MGEC

HW1 Answer Key

Problem 1
A computer products retailer purchases laser printers from a manufacturer at a price of Rs. 25,000
per printer. During the year, the retailer will try to sell the printers at a price greater than Rs.
25,000, but may not be able to sell all the printers. At the end of the year, the manufacturer will buy
back any unsold inventory at 40 percent of the original price. No one other than the manufacturer
would be willing to buy these unsold printers at the end of the year.
a) At the beginning of the year, before the retailer has purchased any printers, what is the
opportunity cost of a laser printer?

Since a printer costs Rs. 25000, before purchasing any printers, the opportunity cost of a laser
printer would be the next best use of Rs. 25000 for the retailer. For example, this money could be
invested elsewhere at a certain rate of return. This return foregone would be the opportunity cost
of the laser printer.

b) After the retailer has purchased the laser printers, what is the opportunity cost associated
with selling a laser printer to a customer? (Assume that if this customer does not buy the
printer, it will be unsold at the end of the year.)

Any unsold inventory will be bought back by the manufacturer at 40% of the original price;
Rs.10,000 (25000*.40). Therefore, the opportunity cost associated with selling a laser printer to a
customer would be Rs. 10,000 as this is the next best alternative available to the retailer.

c) Suppose that at the end of the year, the retailer still has a large inventory of unsold printers.
The retailer has set a retail price of Rs. 30,000 per printer. The manager of the store
proposes that they should cut the price by half and sell the printers at Rs. 15,000 each. The
owner of the store disagrees, pointing out that at Rs. 15,000 each, they would lose Rs. 10,000
on each printer sold. Is the owner’s argument correct?

No, the owner has fallen prey to the sunk cost fallacy. He is anchored to the purchase price of Rs.
25000, and is considering sale of printers at Rs. 15000, as a situation where he would incur a loss
of Rs. 10,000 (Purchase price-offer price; 25000-15000). When in fact, he should be comparing
the following two situations;
 cutting the price by half and selling the printers at Rs. 15,000 each
 unsold printers being bought back by manufacturer at Rs. 10,000 each.
Clearly, the best alternative available to him at this juncture is to select the first option, where he
would actually be cutting his losses by Rs. 5000.
Problem 2
Consider the demand curve for the latest wearable fitness device, QD = 40,000 - 4P.
a) Plot the demand curve

Q = 40000-4P
Price

10000

5000

0 20000 40000 Quantity

b) Find the price and quantity at which the demand is unit elastic
Given that price elasticity of demand (ϵd ) = -1
Demand curve:
Q=40000−4 P

dQ
=−4
dP

dQ P
ϵd = ×
dP Q

P
-1 = −4 ×
40000−4 P

Solve for P. P= 5000.

To find Q, plug P=Rs. 5000 in the demand equation Q = 40000-4P; Q = 20000.
Demand is unit elastic at Price = Rs. 5000 and Q = 20000

c) Compute the elasticity of demand when the staring price is

i. Rs. 2,000

Given, P = Rs. 2000. We can find the corresponding quantity (Q), by plugging P=Rs.
2000 in the demand equation Q = 40000-4P; Q = 32000
Use price elasticity formula to find ϵd
 dQ P
ϵd = ×
dP Q

2000
ϵd = −4 ×
32000
−1
ϵd = or -0.25
4

ii. Rs. 1,000

Given, P = Rs. 1000. We can find the corresponding quantity (Q), by plugging P = Rs.
1000 in the demand equation Q = 40000-4P; Q = 36000
Use price elasticity formula to find ϵd

dQ P
ϵd = ×
dP Q

1000
ϵd = −4 ×
36000
−1
ϵd = or -0.11
9

Problem 3
The demand for beer in Gachibowli is given by: QD = 700 - 20P – 10Pc + 0.1I, where P is the price
of beer, Pc is the price of chips, and I is the average consumer income.
a) Please provide an expression for the elasticity of demand for beer with respect to the price
of chips. Based on your answer, are beer and chips complements or substitutes?

Cross Price elasticity of demand for beer with respect to the price of chips (ϵ bc) can be written as:
dQ Pc Pc
ϵbc = × or ϵbc = −10 ×
dPc Q Q
Beer and Chips are complementary goods since ϵ bc is negative, indicating an inverse relationship
between price of chips and demand for beer. If price of chips goes up (down), the demand for
beer decreases (increases).

b) Calculate the own price elasticity, the cross price elasticity and the income elasticity of the
demand for beer when P = 50, Pc = 15, and I = 14,000

Given demand function: Q = 700 - 20P – 10Pc + 0.1I and P = 50, Pc = 15, and I = 14,000.
Plugging these values into the demand function:
Q = 700 – 20 (50) – 10 (15) + 0.1 (14000)
Q = 950

Price Elasticity at P = 50
dQ P
ϵd = ×
dP Q
50
ϵd = −20 ×
950
ϵd = −¿1.053

Cross price elasticity at Pc = 15

 dQ Pc
ϵxy = ×
dPc Q
15
ϵxy =−10 ×
950
ϵxy = −¿ 0.158

Income elasticity at I = 14000

dQ I
ϵI = ×
dI Q
14000
ϵI =0.1 ×
950
ϵI = 1.473

c) Graph the demand curve for beer when Pc = 15, and I = 14,000
Given demand function: Q = 700 - 20P – 10Pc + 0.1I and given Pc = 15, and I = 14,000.
Plugging these values in the demand function:
Q = 700 – 20P – 10(15) +0.1(14000)
Q = 1950 – 20P

Q = 1950-20P
Price

97.5

50

0 950 1950 Quantity

Problem 4
The demand curve for pedicures is given by: QD = 20 - 4P + 0.2I, where P is the price of a pedicure, and I
is the average consumer income.
a) Assume that I is 400. What is the consumer surplus when P is 15? By how much does the
consumer surplus change if P falls to 10?

Given demand function: Q = 20 - 4P + 0.2I

At I = 400; demand function can be written as; Q = 20 – 4P + 0.2 (400); Q = 100-4P
At P = 15; Q can be found by plugging this value in the demand function; Q = 100-4P
Q = 100 – 4 (15)
Q = 40

This can be shown graphically as:

Q = 100-4P
Price

25 Consumer Surplus

15

0 40 100 Quantity

Consumer surplus is given by the area of the triangle; above market price (P=15) and below the
1
demand curve. We can use the formula for area of a triangle = ×base ×height to calculate the
2
consumer surplus. In this case the base of the triangle is 40 and the height is 10 (25-15), therefore

1
Consumer Surplus= × 40 ×10=200
2

By how much does the consumer surplus change if P falls to 10?

When P falls to 10; Q can be found by plugging this value in the demand function; Q = 100-4P
Q = 100 – 4 (10)
Q = 60

In this case, consumer surplus is given by the area of the triangle; above market price (P=10) and
below the demand. In this case, the base is 60 and the height is 15.
 1
Consumer Surplus= ×60 × 15=450
2
Change in consumer surplus = 450 – 200 = 250

This can be shown graphically as:

Q = 100-4P
Price

25

Change in consumer surplus

15

10

0 40 60 100 Quantity

b) At a market price of 20, what is the pedicurist’s income? Suppose the pedicurist wants to
increase her income. Should she increase or decrease the price of a pedicure?

Demand function: Q = 100-4P (Assuming I = 400)

At P = 20; Q can be found by plugging this value into the demand function, Q = 100 - 4P;
Q = 100 – 4(20)
Q = 20

Pedicurist’s income = Price × Quantity = 20 × 20 = 400

To increase her income, the pedicurist should decrease the price of a pedicure, if the demand
curve is relatively elastic; ϵd >1. If demand curve is relatively inelastic; ϵd <1, she should increase
the price.

At price = 20, price elasticity can be calculated as:

dQ P
ϵd = ×
dP Q
20
ϵd = -4×
20
ϵd = -4
ϵd >1, (consider absolute value), hence the demand curve is relatively elastic; a change in price
will lead to proportionately greater change in quantity demanded and therefore, an increase in
income. Therefore, the pedicurist should decrease the price of a pedicure in order to increase her
income.
c) Assume now that income increases to 500. What is the consumer surplus at P = 15?
Demand Function: Q = 20 - 4P + 0.2I
At I = 500; demand function can be written as; Q = 20 – 4P + 0.2 (500); Q = 120-4P
At P = 15; Q can be found by plugging this value in the demand function; Q = 120-4P
Q = 120 – 4 (15)
Q = 60
Consumer surplus is given by the area of the triangle; above market price (P=15) and below the
1
demand curve. We can use the formula for area of a triangle = ×base ×height to calculate the
2
consumer surplus. In this case the base of the triangle is 60 and the height is 15 (30-15), therefore

1
Consumer Surplus= ×60 × 15=450
2
This can be shown graphically as:

Q = 120-4P
Price

30 Consumer Surplus

15

0 60 120 Quantity
Problem 5
Suppose you are analyzing the demand for buttermilk at the Goel dining hall. Consider each of the
following scenarios and explain whether it would lead to an increase, decrease, or no change in
demand:
a) Term break – Decrease in demand
b) A thunderstorm that brings down the temperature by several degrees – Decrease in demand
c) A decrease in the price of buttermilk – No change in demand, decrease in price of buttermilk
will cause increase in quantity demanded
d) A decrease in the price of watermelon juice – Decrease in demand
e) A decrease in the price of photo copying – No change in demand
f) The latest campus fad – “veganism” – Decrease in demand

Problem 6
Suppose there are 2 countries, X and Y, capable of producing 2 goods: sense and nonsense. The output
per worker in Country X is 8 units if the worker produces sense and 4 units if he/she produces nonsense.
In Country Y, the output per worker is 6 units of sense or 2 units of nonsense. What is the pattern of
absolute and comparative advantage?
Opportunity cost of sense in Opportunity cost of
Sense Nonsense nonsense in terms of sense
terms of nonsense given up given up
X 8 4 1/2 2
Y 6 2 1/3 3
Absolute Advantage: Country X has the absolute advantage of producing both sense and nonsense
because X uses fewer inputs to produce each of these relative to Y.
Comparative Advantage: X has a lower opportunity cost in producing nonsense and Y has a lower
opportunity cost in producing sense. Hence X has a comparative advantage in producing nonsense and Y
has a comparative advantage in producing sense.