ME Problem Set – II

PGP 2017-19
(Answer Keys)

1.
(a)
Before the drop in export demand, the market equilibrium price is found by
setting total demand equal to domestic supply:
3244  283P = 1944 + 207P, or
P = $2.65.
Export demand is the difference between total demand and domestic demand: Q
= 3244  283P minus QD = 1700  107P. So export demand is originally Qe =
1544  176P. After the 40 percent drop, export demand is only 60 percent of
the original export demand. The new export demand is therefore, Qe = 0.6Qe =
0.6(1544  176P) = 926.4  105.6P. Graphically, export demand has pivoted
inward as illustrated in the figure below.
The new total demand becomes
Q = QD + Qe = (1700  107P) + (926.4  105.6P) = 2626.4  212.6P.
Equating total supply and the new total demand,
1944 + 207P = 2626.4  212.6P, or
P = $1.63,
which is a significant drop from the original market-clearing price of $2.65 per
bushel. At this price, the market-clearing quantity is about Q = 2281 million
bushels. Total revenue has decreased from about $6609 million to $3718
million, so farmers have a lot to worry about.

8.77

Qe
926.4 1544
(b) With a price of $3.50, the market is not in equilibrium. Quantity demanded and
supplied are
Q = 2626.4  212.6(3.50) = 1882.3, and
QS = 1944 + 207(3.50) = 2668.5.
Excess supply is therefore 2668.5  1882.3 = 786.2 million bushels. The government must
purchase this amount to support a price of $3.50, and will have to spend $3.50(786.2 million) =
$2751.7 million.

2.
(a) 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.
Price Demand Curves for Tickets

100

75

50
$35
25
Ds Dgp
100 200 300 400 500 Tickets

5(35)
gp   0.54
(b) The elasticity for the general public is 325 and the elasticity for
4(35)
gp   2.33
students is 60 . If the price of tickets increases by ten percent then the
general public will demand 5.4% fewer tickets and students will demand 23.3% fewer
tickets.

(c) 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) 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:
4P
s   1
Q
4P  Q  200  4P
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%.

3. (a)
QUd  10000  100(300)  99(300)
QUd  9700

Using PU  300 and QU  9700 gives

d

 300 
 Q , P  100    3.09
 9700 

(b) Market demand is given by Q  QU  QA . Assuming the airlines charge the same
d d d

price we have
Q d  10000  100 PU  99 PA  10000  100 PA  99 PU
Q d  20000  100 P  99 P  100 P  99 P
Q d  20000  2 P

P=300 , Q  19400 . This implies an elasticity equal to

d
When

 300 
 Q , P  2    .0309
 19400 
4.
Ms. Pampered’s initial budget constraint is the line AC, allowing her to purchase at most 50
burgers or at most 100 pizzas. The $60 cash certificate shifts out her budget constraint
without changing the maximum number of burgers that she can buy. The new budget
constraint is ABD and she can now buy a maximum of 120 pizzas.
Hamburgers

60
55
B
50
A

C D
20 100 120 Pizza

Initially, Ms. Pampered’s optimal basket contains all burgers and no pizza, at point A where
(P, H) = (0, 50), because MUH /PH = 4/6 > MUP / PP = 1/3. Her utility level at point A is U(0,
50) = 200. When she gets the gift certificate, her optimal basket is at point B, spending all of
her regular income on burgers and the $60 gift certificate on pizza. So point B is where (P,
H) = (20, 50) with a utility of U (20, 50) = 220.
However, she could also achieve a utility of 220 by consuming 220/4 = 55 burgers. To buy
the extra 5 burgers she would require 5*6 = $30. So, if she had received a cash gift of $30 it
would have made her exactly as well off as the $60 gift certificate for pizzas.

5.
When demand surges temporarily, putting upward pressure on price, the quantity supplied
expands along the short-run supply curve SS, as shown in the figure below. If demand
increases by the identical rate, but the increase is permanent, the industry would expand along
the long-run supply curve LS. The long-run supply curve is likely to be more price elastic
than the short-run supply curve. If the demand increase and the resulting upward pressure on
price is temporary, producers may be able to do very little to increase supply except to utilize
their existing production facilities more intensively (perhaps by hiring some temporary
labor). If the demand increase is permanent, industry supply can increase in response to
upward pressure on price in a number of ways: existing firms can produce more output in
their existing facilities; existing firms can expand their plants; and new firms can enter the
industry and produce. Thus, over a longer horizon, the industry’s supply response when
prices begin to rise is more flexible than it is over a shorter horizon.

6. Gift cards are not merely a fad. Retailers experience significant benefits from gift
cards since they minimize product returns; independent of whether the good is normal
 or inferior. Gift cards can also benefit consumers. A gift card does not impact the
amount purchased for one good (say the good on the Y axis), but shifts out the budget
constraint for the other good (the good on the X axis) by the face value of the gift
card. The expanded budget constraint permits the consumer to reach a higher
indifference curve; resulting in greater utility.

7. Robinson’s initial budget constraint is BC1 on the diagram below. Since His
indifference curves are always flatter than her budget constraint, he will consume all
coconuts. Thus, he gathers and consumes 64 coconuts. When his neighbor arrives
and offers the exchange, his budget constraint becomes BC2. It is now optimal for
him to gather all bananas and exchange them 1 for 1 with his neighbor for coconuts.
This gives him 128 coconuts to consume. This brings him to the higher indifference
curve I2. Robinson is better off.

8.
Without the gift certificate, Bobby's budget constraint is indicated by the line segment from
10 books and 0 pizza to 0 books and 50 pizzas (labelled BC1). With the gift certificate that
can only be used for book purchases, Bobby still cannot afford anymore than 50 pizzas.
However, she is guaranteed 6 books even if she spends all her money on pizza. Since the
price of books and pizza hasn't changed, the slope of her new budget constraint is the same as
the slope of the old budget constraint. The new budget constraint is drawn above as BC2.
Note that with the gift certificate, Bobby has an expanded opportunity set and is guaranteed
more of both goods no matter what her original consumption choice on BC1 was. This
implies that Bobby is strictly better-off with the gift certificate.

y
=4
9. a) Using the tangency condition, x , and the budget constraint,
4 x+ y=120 , your initial optimum is the basket (x, y) = (15, 60) with an utility of
900.

b) First we need the decomposition basket. This would satisfy the new tangency
y
=3
condition, x and would give you as much utility as before, i.e. xy=900 . This gives
( x, y)=(10 √ 3,30 √ 3) or approximately (17.3,51.9). Now we need the final basket, which
satisfies the same tangency condition as the decomposition basket and also the new budget
constraint: 3 x+ y=120 . Together, these conditions imply that (x, y) = (20, 60). The
substitution effect is therefore 17.3 – 15 = 2.3, and the income effect is 20 – 17.3 = 2.7.

10. Self-expnanatory !!! It is a normal good !