UniversityofToronto,DepartmentofEconomics,ECO20420102011AjazHussain

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Question1[60Points.Allpartsworth10pointseach]
ThisquestionisbasedontheHBScase:ThePrestigeTelephoneCompany.Foryourconveniencehereis
exhibit1fromthecase(figuresbelowareforthePrestigeDataservicescompanyJanuaryMarch2003)
Exhibit1:PrestigeTelephoneCompany
January2003 February2003 March2003
IntercompanyHours 206 181 223
CommercialHours 123 135 138
TotalRevenueHours 329 316 361

ServiceHours 32 32 40
AvailableHours 223 164 143
TotalHours 584 512 544

Inthecase,thecommercialpriceisP
c
= $8uuhourandtheintercompanypriceisP

= $4uuhour:
P
i
=$400/hr.
PrestigeTelephone
Company
PrestigeData
Services
Commercial
Customers
P
C
=$800/hr
Commercial
Other
Services
Data
D
a
t
a
Intercompany

ThePrestigeDataServicescos oursofdataservices): tfunctionwasestimatedtobe(here ish

C() = IFC + IIC() = 22S,4S6 + 28
ThePrestigeDataServicescommercialin e inMarch vers demandfunction
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2003wasestimatedtobe:
P(q) = 1,466 - 4.8Sq
(a)UnderthetermsofaregulationrulingPDSsintercompanybillingarecappedatanaverageof
$82,000/month.Whatdoesthisimplyfortheaverageintercompanyhoursthatcanbebilledper
month?IsPrestigeDataServicesabidingbyorviolatingthetermsoftheruling?Giveabriefexplanation.

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(b)WhatkindofreturnsdoesPDShaveforitsvariableinputs?Giveabriefexplanationbasedonthe
figuresabove(notbelow).

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(c)RecallthatPDShasneverearnedprofits.Calculatethebreakevennumberofcommercialhoursand
theequationofthedemandcurveinthemonthwhenPDSbreakseven.Showallcalculations.

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(d)Ingeneral,isiteasierforthecommercialdivisiontobreakevenifPDScomprisesofcommercial
andintercompanydivisionsversusifPDScomprisesofjustacommercialdivision?Assumethetwo
scenarioshavethesametotalfixedcost.

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(e)[Thispartisindependentofallotherparts]SupposethatinMarch2003,thegovernmentimposesa
10%excisetaxoncommercialdataservices.Assumingallcommercialcustomerscanbemodeledbya
singlerepresentativeconsumerwithincome$ andutilityfunctionu(
1
,
2
) (wheregood1is
commercialdataservicesandgood2iseverythingelse)whatisthemarginalutilityduetotheexcise
taxoncommercialdataservices?Pleaseshowallcalculationsandspecificallystateallassumptions.

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(f)RecallthatthePDSsvariableinputswerequasivariablepower(denotebyP)andquasivariable
labor(denotebyI)whileitsfixedinputswerequasifixedpower,quasifixedlaborandallother
inputs.Denoteallfixedinputsascapitalk.SupposePDSsproductionfunctionis:
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q = o P
1
7
I
6
7
k
y

Assumeo = k = 1 andy > u.Supposethepriceofpoweris$P

p
/hour,thepriceofquasivariablelabor
isP
L
= $Su.2S/hourandthepriceofcapitalisP
K
.GiventhatAIC
P
= $4/hourandAIC
L
= $24hour
whatisthepriceofquasi variablepowerP
P
?Hint:Solve theCMP
m
P
= -P
P
P
L
s. t. q = o P
u
I
[
k
y
ax
,L
-C - P I -P
K
k
andusethefactthatAIC
P
= $4/hourandAIC
L
= $24hour.Showallcalculationsbelow.

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Question2[40Points.Parts(d)&(e)worth5pointseach,allotherpartsworth10pointseach]
ThisquestionisbasedontheHBScaseTheAluminumIndustryin1994.Thefollowingtablecontainsthe
coststructureoftheaverageCISprimaryaluminumsmelter,theaveragestateprimaryaluminum
smelter,andtheaveragerationalprimaryaluminumsmelter(pleasenotethatcumulativecapacity
belowisthetotalcapacityofallsmelterswithinacategory(forexample,thetotalcumulativecapacityof
allCISsmeltersis1.788milliontonsperyear):
Allcostfiguresare$/t
VariablecostsareinBOLD
Smelter
AverageCIS
Smelter
AverageState
Smelter
Average
Rational
Smelter
Country
CIS Allover Allover
Company
CIS State Rational
AverageCapacity(000stpy)
243.73 120.74 121.53
Totalelectricitycost
148.62 454.49 292.29
Totalaluminacost
382.13 407.27 348.49
Otherrawmaterials
63.69 163.57 120.62
Plantpowerandfuel
4.51 11.81 10.34
Consumables
76.92 56.72 73.91
Maintenance
39.57 46.45 53.84
Labor
17.80 62.73 194.19
Freight
68.76 53.17 37.82
Generalandadministrative
67.11 52.48 86.58
Cumulativecapacity(000softons/year)
(allsmeltersinacategory)
1,788.07
(AllCIS)
2,826.95
(Allstate)
16,962.17
(Allrational)
Totalvariablecostsperton($/ton)=AFC(q)
740.14 1,135.25 873.15

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(a)Solvetheprofitmaximizingproblemfortheaverage a ional r t primaryaluminumsmelter:
max
q
= Pq - IFC - IIC(q) s. t. q u, q q
C

HereP = priceofaluminum/ton,IFC = TotalfixedCost, IIC(q)=Totalvariablecostandq

c
=
capacity.AssumeP > u. Showallcalculations.

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(b)Basedonyouranswertopart(a)whatistheimpactontheaveragerationalsmeltersoptimalprofits
from,holdingallelseconstant,a1%increasein:

Thepriceofaluminum?
Capacity?
Theminimumoutput?
Fixedcost?
AssumethatP = $1,1uu/ton.Showallcalculations.

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(c)GraphtheprimaryaluminumindustrysupplycurveasifallCISsmeltersbehaveliketheaverageCIS
smelter,allstateownedsmeltersbehaveliketheaveragestatesmelter,andallrationalsmeltersbehave
liketheaveragerationalsmelter.

(d)[Thispartisindependentofallpartsbelow]Graphtheprimaryaluminumindustrysupplycurvefrom
part(c)belowandthenshowtheimpactofallrationalsmeltersexperiencinglearningbydoing
(assumelearningbydoinghasasmalleffect).

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(e)Usetheprimaryaluminumsupplymodelinpart(c)topredictthedemandforprimaryaluminumfor
thecaseforthecaseswhen(i)P = $8uu/ton,(ii)P = $1,1uu/ton.Pleaseshowallgraphsbelowand
explainyourreasoning.

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TheEnd

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