Managerial Economics

Indian School of Business

HOMEWORK 3 SOLUTIONS

Problem 1
Tata Motors, a profit maximizing firm, produces a single variety of truck, Prima. The truck sells
at Rs. 1,000,000. Sales revenue from Prima is given by Rs. 168,000,000. Tata estimates that, at
this price-quantity, the elasticity of demand for Prima is -4. The general manager at Tata Motors
is well aware about profit maximizing conditions. What is the marginal cost of producing a
Prima? [10 points]

Using the formula expressing MR as a function of price and elasticity,

1
𝑀𝑅 = 𝑃 ( + 1)
𝜂

1
𝑀𝑅 = 1,000,000 (−4 + 1) = 750,000

For profit maximization, MR=MC

Therefore, MC = 750,000

Answer: MC=750,000 (Give 10 points for this answer)

Problem 2
Juhi Chaiwala sells tea on Chaupati beach in the morning. Since making tea is not allowed on the
beach, Juhi sells pre-prepared tea from a flask that she makes at home. There are two types of
customers who like to drink their tea at Juhi’s, the morning walkers and the laughing club
members. The inverse demand curve of the morning walkers (M) and laughing club members (L)
are given by PM = 30 – QM and PL = 34 – QL, respectively. The cost of making each cup of tea is
Rs. 2. Juhi cannot charge separate prices to the morning walkers and the laughing club members.
Can you help Juhi to determine the price for each cup of tea and how many cups to prepare?
[4+3+3 points]

Adding the two demand curves,

𝑄 = 𝑄𝑀 + 𝑄𝐿 = 64 − 2𝑃

where P is the uniform price charged.

Since cost of making tea = Rs.2

𝑇𝐶 = (𝑄𝑀 + 𝑄𝐿 )2 = 2𝑄
Differentiating with respect to Q,

𝑀𝐶 = 2

𝑄
𝑇𝑅 = 𝑃𝑄 = (32 − ) 𝑄
2

Differentiating with respect to Q,

𝑀𝑅 = 32 − 𝑄

For profit maximization, MC=MR

2 = 32 − 𝑄

𝑄 = 30
𝑃 = 17

Substituting P in demand functions,

𝑄𝑀 = 13, 𝑄𝐿 = 17

Answer: P=17, QM=13, QL=17 (4+3+3 marks respectively)

Problem 3
Taranjeet’s satellite company broadcasts TV to subscribers in Hyderabad and Mohali. The
demand curves of Taranjeet’s services for each of these two groups are:

QM = 30 - (1/4) PM

QH =90-(3/4) PH

where Q is in thousands of subscriptions per year, and P is the subscription price per year. The
cost of providing Q units of service is given by C = 100 + 40Q where Q = QM + QH.

a) What at the profit-maximizing prices and quantities for the Mohali and Hyderabad markets?
What are his profits? [2 + 2 + 2 points]

b) The Telecom Regulatory Authority of India passes a rule requiring Taranjeet to charge the
same price in Mohali and Hyderabad. What price should Taranjeet charge? What are his
profits? [2+2 points]

a) Profit maximizing condition for separated markets, say 1 and 2 (where producer can charge
different prices) is given as: MR1 = MR2 = MC
For Mohali,
QM = 30 – (1/4) PM
We get, PM = 120 – 4 QM as the price function.

TRM = PM * QM = 120 QM – 4(QM)2

Differentiating w.r.t. QM, MRM = 120 – 8 QM

The profit maximizing condition for Mohali is MRM = MC

Hence, 120-8 QM = 40
QM = 10 (1 mark)
Substituting in price function, PM = 80 Rs (1 mark)

Similarly, we solve for Hyderabad.

We get, PH = 120 – 4/3 QH as the price function.

TRH = PH * QH = 120 QH – 4/3(QH)2

Differentiating w.r.t. QH, MRH = 120 – 8/3 QH

The profit maximizing condition for Hyderabad is MRH = MC

Hence, 120-8/3 QH = 40
QH = 30 (1 mark)
Substituting in price function, PM = 80 Rs (1 mark)

His profits = TRM + TRH – TC

= 800 + 2400 – (100 + 1600)
= 1500 Rs (2 marks)

b) In case they have to charge same price, then the profit maximization condition should be
MC = AMR (Aggregated Marginal Revenue)

Adding the two demand curves to get Aggregate demand curve,

𝑄 = 𝑄𝐻 + 𝑄𝑀 = 120 − 𝑃

Where, P is the uniform price charged. TR = 120Q – Q2

Differentiating TR with respect to Q, to get MR and equating it to MC, we get

120 − 2𝑄 = 40
𝑄 = 40

Hence, he should charge price at Q = 40 ; where 𝑃 = 80Rs

Hence profits = TR – TC = 3200 – 1700 = Rs 1500 (Coincidentally, remains the same)

Problem 4
The (total) cost of production for Pro-fit, a fitness equipment manufacturing firm that produces
only dumbbells is given by TC=10,000+5q+q2/1000, where q is the quantity of dumbbells
produced. Out of the total fixed cost of Rs. 10,000, Rs. 7,500 can be avoided if the Pro-fit is not
producing at all. Pro-fit operates in a perfectly competitive environment. What is the supply
function for Pro-fit?

Supply is obtained as the upward sloping part of MC curve from the minimum point of AVC curve(shut
down point). Here, MC is a continuously upward sloping curve obtained as 5 + q/500.

AVC = 5 + q/1000 which has an intercept at 5 and is also an upward rising curve (hence minimum AVC
is at q = 0).

The supply curve is obtained as P = 5 + Q/500 (10 points)

Alternative Solution (If you consider avoidable costs – upward sloping AC curve)

If the producer wants to incorporate the avoidable costs (component of fixed cost other than sunk
cost/unavoidable cost), in his production decision i.e. to say, he would produce only if his average cost
(inclusive of avoidable fixed cost component) is recovered, then supply curve is obtained as the upward
sloping part of MC curve from the minimum point of AC curve.

Find AC and then minimum of AC

TC = 7500 + 5q + q2/1000 (only avoidable cost is considered)

AC = 7500/q + 5 + q/1000

Min of AC is obtained at q = 2739 (rounded off)

Thus, the supply curve in this case is given as:

MC = P = 5 + q/500 for q >= 2739 (minimum of AC)

MC = P = 10.478 at q = 0 (value of P obtained by substituting q = 2739 in function of MC)

Note: Unavoidable costs or sunk costs are the component of cost which is never recovered / incurred
even if q = 0. Hence, producers do not take this into consideration while making supply decision.