Ace Institute of Management

EMBA Program - Managerial Economics

Solution to Assignment I
1. Answer the following questions on the basis of table given below: Percentage of resources devoted to gun production 100 80 "0 0 !0 0 Number of guns produced 50 0 #0 !0 10 0 Percentage of resources devoted to butter production 0 !0 0 "0 80 100 Pounds of butter produced 0 5 10 15 !0 !5

i. Plot the production possibilities curve for the production of guns and butter. Put guns on the hori$ontal a%is. ii. &hat is the per unit opportunit' cost of increasing the production of guns from !0 to #0( )rom 0 to 50( iii.&hat happens to the opportunit' cost of producing butter as the production of butter increases( iv. *s producing # guns and + lbs. of butter possible( *s it efficient( Solution:

,iPounds of Butter Produced 30 25 20 15 10 5 0 10 20 30 40 50 Number of Guns Produced 34 guns and 7 lbs. of butter

,ii- )rom the above figure. increasing production of guns b' 10 units ,from !0 to #0 units- requires giving up 5 pounds of butter ,from 15 to 10 pounds-. /herefore opportunit' costs of 10 units of gun is 5 pounds of butter or opportunity costs of 1 unit of gun is or 0.5 pounds of butter.

0imilarl'. per unit opportunit' cost of increasing guns production from 40 to 50 units is also or 0.5 pounds of butter. ,iii- )rom the above figure. as the production of butter increases b' 5 pounds in each case from 5 to 10 units or 10 to 15 units or !0 to !5 units. we can see that the constantl' 10 units of guns have to be given up. /herefore the opportunity cost of producing butter remains constant ,10 units of guns- as the production of butter increases. ,iv- Yes it is possible to produce 34 guns and 7 pounds of butter, but it is not efficient. )rom the above figure. after producing # guns. the remaining resources will produce 1" guns more. &hereas. + lbs. of butter require onl' 1 guns to sacrifice as the per unit opportunit' cost of producing butter is ! ,as 5 pounds of butter requires 10 units of guns to give up from part ,iiiabove-. /herefore. after producing + lbs. of butter and # guns. some more resources will remain which can either produce ! guns or 1 pound of butter. 2. Suppose t at t ere are 10 million !or"ers in #anada, and t at eac of t ese !or"ers can produce eit er 2 cars or 30 bus els of ! eat in a year.
a- &hat is the opportunit' cost of producing a car in 1anada( &hat is the opportunit' cost of producing a bushel of wheat in 1anada( 2%plain the relationship between the opportunit' costs of the two goods. b- 3raw and e%plain 1anada4s production possibilities frontier. c- *f 1anada chooses to consume 10 million cars. how much wheat can it consume without trade( 5abel this point on the production possibilities frontier. d- Now suppose that the 6nited 0tates offers to bu' 10 million cars from 1anada in e%change for !0 bushels of wheat per car. *f 1anada continues to consume 10 million cars. how much wheat does this deal allow 1anada to consume( 5abel this point on 'our diagram. 0hould 1anada accept the deal( Solution:

a. 7ecause a 1anadian wor8er can ma8e either two cars a 'ear or #0 bushels of wheat. the opportunity cost of a car is 15 bus els of ! eat. 0imilarl'. the opportunity cost of a bus el of ! eat is 1$15 of a car. /he opportunit' costs are the reciprocals of eac ot er.

b.

)rom the above figure. if all ten million wor8ers produce two cars each. the' produce a total of !0 million cars. which is the vertical intercept of the production possibilities frontier. *f all ten million wor8ers produce #0 bushels of wheat each. the' produce a total of #00 million bushels. which is the hori$ontal intercept of the production possibilities frontier. 7ecause the trade9off between cars and wheat is alwa's the same. the production possibilities frontier is a straight line. c. *f 1anada chooses to consume ten million cars. it will need five million wor8ers devoted to car production. /hat leaves five million wor8ers to produce wheat. who will produce a total of 150 million bus els of ! eat ,five million wor8ers times #0 bushels per wor8er-. /his is shown as point % on &igure above. d. *f the 6nited 0tates bu's 10 million cars from 1anada and 1anada continues to consume 10 million cars. then 1anada will need to produce a total of !0 million cars. 0o 1anada will be producing at the vertical intercept of the production possibilities frontier. :owever. if #anada gets 20 bus els of ! eat per car, it !ill be able to consume 200 million bus els of ! eat, along with the 10 million cars. /his is shown as point 7 in the figure. #anada s ould accept t e deal because it gets the same number of cars and 50 million more bushes of wheat.

#- Suppose t at your demand sc edule for compact discs is as follo!s'

a. 6se the midpoint method to calculate 'our price elasticit' of demand as the price of compact discs increases from ;8 to ;10 if ,i- 'our income is ;10.000. and ,ii- 'our income is ;1!.000 b. 1alculate 'our income elasticit' of demand as 'our income increases from ;10.000 to ;1!.000 if ,i- the price is ;1!. and ,ii- the price is ;1"

Solution:
a- *f the income is ;10.000. the price elasticit' of demand as the price of compact disc rises from ;8 to ;10 is <,#! = 0->#"?><,10 = 8->@? A (1. *f the income is ;1!.000. the elasticit' is <, 5 = 50-> +.5?><10 = 8->@? A 0.473).

b- *f the price is ;1!. the income elasticit' of demand as the income increases from ;10.000 to ;1!.000 is <,#0 =! ->!+?><,1!.000 = 10.000->11.000? A 1.22. *f the price is ;1". the income elasticit' of demand as the income increases from ;10.000 to ;1!.000 is <,1! = 8->10?><,1!.000 = 10.000->11.000? A 2.2

4) Given the demand for a product A: BA A 850 = 5PA C1.5P7 C 0. D &here PA and P7 are the prices per unit of A and 7 commodit' and are Es. !00 and 100 respectivel'. 1onsumer4s income D is Es. 10.000. a- 1alculate price elasticit' of demand b- *ncome elasticit' of demand for when the income increases to Es.15000. c- Are the goods A and 7 substitute ,or competitive- or 1omplimentar'( Solution: 3emand for Product A is given b': BA A 850 = 5PA C1.5P7 C 0. D PA A Es. !00 P7 A Es.100 D A Es. 10.000 a- BA A 850 = 5PA C1.5P7 C 0. D A 850 = 5,!00- C1.5,100- C 0. ,10000A 850 = 1000 C150 C 000 A 8000 P23 A 95 ,!00>8000- A 9 0.1!5

b- &hen D A 1000. BA A 8000 &hen D A 15000. BA A 850 = 5PA C1.5P7 C 0. D A 850 = 5,!00- C1.5,100- C 0. ,15000A 850 = 1000 C150 C "000 A 10000

*ncome elasticit' of 3emand A ,dBA>dD- F ,1hange in *ncome > 1hange in BAA 0. % ,5000 > !000- A 1 or. *1 A 10.000. B1 A 8000. *! A 15000. B! A 10000 *23 A 0.5"+

c- 1ross Price 2lasticit' of 3emand A 1.5 % ,100 > 8000- A 0.018 0ince 1ross P23 G 0. goods A and 7 are substitute to each other.

5. #onsider a mar"et !it demand cur*e + , 500 - 20p and supply cur*e + , ( 50 . 25p. /ere + is in million "ilograms per day and p is in rupees per "ilogram a- 3etermine the mar8et equilibrium price and quantit'. the total revenue and consumer and producer surpluses in this mar8et. b- 1alculate the price elasticit' of demand and the price elasticit' of suppl' at the mar8et equilibrium. c- *magine that the government imposes a Es.! per9unit ta% on the bu'ers. &rite down the new mar8et suppl' and demand curves. and find the new mar8et equilibrium price and quantit'. :ow much of the ta% burden is borne b' the bu'ers. and how much b' the sellers( 1alculate the 3eadweight loss ,using H % b % h- due to the ta%. 1alculate the change in consumer and producer surpluses in this mar8et. d- Now imagine that the government instead decides to impose a Es.! per9unit ta% on the sellers. &rite down the new mar8et suppl' and demand curves. find the new mar8et equilibrium price and quantit'. and compare with 'our answer from above ,where the ta% is on the bu'er-. 1alculate the 3eadweight loss. 1alculate the change in consumer and producer surpluses in this mar8et. e- Now imagine that the government instead decides to impose a sales ta% of !0I on the sellers. :ow will this change things( &rite down the new mar8et suppl' and demand curves and find the new mar8et equilibrium price and quantit'. 1alculate the 3eadweight loss. 1alculate the change in consumer and producer surpluses in this mar8et. Solution
Jar8et demand curve. q A 500 9!0p KKKKKKKKK,iJar8et 0uppl' curve. q A 9 50C!5p KKKKKKKKKK,ii*n equilibrium mar8et. 500 9!0p A 9 50C!5p 5p A 550 p A Es.1!.!!>Lg 0ubstituting the value of Mp4 in equation ,i-

q A 500 = !0%1!.!! A !55." million 8g /E A p%q A Es. #1!#. # per da' )inding consumer surplus. substituting q A 0 in demand curve. 0 A 500 = !0p P A Es.!5 0imilarl'. finding producer4s surplus. substituting q A 0 in suppl' curve. 0 A 9 50 C !5p P A Es.!

/herefore. 1onsumer 0urplus A 1>! % !55." % ,!5 = 1!.!!- A Es.1"##.!8 Producer 0urplus A 1>! % !55." % ,1!.!! =!- A Es.1#0".1!

b.

0rice 1lasticity of demand , (20 212.22$255.)3 , ( 0.4) 0rice 1lasticity of Supply , 25 212.22$255.)3 ,1.14

c.

&hen the government impose Es.! per unit ta% on bu'ers. the total amount that bu'ers pa' is pC! where the price is p.

0o. the new mar8et demand curve is: q A 500 9!0,pC!- A 500 9!0p9 0 A "0 9!0p. 0o. the ne! mar"et demand cur*e is' + , 4)0 (20p KKKKKKKKKKKK..,iii0ince the ta% is imposed on bu'ers. there is no change in the suppl' curve. /herefore. the mar"et supply cur*e remains t e same' + , ( 50.25p. 2quating equation ,iii- and ,ii-. we have. "0 9!0p A 9 50C!5p or. p A 11.## and substituting the value of Mp4 in ,iii-. q A !##.

5 erefore, ne! e+uilibrium price is 6s. 11.33 per "g 7e! e+uilibrium +uantity is 233.4 million "gs.

5 e total price t at buyers pay , 7e! 1+uilibrium 0rice . 5a8 , 11.33 . 2 , 6s. 13.33 per 9g. 0ince the original equilibrium price was Es.1!.!! and after the imposition of ta%. bu'ers pa' Es. 1#.##. 5 e burden of t e ta8 s ared by t e buyers is 6s.13.33 : 6s. 12.22 , 6s. 1.11 per 9g.

5 e total price t at sellers recei*e , 7e! e+uilibrium price , 6s. 11.33 0ince the original equilibrium price was Es.1!.!! and after the imposition of ta%. sellers receive Es. 11.##. 5 e burden of t e ta8 s ared by t e sellers is 6s. 12.22 : 6s.11.33 , 6s. 0.;4 per 9g.

Deadweight Loss = 1 ! " ! " #!$$%& ' !((%4) = )s%!!%! 1onsumer 0urplus A 1>! % !##. % ,!5 = 1#.##- A Es.1#"1.8@

*hange in *onsumer Surplus = 1&((%!+ ' 1(&1%+, = )s%!-1%(,

Producer 0urplus A 1>! % !##. % ,11.## = !- A 1088.81 *hange in .roducer Surplus = 1(/&%1! ' 1/++%+1 = )s%!1-%(1

d-

&hen the government impose Es.! per unit ta% on sellers. the total amount that sellers receive is p9! where the price is p.

0o. the new mar8et suppl' curve is: q A 9 50C!5,p9!- A 9 50 C!5p950 A 9 100 C !5p. 0o. the ne! mar"et supply cur*e is' + , ( 100 . 25p KKKKKKKKKKKK..,iv-

0ince the ta% is imposed on sellers. there is no change in the demand curve. /herefore. the mar"et demand cur*e remains t e same' + , 500(20pKK..,i2quating equation ,i- and ,iv-. we have. 500 9!0p A 9 100 C !5p or. p A 1#.## and substituting the value of Mp4 in ,iv-. q A !##. 5 erefore, ne! e+uilibrium price is 6s. 13.33 per "g 7e! e+uilibrium +uantity is 233.4 million "gs.

5 e total price t at buyers pay , 7e! 1+uilibrium 0rice , 6s. 13.33 per 9g. 0ince the original equilibrium price was Es.1!.!! and after the imposition of ta%. bu'ers pa' Es. 1#.##. 5 e burden of t e ta8 s ared by t e buyers is 6s.13.33 : 6s. 12.22 , 6s. 1.11 per 9g.

5 e total price t at sellers recei*e , 7e! e+uilibrium price : 5a8 , 6s. 13.33 : 6s. 2 , 6s.11.33 0ince the original equilibrium price was Es.1!.!! and after the imposition of ta%. sellers receive Es.11.##. 5 e burden of t e ta8 s ared by t e sellers is 6s. 12.22 : 6s.11.33 , 6s. 0.;4 per 9g.

1omparing results of part ,c- and ,d-. both have same results: bu'ers pa' Es.1#.## per 8g. and sellers receive Es. 11.## per 8g. *n both cases. burden of ta% shared b' bu'ers is Es.1.11 per 8g and burden of ta% shared b' sellers is Es. 0.8@ per 8g. /his result shows the ta% equivalence.

Since there is no change in the price that bu0ers pa0 and sellers receive1 Deadweight Loss = )s%!!%! *hange in *onsumer Surplus = )s%!-1%(, *hange in .roducer Surplus = )s%!1-%(1

e-

&hen the government imposes sales ta% of !0I on the sellers. then what sellers reall' get is 100-20 , ;0< of Mp4. i.e.. 0.8pN 0ince the before9ta% suppl' curve is q = - 50 + 25p. the after9ta% suppl' curve will be: 2 = 3 $/ 4 !$#%+p) or1 + , ( 50 . 20p KKKKKKKKKKKK ,v-

0ince the ta% is imposed on sellers. there is no change in the demand curve. /herefore. the mar"et demand cur*e remains t e same' + , 500 ( 20pKK..,i2quating equation ,i- and ,v-. we have. 500 9!0p A 9 50 C !0p or. p A 1#.+5 and substituting the value of Mp4 in ,v-. q A !!5

5 erefore, ne! e+uilibrium price is 6s. 13.75 per "g 7e! e+uilibrium +uantity is 225 million "gs.

5 e total price t at buyers pay , 7e! 1+uilibrium 0rice , 6s. 13.75 per 9g. 0ince the original equilibrium price was Es.1!.!! and after the imposition of ta%. bu'ers pa' Es. 1#.+5. 5 e burden of t e ta8 s ared by t e buyers is 6s.13.75 : 6s. 12.22 , 6s. 1.53 per 9g.

5 e total price t at sellers recei*e , 7e! e+uilibrium price : 5a8 , 6s. 13.75 : 6s.220< of 13.753 , 6s.11 0ince the original equilibrium price was Es.1!.!! and after the imposition of ta%. sellers receive Es.11. 5 e burden of t e ta8 s ared by t e sellers is 6s. 12.22 : 6s.11 , 6s.1.22 per 9g.

Deadweight Loss = 1 ! " #1(%-$ ' 11) " #!$$%& ' !!$) = )s%4/%/-$ 1onsumer 0urplus A 1>! % !!5 % ,!5 = 1#.+5- A Es.1!"5."# *hange in *onsumer Surplus = 1&((%!+ ' 1!&$%&( = )s%(&-%&$

Producer 0urplus A 1>! % !!5 % ,11 = !- A 101!.5 *hange in .roducer Surplus = 1(/&%1! ' 1/1!%$ = )s%!,(%&!

)3 #onsider a competiti*e mar"et for ! ic t e +uantities demanded and supplied 2per year3 at *arious prices are gi*en as follo!s'
Price ($) 60 0 100 120 Demand (millions) 22 20 1 16 Supply (millions) 14 16 1 20

,a,b,c,d-

1alculate the price elasticit' of demand when the price is ;80 1alculate the price elasticit' of suppl' when the price is ;80 &hat is the equation for the demand curve( &hat is the equation for the suppl' curve(

Solution:
a-. &e 8now that the price elasticit' of demand ma' be calculated using equation:

ED

Q D QD P Q D = = . P Q D P P

)rom the above question. with each price increase of ;!0. the quantit' demanded decreases b' !. /herefore.

QD = 2 = 0.1. P 20
%t 0 , ;0, +uantity demanded e+uals 20 and ED = ( 0.1) = 0.40. 20 b/he elasticit' of suppl' is given b':
Q S QS P Q S ES = = . P Q S P P

80

&ith each price increase of ;!0. quantit' supplied increases b' !. /herefore.

QS = 2 = 0.1. P 20
%t 0 , ;0, +uantity supplied e+uals 1) and

80 ES = (0.1) = 0.5. 16
c=y definition, t e e+uation for t e demand cur*e is gi*en as >,a.b0 where Mb4 is the slope of the demand curve and Ma4 is the demand for the goods. /he above table shows that ever' time price increases of ;!0. quantit' demanded falls b' ! millions
D = = 0.1. /herefore. dB>dP A P 20

2quation for 3emand 1urve is B A a90.1P. KKKKK.,iPutting P A 80 and BA!0 from the above table in equation ,i-N , 7ote? in fact any combination of *alues of 0 and > from t e abo*e table can be put in t e e+uation 2i3 to sol*e t e *alue @aANow we have. !0Aa90.1O80. /herefore. aA!8 and 5 e e+uation for t e demand cur*e is >,2;(0.1p

d)

=y definition, t e e+uation for supply is gi*en as >,a.b0. &ith each price increase of ;!0. quantit' supplied increases b' !. /herefore.

S = = 0.1. dB>dP A P 20

/herefore. the equation for 0uppl' curve is B A aC0.1p KKKKKK.,iiPutting P A 80 and BA1" from the above table in equation ,ii-N ,7ote? in fact any combination of *alues of 0 and > from t e abo*e table can be put in t e e+uation 2ii3 to sol*e t e *alue @aA Now we have. 1"AaC0.1O80. /herefore. aA8 and 5 e e+uation for t e supply cur*e is >,;.0.1p

-% 0uppose the demand function for corn is Bd A 10 = !p and suppl' function is Bs A #p = 5. /he government is concerned that the mar8et equilibrium price of corn is too low and would li8e to implement a price support polic' o protect the farmers. 7' implementing the price support polic'. the government sets a support price and purchases the e%tra suppl' at the support price. *n this case. the government sets the support price Ps A . a- 1alculate the original mar8et equilibrium price and quantit' in absence of the price support polic'. , p A #. B A b- At the support price Ps A . find the quantit' supplied b' the farmers. quantit' demanded b' the mar8et and the quantit' purchased b' the government. ,Bs A +. Bd A !. Povernment purchase A 5c- 3raw a diagram to show the change in producer surplus due to the implementation of the price support polic'. 1alculate the change in the producer surplus. *nitial producer surplus A 1>! % % ,# = 1."+- A !."" )inal producer surplus A 1>! % + % , = 1."+- A 8.1" 1hange A 5.5 d- 3raw a diagram to show the change in the consumer surplus due to the implementation of the price support polic'. 1alculate the change in consumer surplus. *nitial consumer surplus A 1>! % % ,5 9 #- A )inal consumer surplus A 1>! % ! % ,5 9 - A 1 1hange A # e- 1alculate the cost to the government to implement the price support polic'. 3raw a diagram to show the government cost. 1ost to the government A % 5 A !0 f- 0uppose now the government switches from price support polic' to subsid' polic'. )or each unit of corn produced. the government subsidi$es the farmers 0 A 5>#. )ind the new equilibrium price under this polic'. :ow much mone' will the government have to spend in order to implement this subsid' polic'( After subsid'. Bs A #,PC5>#- = 5 A #P #P A 10 = !P P A !. B A " Povernment e%penditure A " % ,5>#- A 10

+% 0agar ta8es a Qob that pa's him annuall' Es.#00.000. :e sets some of this income aside in a savings account that pa's an annual interest rate of 5 percent. 6se a diagram with a budget constraint and indifference curves to show how 0agar4s consumption changes in each of the following situations. a. 0agar4s annual salar' increases to Es. 00.000 b. /he interest rate on his ban8 account rises to 8 percent.
Solution:
a! Sa"ar#s salary increases $o $40%000! Solution:

Above figure shows the situation in which 0agar4s salar' increases from ;#0.000 to ; 0.000. &ith numbers shown in thousands of dollars in the figure. his initial budget constraint. 711. has a hori$ontal intercept of #0. since he could spend all his income when 'oung. /he vertical intercept is #1.5. since if he spent nothing when 'oung and saved all his income. earning 5 percent interest. he would have ;#1.500 to spend when old. *f his salar' increases to ; 0.000. his budget constraint shifts out in a parallel fashion. with intercepts of 0 and !. respectivel'. /his is an income effect onl'. so if consumption when 'oung and old are both normal goods. he will spend more in both periods. &! '(e in$eres$ ra$e on &an) accoun$ rises $o percen$! Solution: *f the interest rate on his ban8 account rises to 8 percent. his budget constraint rotates. *f he spends all his income when 'oung. he will spend Qust ;#0.000. as before. 7ut if he saves all his income. his old9age consumption increases to ;#0.000 % 1.08 A ;#!. 00. compared to ;#1.500 before. As following figure indicates. the steeper budget line leads him to substitute future consumption for current consumption. 7ut the income effect of the higher return on his saving leads him to want to increase both future and current consumption if both are normal goods. /he result is that his consumption when old certainl' rises and his consumption when 'oung could increase or decrease. depending on whether the income or substitution effect dominates.

@. Rne reason wh' mar8et outcome is the most efficient one is that the total surplus is ma%imi$ed at this level. 0how 'our acquaintance with this statement with a diagram. Solution: Jar8et is considered efficient if it ma%imi$es the total surplus Ja%imi$ing total surplus: *a+imi,in" consumer surplus &y in-ol-in" ma+imum num&er o. consumers in $(e mar)e$ .or $rade + *a+imi,in" producer surplus &y in-ol-in" ma+imum num&er o. producers in $(e mar)e$ .or $rade *f there is an e%cess demand sellers will be able to increase total surplus b' producing more. *f there is an e%cess suppl'. sellers will be able to increase total surplus b' producing less. 6se /otal surplus diagram.

10. Janagerial economics is the branch of microeconomics that deals with tools and ideas that a manager uses in his da'9to9da' decision ma8ing process. 2%plain how does managerial economics assist in corporate decision ma8ing(

Solution: )irst e%plain wh' decision ma8ing is important 2%plain how economics principles are used in decision ma8ing b' giving some e%amples from principles of economics or others such as price mechanism. profit ma%imi$ation. revenue ma%imi$ation or an' other economic theories and show how these theories help to ma8e decisions.