ED, the pass-through fraction is
4 4
=  0.95.
4 − (−0.2) 4.2
Therefore, just over 95% of the tax is passed through to consumers because supply is highly
elastic while demand is very inelastic. So liquor consumers will bear almost all the burden of
the tax.

b. Assuming that beer supply is infinitely elastic, how will the new tax affect the beer market?
With an increase in the price of liquor (from the large pass-through of the liquor tax), some
consumers will substitute away from liquor to beer because the cross-elasticity is positive.
This will shift the demand curve for beer outward. With an infinitely elastic supply for beer
(a horizontal supply curve), the equilibrium price of beer will not change, and the quantity of
beer consumed will increase.

15. In 2011, Americans smoked 16 billion packs of cigarettes. They paid an average retail price of
$5.00 per pack.
a. Given that the elasticity of supply is 0.5 and the elasticity of demand is −0.4, derive linear
demand and supply curves for cigarettes.
Let the demand curve be of the general linear form Q = a − bP and the supply curve be
Q = c + dP, where a, b, c, and d are positive constants that we have to find from the information
given above. To begin, recall the formula for the price elasticity of demand

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 P Q
EPD = .
Q P
We know the values of the elasticity, P, and Q, which means we can solve for the slope, which
is −b in the above formula for the demand curve.
 5.00 
−0.4 =   ( −b)
 16 
 16 
b = 0.4   = 1.28.
 5.00 
To find the constant a, substitute for Q, P, and b in the demand curve formula: 16 = a − 1.28(5.00).
Solving yields a = 22.4. The equation for demand is therefore Q = 22.4 − 1.28P. To find the
supply curve, recall the formula for the elasticity of supply and follow the same method as
above:
P Q
EPS =
Q P
 5.00 
0.5 =   (d )
 16 
 16 
d = 0.5   = 1.6
 5.00 
To find the constant c, substitute for Q, P, and d in the supply formula, which yields
16 = c + 1.6(5.00). Therefore c = 8, and the equation for the supply curve is Q = 8 + 1.6P.

b. Cigarettes are subject to a federal tax, which was about $1.00 per pack in 2011. What does
this tax do to the market-clearing price and quantity?
The tax drives a wedge between supply and demand. At the new equilibrium, the price buyers
pay, Pb, will be $1.00 higher than the price sellers receive, Ps. Also, the quantity buyers demand
at Pb must equal the quantity supplied at price Ps. These two conditions are:
Pb − Ps = 1.00 and 22.4 − 1.28Pb = 8 + 1.6 Ps.
Solving these simultaneously, Ps = $4.56 and Pb = $5.56. The new quantity will be Q = 22.4 −
1.28(5.56) = 15.3 billion packs. So the price consumers pay will increase from $5.00 to $5.56
(a 56-cent increase) and consumption will fall from 16 to 15.3 billion packs per year (a drop of
700 million packs per year).

c. How much of the federal tax will consumers pay? What part will producers pay?
Consumers pay $5.56 − 5.00 = $0.56 and producers pay the remaining $5.00 − 4.56 = $0.44 per
pack. We could also find these amounts using the pass-through formula. The fraction of the tax
paid by consumers is ES/(ES − ED) = 0.5/[0.5 − (−0.4)] = 0.5/0.9 = 0.56. Therefore, consumers will
pay 56% of the $1.00 tax, which is 56 cents, and suppliers will pay the remaining 44 cents.

Page 23 of 31
 Chapter 10
Market Power: Monopoly and Monopsony

◼ Review Questions

1. A monopolist is producing at a point at which marginal cost exceeds marginal revenue. How
should it adjust its output to increase profit?
When marginal cost is greater than marginal revenue, the cost of producing the last unit is greater
than the additional revenue from the sale of the last unit, so the firm loses money on that unit. The
firm would increase profit by not producing as many units. It should reduce production, thereby
decreasing marginal cost and increasing marginal revenue, until marginal cost is equal to marginal
revenue. The diagram shows this situation. The firm is producing an output like Q, where MC >
MR. The firm should decrease output until it reaches the profit-maximizing output Q*.

7. Why is there a social cost to monopoly power? If the gains to producers from monopoly power
could be redistributed to consumers, would the social cost of monopoly power be eliminated?
Explain briefly.
When the firm exploits its monopoly power by charging a price above marginal cost, consumers buy
less at the higher price, and consumer surplus decreases. Some of the lost consumer surplus is not
captured by the seller, however, because the quantity produced and consumed decreases at the higher
price, and this is a deadweight loss to society. Therefore, if the gains to producers were redistributed
to consumers, society would still suffer the deadweight loss.

8. Why will a monopolist’s output increase if the government forces it to lower its price? If the
government wants to set a price ceiling that maximizes the monopolist’s output, what price
should it set?
By restricting price to be below the monopolist’s profit-maximizing price, the government can
change the shape of the firm’s marginal revenue curve. When a price ceiling is imposed, MR is equal
to the price ceiling for all quantities less than or equal to the quantity demanded at the price ceiling.
For example, in the diagram the price ceiling is set at P, which is below the profit-maximizing price
P*. The MR curve becomes the line PA and then jumps down to B and follows the original MR
curve beyond that point. The optimal output for the monopolist is then Q, which is greater than the
profit-maximizing output.

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 If the government wants to maximize output, it should set a price ceiling at the point where the
demand curve and the marginal cost curve intersect, point C in the diagram. Then, when the firm
produces where MR = MC, it will be producing the output level at which P = MC, where P is the
price ceiling. In this way, the government can induce the monopolist to produce the competitive
level of output. If the price ceiling is set below this point, the monopolist will decrease output below
the competitive level.

◼ Exercises

5. The following table shows the demand curve facing a monopolist who produces at a constant
marginal cost of $10:
Price Quantity
18 0
16 4
14 8
12 12
10 16
8 20
6 24
4 28
2 32
0 36

a. Calculate the firm’s marginal revenue curve.

To find the marginal revenue curve, we first derive the inverse demand curve. The intercept of
the inverse demand curve on the price axis is 18. The slope of the inverse demand curve is the
change in price divided by the change in quantity. For example, a decrease in price from 18 to
16 yields an increase in quantity from 0 to 4. Therefore, the slope of the inverse demand is
P −2
= = −0.5, and the demand curve is therefore
Q 4
P = 18 − 0.5Q.

Page 25 of 31
 The marginal revenue curve corresponding to a linear demand curve is a line with the same
intercept as the inverse demand curve and a slope that is twice as steep. Therefore, the marginal
revenue curve is
MR = 18 − Q.
b. What are the firm’s profit-maximizing output and price? What is its profit?
The monopolist’s profit-maximizing output occurs where marginal revenue equals marginal
cost. Marginal cost is a constant $10. Setting MR equal to MC to determine the profit-
maximizing quantity:
18 − Q = 10, or Q = 8.
To find the profit-maximizing price, substitute this quantity into the demand equation:
P = 18 − (0.5)(8) = $14.
Total revenue is price times quantity:
TR = (14)(8) = $112.
The profit of the firm is total revenue minus total cost, and total cost is equal to average cost
times the level of output produced. Since marginal cost is constant, average variable cost is
equal to marginal cost. Ignoring any fixed costs, total cost is 10Q or 80, and profit is
 = 112 − 80 = $32.

c. What would the equilibrium price and quantity be in a competitive industry?

For a competitive industry, price would equal marginal cost at equilibrium. Setting the
expression for price equal to a marginal cost of 10:
18 − 0.5Q = 10, so that Q = 16 and P = $10.
Note the increase in the equilibrium quantity and decrease in price compared to the monopoly
solution.

d. What would the social gain be if this monopolist were forced to produce and price at the
competitive equilibrium? Who would gain and lose as a result?
The social gain arises from the elimination of deadweight loss. When price drops from $14 to
$10, consumer surplus increases by area A + B + C = 8(14 − 10) + (0.5)(16 − 8)(14 − 10) = $48.
Producer surplus decreases by area A + B = 8(14 − 10) = $32. So consumers gain $48 while
producers lose $32. Deadweight loss decreases by the difference, $48 − 32 = $16. Thus the
social gain if the monopolist were forced to produce and price at the competitive level is $16.

Page 26 of 31
11. A monopolist faces the demand curve P = 11 − Q, where P is measured in dollars per unit and
Q in thousands of units. The monopolist has a constant average cost of $6 per unit.
a. Draw the average and marginal revenue curves and the average and marginal cost curves.
What are the monopolist’s profit-maximizing price and quantity? What is the resulting
profit? Calculate the firm’s degree of monopoly power using the Lerner index.
Because demand (average revenue) is P = 11 − Q, the marginal revenue function is MR = 11 −
2Q. Also, because average cost is constant, marginal cost is constant and equal to average cost,
so MC = 6.
To find the profit-maximizing level of output, set marginal revenue equal to marginal cost:
11 − 2Q = 6, or Q = 2.5.
That is, the profit-maximizing quantity equals 2500 units. Substitute the profit-maximizing
quantity into the demand equation to determine the price:
P = 11 − 2.5 = $8.50.
Profits are equal to total revenue minus total cost,
 = TR − TC = PQ − (AC)(Q), or
 = (8.50)(2.5) − (6)(2.5) = 6.25, or $6250.
The diagram below shows the demand, MR, AC, and MC curves along with the optimal price
and quantity and the firm’s profits.

The degree of monopoly power according to the Lerner Index is:

P − MC 8.5 − 6
= = 0.294.
P 8.5

b. A government regulatory agency sets a price ceiling of $7 per unit. What quantity will be
produced, and what will the firm’s profit be? What happens to the degree of monopoly
power?
To determine the effect of the price ceiling on the quantity produced, substitute the ceiling price
into the demand equation.

Page 27 of 31
 7 = 11 − Q, or Q = 4.
Therefore, the firm will choose to produce 4000 units rather than the 2500 units without the
price ceiling. Also, the monopolist will choose to sell its product at the $7 price ceiling because
$7 is the highest price that it can charge, and this price is still greater than the constant marginal
cost of $6, resulting in positive monopoly profit.
Profits are equal to total revenue minus total cost:
 = 7(4000) − 6(4000) = $4000.
The degree of monopoly power falls to
P − MC 7 − 6
= = 0.143.
P 7

Page 28 of 31
 Chapter 11
Pricing With Market Power

◼ Review Questions

1. Suppose a firm can practice perfect first-degree price discrimination. What is the lowest price
it will charge, and what will its total output be?
When a firm practices perfect first-degree price discrimination, each unit is sold at the reservation
price of each consumer (assuming each consumer purchases one unit). Because each unit is sold at
the consumer’s reservation price, marginal revenue is simply the price at which each unit is sold,
and thus the demand curve is the firm’s marginal revenue curve. The profit-maximizing output is
therefore where MR = MC, which is the point where the marginal cost curve intersects the demand
curve. Thus the price of the last unit sold equals the marginal cost of producing that unit, and the
firm produces the perfectly competitive level of output.

3. Electric utilities often practice second-degree price discrimination. Why might this improve
consumer welfare?
Consumer surplus may be higher under block pricing than under monopoly pricing because more
output is produced. For example, assume there are two prices, P1 and P2, with P1  P2 as shown in
the diagram below. Customers with reservation prices above P1 pay P1, capturing surplus equal to
the area bounded by the demand curve and P1. For simplicity, suppose P1 is the monopoly price;
then the area between demand and P1 is also the consumer surplus under monopoly.
Under block pricing, however, customers with reservation prices between P1 and P2 capture
additional surplus equal to the area bounded by the demand curve, the difference between P1 and P2,
and the difference between Q1 and Q2. Hence block pricing under these assumptions improves
consumer welfare.

5. Show why optimal third-degree price discrimination requires that marginal revenue for each
group of consumers equals marginal cost. Use this condition to explain how a firm should change
its prices and total output if the demand curve for one group of consumers shifts outward,
causing marginal revenue for that group to increase.

Page 29 of 31
 We know that firms maximize profits by choosing output so marginal revenue is equal to marginal
cost. If MR for one market is greater than MC, then the firm should increase sales in that market,
thus lowering price and possibly raising MC. Similarly, if MR for one market is less than MC, the
firm should decrease sales by raising the price in that market. By equating MR and MC in each
market, marginal revenue is equal in all markets.
Determining how prices and outputs should change when demand in one market increases is actually
quite complicated and depends on the shapes of the demand and marginal cost curves. If all demand
curves are linear and marginal cost is upward sloping, here’s what happens when demand increases
in market 1.
Since MR1 = MC before the demand shift, MR1 will be greater than MC after the shift. To bring MR1
and MC back to equality, the firm should increase both price and sales in market 1. It can raise price
and still sell more because demand has increased.
In addition, the firm must increase the MRs in its other markets so that they equal the new larger value
of MR1. This is done by decreasing output and raising prices in the other markets. The firm increases
total output and shifts sales to the market experiencing increased demand and away from other
markets.

6. When pricing automobiles, American car companies typically charge a much higher
percentage markup over cost for “luxury option” items (such as leather trim, etc.) than for the
car itself or for more “basic” options such as power steering and automatic transmission.
Explain why.
This can be explained partially as an instance of third-degree price discrimination. Consider leather
seats, for example. Some people would like leather seats but are not willing to pay a lot for them, so
their demand is highly elastic. Others have a strong preference for leather, and their demand is not
very elastic. Rather than selling leather seats to both groups at different prices (as in the pure case of
third-degree price discrimination), the car companies sell leather seats at a high markup over cost
and cloth seats at a low markup over cost. Consumers with a low elasticity and strong preference for
leather seats buy the leather seats while those with a high elasticity for leather seats buy the cloth seats
instead. This is like the case of supermarkets selling brand name items for higher prices and markups
than similar store brand items. Thus the pricing of automobile options can be explained if the
“luxury” options are purchased by consumers with low elasticities of demand relative to consumers
of more “basic” options.

◼ Exercises

4. Suppose that BMW can produce any quantity of cars at a constant marginal cost equal to
$20,000 and a fixed cost of $10 billion. You are asked to advise the CEO as to what prices
and quantities BMW should set for sales in Europe and in the United States. The demand for
BMWs in each market is given by:
QE = 4,000,000 − 100PE and QU = 1,000,000 − 20PU
where the subscript E denotes Europe and the subscript U denotes the United States. Assume
that BMW can restrict U.S. sales to authorized BMW dealers only.
a. What quantity of BMWs should the firm sell in each market, and what should the price be
in each market? What should the total profit be?

Page 30 of 31
 BMW should choose the levels of QE and QU so that MRE = MRU = MC.
To find the marginal revenue expressions, solve for the inverse demand functions:
PE = 40,000 − 0.01QE and PU = 50,000 − 0.05QU .
Since demand is linear in both cases, the marginal revenue function for each market has the
same intercept as the inverse demand curve and twice the slope:
MRE = 40,000 − 0.02QE and MRU = 50,000 − 0.1QU .
Marginal cost is constant and equal to $20,000. Setting each marginal revenue equal to 20,000
and solving for quantity yields:
40,000 − 0.02QE = 20,000, or QE = 1,000,000 cars in Europe, and
50,000 − 0.1QU = 20,000, or QU = 300,000 cars in the United States
Substituting QE and QU into their respective inverse demand equations, we may determine the
price of cars in each market:
PE = 40,000 − 0.01(1,000,000) = $30,000 in Europe, and
PU = 50,000 − 0.05(300,000) = $35,000 in the United States
Profit is therefore:
 = TR − TC = (30,000)(1,000,000) + (35,000)(300,000)
− [10,000,000,000 + 20,000(1,300,000)]
 = $4.5 billion.
b. If BMW were forced to charge the same price in each market, what would be the quantity
sold in each market, the equilibrium price, and the company’s profit?
If BMW must charge the same price in both markets, they must find total demand, Q = QE + QU,
where each price is replaced by the common price P:
5,000,000 Q
Q = 5,000,000 − 120P, or in inverse form, P = − .
120 120
Marginal revenue has the same intercept as the inverse demand curve and twice the slope:
5,000,000 Q
MR = − .
120 60
To find the profit-maximizing quantity, set marginal revenue equal to marginal cost:
5,000,000 Q
− = 20,000, or Q* = 1,300,000 cars.
120 60
Substituting Q* into the inverse demand equation to determine price:
5,000,000  1,300,000 
P= −  = $30,833.33.
120  120 
Substitute into the demand equations for the European and American markets to find the
quantity sold in each market:
QE = 4,000,000 − (100)(30,833.3), or QE = 916,667 cars in Europe, and
QU = 1,000,000 − (20)(30,833.3), or QU = 383,333 cars in the United States
Profit is  = $30,833.33(1,300,000) − [10,000,000,000 + 20,000(1,300,000)], or
 = $4.083 billion.
U.S. consumers would gain and European consumers would lose if BMW were forced to sell at the
same price in both markets, because Americans would pay $4166.67 less and Europeans would
pay $833.33 more for each BMW. Also, BMW’s profits would drop by more than $400 million.

Page 31 of 31
Answer key for sample mid-term

Problem 1
Explain how each of the following events would influence the market in the short run. Assume standard
demand and supply curves, i.e., a downward sloping demand curve and an upward sloping supply curve.
The market that needs to be analyzed is indicated in parentheses against each event.

For each event, you have to indicate the direction of movement of the demand curve (outward, inward, or
no change; alternatively, rightward, leftward, or no change), the supply curve (outward, inward, or no
change; alternatively, rightward, leftward, or no change), equilibrium price (up, down, or no change), and
equilibrium quantity (up, down, or no change)

For all the parts below, assume that the markets are competitive and that only the event being described has
changed i.e. do not make any additional assumptions than what is mentioned in the question.

Note: For demand and supply curves, allow all types of terms: increase/outward/rightward and analogously
for decrease

a. A major war breaks out due to which several civilians join the army and are deployed at the front.
What is the effect on the labour market?

Demand curve
Increases
Decreases
No change
Ambiguous

Supply curve
Increases
Decreases
No change
Ambiguous

Equilibrium price
Increases
Decreases
No change
Ambiguous

Equilibrium quantity
Increases
Decreases
No change

Page 1 of 12
 Ambiguous

b. In August 2019, thousands of restaurants delisted themselves from Zomato’s platform as part of a
#logout campaign What is the effect on market for food deliveries on Zomato’s platform? (Zomato
is an Indian restaurant aggregator and food delivery service provider.)

Demand curve
Increases
Decreases
No change
Ambiguous

Supply curve
Increases
Decreases
No change
Ambiguous

Equilibrium price
Increases
Decreases
No change
Ambiguous

Equilibrium quantity
Increases
Decreases
No change
Ambiguous

c. An increase in the price of movie tickets. What is the effect on the market for movie theatre
popcorn?

Demand curve
Increases
Decreases
No change
Ambiguous
Supply curve
Increases
Decreases
No change
Ambiguous

Page 2 of 12
 Equilibrium price
Increases
Decreases
No change
Ambiguous
Equilibrium quantity
Increases
Decreases
No change
Ambiguous

d. A new technology that makes it cheaper to extract juice from oranges. What is the effect in the
market for orange juice?

Demand curve
Increases
Decreases
No change
Ambiguous

Supply curve
Increases
Decreases
No change
Ambiguous
Equilibrium price
Increases
Decreases
No change
Ambiguous
Equilibrium quantity
Increases
Decreases
No change
Ambiguous
e. An increase in the proportion of twins relative to singletons among newborns. What is the effect
on the market for baby clothes?

Demand curve
Increases
Decreases
No change

Page 3 of 12
 Ambiguous

Supply curve
Increases
Decreases
No change
Ambiguous

Equilibrium price
Increases
Decreases
No change
Ambiguous
Equilibrium quantity
Increases
Decreases
No change
Ambiguous

f. A prediction by the Indian Meteorological Department that the monsoon is going to be “below
normal”. What is the effect in the market for food grains?

Demand curve
Increases
Decreases
No change
Ambiguous
Supply curve
Increases
Decreases
No change
Ambiguous

Equilibrium price
Increases
Decreases
No change
Ambiguous

Equilibrium quantity
Increases
Decreases
No change
Ambiguous

Page 4 of 12
Problem 2
JustPizza! is a profit maximizing firm in a perfectly competitive market, where a pizza sells for Rs.
500. JustPizza!’s cost curves are:
TC = 75,000 + q^2 (Note: q^2 should be read and written as q square)
MC = 2q
where q is the number of pizzas sold every day by JustPizza!

a. Calculate JustPizza! profit maximizing quantity. Is the firm earning a profit?

b. Analyze JustPizza! position in terms of the shutdown condition. Should JustPizza! operate or shut
down in the shortrun? Explain your answer in no more than 1-2 sentences, but do support your work
with any calculations that may be required.
Answer:

a.
JustPizza! profit maximizing quantity is

100
250
500
50

Profit maximizing condition for perfectly competitive firms is P = MC

P = MC
500 = 2q
q = 250 units
b. Is the firm earning a profit?
Yes, the profit of firm is 12500
Yes, the profit of firm is 500
No, the loss of firm is 12500
No, the firm is at no profit- no loss situation

Profits = TR – TC
TR = P.q = 500 * 250 = 125,000
TC = 75,000 + 250*250 = 75,000 + 62,500 = 137,500
Profits = 125,000 – 137,500 = -12,500 Or,
No, the firm is making is loss.
b.
To analyze the firms short run decision, we need to compare AVC at q = 250 units with the price.
AVC = TVC/q
AVC = (TC – FC)/q = (137,500-75,000)/250 = 62,500/250 = 250
The firm should not shut down because the price (Rs. 500) is greater than the AVC (Rs. 250) and it is able
to cover its variable costs.

Page 5 of 12
If the firm shuts down it will lose 75,000 and since the current looses are lower than that it should continue
to operate.

Note: if answer just says “do not shut down because VC are being covered” then the answer is incomplete
as it doesn’t provide the calculation that was asked.
Problem 3

The market for supplying flowers outside the Jagannath temple in Puri is perfectly competitive. All
firms (a firm is a stall) sell flowers in small bamboo baskets. Each existing firm and every potential
entrant are identical and they face the same long run average cost and long run marginal cost curves.
The minimum level of long run average cost is Rs. 5 per bamboo basket, and occurs when a firm sells
200 bamboo baskets of flowers each day. The market demand curve for a basket of flowers is Q =
28,005 – P, where P is the market price in Rupees per basket.

a. What is the long run equilibrium price per basket of flowers in the market?
b. How many baskets does each firm sell at this price?
c. How many firms will be in the market at the long-run equilibrium?
d. What are the economic profits in the long run in this market? Would a competitive firm stay in
business at this level of profit? Explain your answer in no more than 2-3 sentences.
Answer:

a. What is the long run equilibrium price per basket of flowers in the market?

Rs 10
Rs. 5
Rs. 20
Rs. 15
In the long run equilibrium in a perfectly competitive market, the demand/AR curve is tangent to the AC
curve (at its minimum point). Therefore, the long run equilibrium price is the same as the minimum level
of LAC:
P = Rs. 5
b. How many baskets does each firm sell at this price?
100
200
50
500

We are given that the minimum LAC for a firm corresponds to a quantity of 200 baskets. Therefore, in the
long run equilibrium quantity for a firm is q = 200 baskets
c. How many firms will be in the market at the long-run equilibrium?
100
120
140
160

Page 6 of 12
We can figure out the market demand at the LR equilibrium price by plugging in the value of P into the
demand curve:
Q = 28005 – 5
Q = 28000

Since, each firm produces 200 baskets, the number of firms N is given by N = Qd/q

28,000
𝑁=
200

𝑁 = 140
There are 140 firms in the market.

d.
In the long run, firms make zero economic profits (economic profit equals total revenue minus total cost,
and total cost includes all the opportunity costs of the firm).
In particular, total cost includes the opportunity cost of the time and money that the firm owners devote to
the business. In the zero-profit equilibrium, the firm’s revenue must compensate the owners for the time
and money that they expend to keep their business going.
Note: Firm is indifferent is also OK.

Problem 4
A firm operating in the perfectly competitive market of spectacles has hired you to estimate the
supply and demand curves for spectacles. You have been informed that the price elasticity of supply
is 1.7 and the price elasticity of demand is -0.85. The current equilibrium quantity is 1206 units and
current price of spectacles is $41. Given this:

a. Estimate the linear demand curve at the current price and quantity. Assume that the demand curve
takes the form Qd = a – bP. You may round off the parameters (a and b) of the demand curve to the
nearest whole number.
Qd=2231+25P
Qd= 2231-25P
Qd= 1205-5P
Qd= 1205+5P

b. Estimate the linear supply curve at the current price and quantity. Assume that the supply curve
takes the form Qs = c + dP. You may round off the parameters (c and d) of the supply curve to the
nearest whole number
Qs=-844+50P
Qs=-844-50P
Qs=-1206+41P
Qs=1206+41P

c. The government is considering imposing a $1 tax per unit on spectacle sellers to raise revenue to

Page 7 of 12
fund a vision correction program for low-income families. Some sellers are upset that the tax is levied
on them and they argue that under the current market conditions they would have a pay a larger
percentage of the burden of tax? Based on the information provided in the question above, do you agree
with this assessment? Calculate the economic incidence of the tax on buyers and sellers.
Incidence of the tax on buyers is 0.33, seller 0.66
Incidence of the tax on buyers is 0.66, seller 0.33
Equal incidence on both
Whole incidence on the buyer

d. What is the demand curve facing an individual firm this competitive market (assume we are
referring to the short run)? Explain your answer in no more than 1-2 sentences.
Descriptive answer

Answer:

a.
First, we estimate the demand curve.
Q = a - bP

Elasticity of demand = b ×

.85 = b ×

-1025.1 = b × 41
b = 25 (or the precise number)
Qd = a - bP
1206 = a - 25(41)
1206 = a - 1025
a = 2231 (or the precise number)
Qd = 2231 - 25P

Or, P in terms of Q
b.
Next, we estimate the supply curve.
Qs = c + dP

Elasticity of Supply = d ×

1.7 = d ×

2050.2x = d × 41
d = 50 (or the precise number)
Q = c + dP

Page 8 of 12
 1206 = c + 50(41)
c = -844 (or the precise number)
Qs = -844 + 50P
Or, P in terms of Q
c.
The economic incidence of the tax on buyers is Es/(Es + |Ed|) = 1.7/2.55 = 0.66 and the economic incidence
of the tax on sellers is |Ed|/(Es+Ed) = 0.85/2.55 = 0.33.
The sellers’ argument is wrong. Since the demand curve is inelastic and the supply curve is (relatively)
elastic, the sellers are able to pass on a larger proportion of the tax on the buyers. They pay only 33% of the
tax burden but the buyers will pay 66% of the tax.

d.
The demand curve facing an individual firm in perfect competition is perfectly elastic.
Note: saying p = 41 and firm being "price taker" is also fine.

Problem 5
Asian News International (ANI), an Indian news agency, has monopoly in the market of syndicated
news video feeds, especially archival footage. ANI has hired you to assist them in setting the price
that they should charge television channels for their archival footage. The managers recognize that
there are two distinct demand curves for archival footage. One demand curve applies to national
media TV channels and the other applies to regional media TV channels. The two demand curves
are:
P1= 9.6 - 0.08Q1
P2 = 4 - 0.05Q2

where P1 = price charged to national TV channels, P2 = price charged to regional media channels,
Q1 = duration of archival footage for national TV channels, and Q2 = duration of archival footage
for regional TV channels. Assume that the archives require only a fixed cost to be maintained, so that
the managers consider marginal cost to be zero.

a. If ANI decides to price discriminate, what should the profit maximizing price and quantity be in
each market?
Q1=40, P1=4.8, Q2=60, P2=2
Q1=60, P1=2, Q2=40, P2=4.8
Q1=60, P1=4.8, Q2=40, P2=2
Q1=60, P1=4.8, Q2=60, P2=2

b. What is the elasticity of demand at the quantities and prices calculated in part (a) of this question
for each market?
E1=E2=1
E1=E2=-1
E1=E2=0
E1=E2=-0.5

Page 9 of 12
c. Are these elasticities consistent with your understanding of profit maximization and the
relationship between marginal revenue and elasticity? Explain your answer in no more than 1-2
sentences.
Yes, it is consistent
No, not consistent
Can't ascertain

d. Would your answer to part (a) change if the marginal cost was not zero and instead you were
informed that marginal cost of ‘producing’ archival footage was Rs 4? Why or why not? Explain
your answer in no more than 1-2 sentences.
Yes, answer would change
No, answer would not change

e. Compared to the case of the monopolist charging an uniform price, what would be the effect of a
price discriminating monopolist on total welfare/social surplus? Would it increase, decrease or not
change? No further calculations are required. Explain your answer in no more than 1-2 sentences.
Decrease
Increase
No change

Answer:

a.
Optimal price discrimination requires that ANI sets MR1 = MR2 = MC.

MR1 = MC = 0
Setting MR1 = 0
9.6 - 0.16Q1 = 0
9.6 = 0.16Q1
Q1 = 60

P1 = 9.6 - 0.08(60)
P1 = 4.8

MR2 = MC = 0
Setting MR2 = 0
MR2 = 4 - 0.10Q2 = 0
4 = 0.10Q2
Q2 = 40

P2 = 4 - 0.05(40) = $2
P2 = Rs 2

Page 10 of 12
b.
To calculate elasticities, solve for Q.
P1 = 9.6 - 0.08Q1
P1 - 9.6 = -0.08Q1
Q1 = 120 - 12.50P1

Q1 = 120 - 12.5P1

E1 = ∙

E1 = -12.50 ∙

E1 = = -1.0

P2 = 4 - 0.05Q2
P2 = 4 - 0.05Q2
P2 - 4 = -0.05Q2
Q2 = 80 - 20P2

E2 = -20 ∙

E2 = -1
Or,
The elasticities for both segments are -1 (unitary elastic)

Or,
E1 = E2 = -1

Or,
|E1| = |E2| = 1

c.
Yes, it is consistent.
When MC = 0, profit maximization requires that MR = 0 (which in turn implies that there should be no
change in TR when price/quantity changes, as firms are on the portion of the demand curve which is unitary
elastic)
d.
Yes, the answer would change.

Page 11 of 12
ANI shouldn’t supply video to the second market (regional media TV channels) because it is too small. The
maximum willingness to pay in that market is Rs 4 (P2 = 4 – 0.05*0 = 4) which is the same as the marginal
cost. Formally, we can see this by setting MR2 = 4 - 0.10Q2 = MC = 4. This implies that Q2 = 0.
e.
Increase
The total surplus would increase in case monopolist practices price discrimination (because the deadweight
loss is minimized).

Page 12 of 12
 MGEC: Async Session

Practice Problems Answer Key

Practice Problem 1

The demand for rutabagas is Q = 2,000 - 100P and the supply of rutabagas is Q = -100 + 200P. The
government imposes a $2 per unit tax on the sale of rutabagas.
a) How much is the economic incidence of this tax for buyers?

Equilibrium price and quantity without tax, can be calculated by equating the given demand and supply
equations;
2,000 − 100𝑃 = −100 + 200𝑃
𝑃 = $7
Equilibrium quantity can be found by plugging price into either the demand or the supply equation; Q =
1300 units of rutabagas

Tax: $2 per unit on sale of rutabagas. Economic incidence of on the buyer or the supplier remains same
irrespective of whether the tax is imposed on the demand side or the supply side.
Let us suppose that the tax is imposed on the sellers. The new supply curve can be rewritten as: Q = -100
+ 200 (P-2)

The new equilibrium price and quantity with tax, can be calculated by equating the given demand and
new supply equations:
2,000 − 100𝑃 = −100 + 200 (𝑃 − 2)
2,000 − 100𝑃 = 200𝑃 − 500
2500
𝑃=
300
𝑃 = $8.33
Equilibrium quantity can be found by plugging price into either the demand or the supply equation; Q =
1167 units of rutabagas

The buyers tax burden: (Post tax price – pretax price) + tax paid by consumer

= (8.33 − 7) + 0

= $1.33

In other words, buyers are bearing 2/3 of the burden of this tax.

b) How much is the economic incidence of this tax for sellers?

The sellers tax burden: (Pre-tax price – Post tax price) + tax paid by sellers

= (7 − 8.33) + 2

= $0.67

Sellers are bearing 1/3 of the burden of this tax.

 c) Calculate the government revenue and the deadweight loss from the tax.

𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝐸𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑤𝑖𝑡ℎ 𝑡𝑎𝑥𝑒𝑠 × 𝑡𝑎𝑥 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 1167 × 2

𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = $2334

Deadweight loss is calculated as the area of the triangle, the height of which is the tax per unit and the
base is change in equilibrium quantity purchased due to tax. In this case the height of the triangle is 2 and
the base of the triangle is 133 (1300-1167) and therefore,

1
Dead Weight Loss = × 2 × 133 = 133
2
S
Problem 1 (15 points)

Suppose anyone with a driver’s license is capable of supplying one trip from the Hyderabad airport to the Financial
District, just down the road from ISB, on any given day. The long run supply curve of such trips is horizontal at
P = Rs. 500, which is the average cost of such a trip. Suppose daily demand is Q = 1000 – P.

a. How many trips from the airport to the Financial District will be sold each day, and at what price? (4 points)

The supply curve is given by: P = 500

Therefore, the only price at which trips will be supplied is P = 500, and at this price any number of trips can be
supplied. This implies that the equilibrium price is 500.

The equilibrium quantity can be calculated by plugging this price into the demand curve (since any number of
trips can be supplied at P = 500, the equilibrium quantity will just be the quantity that is demanded at this price.
Therefore: Q = 1000 – 500 = 500

b. What are the consumer and producer surplus at equilibrium? (3 points)

1000

500 Supply

Demand
0 500 1000

The consumer surplus is the area under the demand curve and above the market price. Therefore, it is given by the
area of the triangle A.
CS = ½ . 500 . 500 = 125,000

The producer surplus is the area above the supply curve and below the market price. In this case, they are the same.
Therefore, the producer surplus is 0

The consumer surplus is the area under the demand curve and above the market price. Therefore, it is given by the
area of the triangle A.
CS = ½ . 500 . 500 = 125,000

The producer surplus is the area above the supply curve and below the market price. In this case, they are the same.
Therefore, the producer surplus is 0

1|Page
 c. Suppose the city of Hyderabad mandates that people supplying such trips must possess a special permit, and
that only 300 such permits will be issued. What is the price and quantity of trips sold under this regulation?
(2 points)

Since only 300 permits will be issued and an individual can supply only 1 trip per day, the quantity of trips sold will
be 300
The price corresponding to this quantity sold can be calculated off the demand curve:
Q = 1000 – P
300 = 1000 – P
P = 700

d. What is the change in consumer surplus, producer surplus, and social welfare under the new regulations as
compared to the unregulated market? (6 points)

P
1000

A
700
B
C
500 Supply

0 Demand
300 500 1000 Q

The new consumer surplus is given by the triangle A:

CS = ½ . 300 . 300 = 45,000
Change in CS = 45,000 - 125,000 = - 80,000

The new producer surplus is given by the rectangle B:

PS = 300 . 200 = 60,000
Change in PS = 60,000 - 0 = 60,000

The original social welfare was simply the original CS as the original PS was 0.
Therefore, original social welfare = 125,000
New social welfare is the sum of new CS and new PS:
New social welfare = 45,000 + 60,000 = 105,000
Change in SW = 105,000 - 125,000 = - 20,000
Alternatively, someone might calculate DWL directly as the area of triangle C.
DWL = ½ . 200 . 200 = 20,000

Problem 2 (10 points)

A British publication once pointed out that iTunes prices vary by the customer’s currency. In terms of the British
currency (£), the prices are: UK: £0.79; Germany & France: 99 Euro cents (£0.68); US: 99 US cents (£0.51); and
Canada: 99 Canadian cents (£0.41). Evidence suggests that iTunes’ marginal cost is constant; you may suppose that
it is £0.10.

a. What kind of price discrimination is being followed here? Explain in 1 or 2 sentences. (2 points)

Third-degree price discrimination

2|Page
Explanation: Different customers (residents of different countries) are being charged different prices for an identical
product

b. Estimate the (own-price) demand elasticity for iTunes in Canada, assuming that iTunes prices in each region
are set at the profit-maximizing level. (4 points)

Use the inverse elasticity pricing rule:

𝑷𝑷 − 𝑴𝑴𝑴𝑴 𝟏𝟏
= −
𝑷𝑷 𝝐𝝐

.𝟒𝟒𝟒𝟒−.𝟏𝟏𝟏𝟏 𝟏𝟏 𝟒𝟒𝟒𝟒−𝟏𝟏𝟏𝟏 𝟏𝟏
=− OR =−
.𝟒𝟒𝟒𝟒 𝝐𝝐 𝟒𝟒𝟒𝟒 𝝐𝝐

𝟑𝟑𝟑𝟑 𝟏𝟏
== −
𝟒𝟒𝟒𝟒 𝝐𝝐
𝟒𝟒𝟒𝟒 𝟒𝟒𝟒𝟒
𝝐𝝐 = −𝟏𝟏. 𝟑𝟑𝟑𝟑 𝑶𝑶𝑶𝑶 𝟏𝟏. 𝟑𝟑𝟑𝟑 OR OR −
𝟑𝟑𝟑𝟑 𝟑𝟑𝟑𝟑

c. Consider an average Canadian iTunes user. What would happen to this user’s total expenditure on iTunes if
the iTunes price increases? Explain in 1 or 2 sentences. (4 points)

If the iTunes price increases, the total expenditure of an average Canadian on iTunes would decrease.

Explanation: The total expenditure of a customer on iTunes is price times quantity. Since the elasticity of demand
is more than 1, an increase in price would lead to a more than proportionate decrease in quantity demanded.
Therefore, the total expenditure would decrease.

In case someone calculates the elasticity incorrectly as a number which is less than 1 in absolute value and based on
this answer, argues that total expenditure would increase,

Problem 3 (11 points)

The market for supplying flowers outside the Jagannath temple in Puri is perfectly competitive. All firms (a firm is a
stall) sell flowers in small bamboo baskets. Each existing firm and every potential entrant faces an identical average
cost curve. The minimum level of average cost is Rs. 5 per bamboo basket, and occurs when a firm sells 200 bamboo
baskets of flowers each day. The market demand curve for a basket of flowers is Q = 28005 – P, where P is the market
price in Rupees per basket.

a. What is the long run equilibrium price per basket of flowers? (2 points)

In the long run equilibrium in a perfectly competitive market, the AR curve is tangent to the AC curve (at its minimum
point). Therefore, the long run equilibrium price is the same as the minimum level of AC:
P= 5

b. How many baskets does each firm sell at this price? (2 points)

We are given that the minimum AC for a firm corresponds to a quantity of 200 baskets. Therefore, the long run
equilibrium quantity for a firm is Q = 200

3|Page
 c. How many firms will be in the market at the long-run equilibrium? (3 points)

We can figure out the market demand at the LR equilibrium price by plugging in the value of P into the demand curve:
Q = 28005 – 5
Q = 28000

Each firm produces 200 baskets. Therefore, the number of firms N is given by:
28000
𝑁𝑁 =
200

𝑁𝑁 = 140

d. Suppose the new railway minister starts a new train to Puri, which increases the number of visitors to the
Jagannath temple. As a result, the demand curve shifts to the right, and becomes Q = 34005 – P. How many
new firms will have to enter the market for the long run equilibrium to be established? (4 points)

The long run equilibrium price and per firm quantity would remain the same as each incumbent and potential entrant
firm has the same AC curve with its minimum point at 5, corresponding to a quantity of 200.

Therefore, we can follow the same steps as in c to get the new market demand:

Q = 34005 – 5
Q = 34000

Each firm produces 200 baskets. Therefore, the number of firms N is given by:
34000
𝑁𝑁 =
200

𝑁𝑁 = 170

Therefore, 30 new firms would have to enter the market for LR equilibrium to be established

Problem 4 (17 points)

As part of scoping work for setting up a nation-wide chain of de-addiction and rehabilitation centres, you have been
trying to develop a better understanding of the problem of drug use in the United States. As part of this, you have
become interested in what the impact would be if authorities could be more effective at getting drugs off the streets.
The DEA has estimated the following data:

• Elasticity of Demand for Cocaine: -.55

• Elasticity of Supply: 1.0

• Current Market Price Cocaine: $80 per gram

• Current Cocaine Sales (annual): 950M grams

Suppose we are using a simply supply/demand framework, where the demand curve is given by:

4|Page
 Qd = a + bP

and the supply curve is given by:

Qs = c + dP

a. Use the data above to find the parameters a, b, c, and d (8 points)

𝑸𝑸 𝟗𝟗𝟗𝟗𝟗𝟗
𝒃𝒃 = 𝝐𝝐𝒅𝒅 . = -.55( ) = -6.53
𝑷𝑷 𝟖𝟖𝟖𝟖

a = Q − bP = 950 + 6.53(80) = 1472.4

𝑸𝑸 𝟗𝟗𝟗𝟗𝟗𝟗
𝒅𝒅 = 𝝐𝝐𝒔𝒔 . = 1( ) = 11.88
𝑷𝑷 𝟖𝟖𝟖𝟖

c = Q − dP = 950 −11.88( 80) = 0

b. Suppose there is a major crackdown on drug dealers, during which the DEA is able to seize 100M
grams of cocaine and take it off the market. What will happen to the equilibrium price and quantity? (5
points)

So, we need to subtract 100 from the market supply and resolve for price
and quantity. Intuitively, what should happen is that the seizure will force
the price up, which creates incentives for more supply.

Qd = 1472.4 − 6.53P Qs
= 11.88P −100

1472.4 − 6.53P = 11.88P −100

P = $85.4

Q = 11.88*85.4 −100 = 914

c. Suppose your rehab chain finally takes off. As part of a group counselling session at one of the centers,
you meet two former addicts, Jo and Bo. Jo says that she always spent $200 a month on cocaine, no
matter what the price. To this Bo responds that he didn’t care about the price either, and always bought
exactly 2 grams of cocaine. Based on this conversation, what can you conclude about Jo’s and Bo’s
price elasticity of demand for cocaine? (4 points)

Since Jo is going to spend the same amount of money on cocaine, no matter what the price, her demand for
cocaine is unit elastic OR has an elasticity of 1 OR -1
5|Page
 Since Bo quantity demanded is going to be entirely unaffected by the price, his demand is perfectly inelastic
OR has an elasticity of 0

Problem 5 (13 points)

Apple has traditionally outsourced the production of iPhones, iPads and other electronic devices to a contract
manufacturer based in China, Foxconn, which employs 800,000 workers in factories located all over China to work
on manufacturing these devices. Faced with increased competition for labor a few years back, Foxconn raised wages
and increased benefits for its workers. In April 2012, Samsung sued Apple for violating various Samsung patents to
produce mobile phones. (Sources: “Foxconn to raise salaries by 20% after suicides”, Financial Times, May 28, 2010;
“Samsung sues Apple on patent-infringement claims as legal dispute deepens”, Bloomberg, April 22, 2011.)

a. Explain how Apple should adjust its production and price if Foxconn raises prices for contract manufacturing.
(Note: given that Apple’s products are protected through patents, assume they are operating as a monopoly.)
(2 points)

If Foxconn raises the price of contract manufacturing, the MC of production goes up.

The equality of MR and MC will happen at a higher P and lower Q.

Therefore, Apple should increase P and decrease Q

b. Suppose that Apple must pay a royalty to Samsung for patent infringement on each mobile device that it
produces. How do Apple’s costs of production and its revenues change because of the royalty. How should
Apple adjust its production and price in response to the royalty? (Note: We know that Samsung ultimately
had to pay Apple for patent infringement, but for purposes of this question, let’s assume that Apple has to
pay Samsung.) (2 points)

If Apple must pay Samsung a royalty on each mobile device produced, then the marginal cost of each product
would be higher.

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 The effect would be the same as with the increase in Foxconn’s pricing, i.e., increase in P and decrease in Q.

c. How would your answer in (b) change if Apple must pay Samsung a lump sum in damages rather than a
royalty per unit produced? A diagram is not required. (4 points)

If Apple must pay Samsung a lump sum in damages, it is similar to an increase in fixed costs.

In this case, Apple should not adjust its production and price (the profit-maximizing sales and price
do not depend on the level of fixed costs).

Problem 6 (12 points: 2 points each)

Explain how each of the following events would influence the market in the short run. Assume standard demand and
supply curves, i.e., a downward sloping demand curve and an upward sloping supply curve. The market that needs to
be analyzed is indicated in parentheses against each event.
For each event, you have to indicate the direction of movement of the demand curve (outward, inward, or no change;
alternatively, rightward, leftward, or no change), the supply curve (outward, inward, or no change; alternatively,
rightward, leftward, or no change), equilibrium price (up, down, or no change), and equilibrium quantity (up, down,
or no change)
For all the parts below, assume that other than the event being described, nothing else has changed.

Note: For demand and supply curves, allow all types of terms: increase/outward/rightward and analogously for
decrease

a. A major war breaks out due to which several civilians join the army and are deployed at the front (labour
market)

Demand curve _____no change______________________

Supply curve ___________decrease_________________

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 Equilibrium price __________increase_______________

Equilibrium quantity ___________decrease____________

b. The scenario described in the course pack reading on coconuts (market for conventional coconut oil)

Demand curve _______no change_________________

Supply curve ________________decrease____________

Equilibrium price ____________increase_____________

Equilibrium quantity ______ decrease

c. An increase in the price of movie tickets (market for movie theatre popcorn)

Demand curve ___________decrease________________

Supply curve ___________no change_________________

Equilibrium price ________decrease_________________

Equilibrium quantity __________decrease_____________

d. A new technology that makes it cheaper to extract juice from oranges (market for orange juice)

Demand curve _____________no change______________

Supply curve ______________increase______________

Equilibrium price _______decrease__________________

Equilibrium quantity _________increase______________

e. An increase in the proportion of twins relative to singletons among newborns (market for baby clothes)

Demand curve _______increase____________________

Supply curve ____________no change________________

Equilibrium price _________increase________________

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 Equilibrium quantity _______increase________________

f. A prediction by the Indian Meteorological Department that the monsoon is going to be “below normal”
(market for food grains)

Demand curve ____________increase_______________

Supply curve ____________________decrease________

Equilibrium price _____________increase____________

Equilibrium quantity _________ambiguous______________

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