Problem 1 (15 points)

Suppose anyone with a driver’s license is capable of supplying one trip from the Hyderabad airport to the Financial
District, just down the road from ISB, on any given day. The long run supply curve of such trips is horizontal at
P = Rs. 500, which is the average cost of such a trip. Suppose daily demand is Q = 1000 – P.

a. How many trips from the airport to the Financial District will be sold each day, and at what price? (4
points)

The supply curve is given by: P = 500

Therefore, the only price at which trips will be supplied is P = 500, and at this price any number of trips can be
supplied. This implies that the equilibrium price is 500.

The equilibrium quantity can be calculated by plugging this price into the demand curve (since any number of
trips can be supplied at P = 500, the equilibrium quantity will just be the quantity that is demanded at this price.
Therefore: Q = 1000 – 500 = 500

b. What are the consumer and producer surplus at equilibrium? (3 points)

1000

500 Supply

Demand
0 500 1000

The consumer surplus is the area under the demand curve and above the market price. Therefore, it is given by the
area of the triangle A.
CS = ½ . 500 . 500 = 125,000

The producer surplus is the area above the supply curve and below the market price. In this case, they are the same.
Therefore, the producer surplus is 0

The consumer surplus is the area under the demand curve and above the market price. Therefore, it is given by the
area of the triangle A.
CS = ½ . 500 . 500 = 125,000

The producer surplus is the area above the supply curve and below the market price. In this case, they are the same.
Therefore, the producer surplus is 0

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 c. Suppose the city of Hyderabad mandates that people supplying such trips must possess a special permit,
and that only 300 such permits will be issued. What is the price and quantity of trips sold under this
regulation? (2 points)

Since only 300 permits will be issued and an individual can supply only 1 trip per day, the quantity of trips sold will
be 300
The price corresponding to this quantity sold can be calculated off the demand curve:
Q = 1000 – P
300 = 1000 – P
P = 700

d. What is the change in consumer surplus, producer surplus, and social welfare under the new regulations as
compared to the unregulated market? (6 points)

P
1000

A
700
B
C
500 Supply

0 Demand
300 500 1000 Q

The new consumer surplus is given by the triangle A:

CS = ½ . 300 . 300 = 45,000
Change in CS = 45,000 - 125,000 = - 80,000

The new producer surplus is given by the rectangle B:

PS = 300 . 200 = 60,000
Change in PS = 60,000 - 0 = 60,000

The original social welfare was simply the original CS as the original PS was 0.
Therefore, original social welfare = 125,000
New social welfare is the sum of new CS and new PS:
New social welfare = 45,000 + 60,000 = 105,000
Change in SW = 105,000 - 125,000 = - 20,000
Alternatively, someone might calculate DWL directly as the area of triangle C.
DWL = ½ . 200 . 200 = 20,000

Problem 2 (10 points)

A British publication once pointed out that iTunes prices vary by the customer’s currency. In terms of the British
currency (£), the prices are: UK: £0.79; Germany & France: 99 Euro cents (£0.68); US: 99 US cents (£0.51); and
Canada: 99 Canadian cents (£0.41). Evidence suggests that iTunes’ marginal cost is constant; you may suppose that
it is £0.10.

a. What kind of price discrimination is being followed here? Explain in 1 or 2 sentences. (2 points)

Third-degree price discrimination

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Explanation: Different customers (residents of different countries) are being charged different prices for an identical
product

b. Estimate the (own-price) demand elasticity for iTunes in Canada, assuming that iTunes prices in each region
are set at the profit-maximizing level. (4 points)

Use the inverse elasticity pricing rule:

P−MC −1
=
P ϵ

.41−.10 −1 41−10 −1
= OR =
.41 ϵ 41 ϵ

31 1
=¿−
41 ϵ

41 −41
ϵ =−1.32∨1.32 OR OR
31 31
c. Consider an average Canadian iTunes user. What would happen to this user’s total expenditure on iTunes if
the iTunes price increases? Explain in 1 or 2 sentences. (4 points)

If the iTunes price increases, the total expenditure of an average Canadian on iTunes would decrease.

Explanation: The total expenditure of a customer on iTunes is price times quantity. Since the elasticity of
demand is more than 1, an increase in price would lead to a more than proportionate decrease in quantity
demanded. Therefore, the total expenditure would decrease.

In case someone calculates the elasticity incorrectly as a number which is less than 1 in absolute value and based on
this answer, argues that total expenditure would increase,

Problem 3 (11 points)

The market for supplying flowers outside the Jagannath temple in Puri is perfectly competitive. All firms (a firm is a
stall) sell flowers in small bamboo baskets. Each existing firm and every potential entrant faces an identical average
cost curve. The minimum level of average cost is Rs. 5 per bamboo basket, and occurs when a firm sells 200
bamboo baskets of flowers each day. The market demand curve for a basket of flowers is Q = 28005 – P, where P is
the market price in Rupees per basket.

a. What is the long run equilibrium price per basket of flowers? (2 points)

In the long run equilibrium in a perfectly competitive market, the AR curve is tangent to the AC curve (at its
minimum point). Therefore, the long run equilibrium price is the same as the minimum level of AC:
P= 5

b. How many baskets does each firm sell at this price? (2 points)

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We are given that the minimum AC for a firm corresponds to a quantity of 200 baskets. Therefore, the long run
equilibrium quantity for a firm is Q = 200

c. How many firms will be in the market at the long-run equilibrium? (3 points)

We can figure out the market demand at the LR equilibrium price by plugging in the value of P into the demand
curve:
Q = 28005 – 5
Q = 28000

Each firm produces 200 baskets. Therefore, the number of firms N is given by:
28000
N=
200

N=140

d. Suppose the new railway minister starts a new train to Puri, which increases the number of visitors to the
Jagannath temple. As a result, the demand curve shifts to the right, and becomes Q = 34005 – P. How many
new firms will have to enter the market for the long run equilibrium to be established? (4 points)

The long run equilibrium price and per firm quantity would remain the same as each incumbent and potential entrant
firm has the same AC curve with its minimum point at 5, corresponding to a quantity of 200.

Therefore, we can follow the same steps as in c to get the new market demand:

Q = 34005 – 5
Q = 34000

Each firm produces 200 baskets. Therefore, the number of firms N is given by:
34000
N=
200

N=170
Therefore, 30 new firms would have to enter the market for LR equilibrium to be established

Problem 4 (17 points)

As part of scoping work for setting up a nation-wide chain of de-addiction and rehabilitation centres, you have been
trying to develop a better understanding of the problem of drug use in the United States. As part of this, you have
become interested in what the impact would be if authorities could be more effective at getting drugs off the streets.
The DEA has estimated the following data:

 Elasticity of Demand for Cocaine: -.55

 Elasticity of Supply: 1.0

 Current Market Price Cocaine: $80 per gram

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  Current Cocaine Sales (annual): 950M grams

Suppose we are using a simply supply/demand framework, where the demand curve is given by:

Qd = a + bP

and the supply curve is given by:

Qs = c + dP

a. Use the data above to find the parameters a, b, c, and d (8 points)

Q 950
b=ϵd . = -.55( ) = -6.53
P 80

a Q bP 950 6.53801472.4

Q 950
d=ϵs . = 1( ) = 11.88
P 80

c Q dP 950 11.88800

b. Suppose there is a major crackdown on drug dealers, during which the DEA is able to seize 100M
grams of cocaine and take it off the market. What will happen to the equilibrium price and quantity? (5
points)

So, we need to subtract 100 from the market supply and resolve for price
and quantity. Intuitively, what should happen is that the seizure will force
the price up, which creates incentives for more supply.

Qd 1472.4 6.53P Qs
11.88P 100

1472.4 6.53P 11.88P 100

P $85.4

Q 11.88*85.4 100 914

c. Suppose your rehab chain finally takes off. As part of a group counselling session at one of the centers,
you meet two former addicts, Jo and Bo. Jo says that she always spent $200 a month on cocaine, no
matter what the price. To this Bo responds that he didn’t care about the price either, and always bought
exactly 2 grams of cocaine. Based on this conversation, what can you conclude about Jo’s and Bo’s
price elasticity of demand for cocaine? (4 points)

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 Since Jo is going to spend the same amount of money on cocaine, no matter what the price, her demand for
cocaine is unit elastic OR has an elasticity of 1 OR -1

Since Bo quantity demanded is going to be entirely unaffected by the price, his demand is perfectly
inelastic OR has an elasticity of 0

Problem 5 (13 points)

Apple has traditionally outsourced the production of iPhones, iPads and other electronic devices to a contract
manufacturer based in China, Foxconn, which employs 800,000 workers in factories located all over China to work
on manufacturing these devices. Faced with increased competition for labor a few years back, Foxconn raised wages
and increased benefits for its workers. In April 2012, Samsung sued Apple for violating various Samsung patents to
produce mobile phones. (Sources: “Foxconn to raise salaries by 20% after suicides”, Financial Times, May 28,
2010; “Samsung sues Apple on patent-infringement claims as legal dispute deepens”, Bloomberg, April 22, 2011.)

a. Explain how Apple should adjust its production and price if Foxconn raises prices for contract
manufacturing. (Note: given that Apple’s products are protected through patents, assume they are
operating as a monopoly.) (2 points)
If Foxconn raises the price of contract manufacturing, the MC of production goes up.

The equality of MR and MC will happen at a higher P and lower Q.

Therefore, Apple should increase P and decrease Q

b. Suppose that Apple must pay a royalty to Samsung for patent infringement on each mobile device that it
produces. How do Apple’s costs of production and its revenues change because of the royalty. How should
Apple adjust its production and price in response to the royalty? (Note: We know that Samsung ultimately
had to pay Apple for patent infringement, but for purposes of this question, let’s assume that Apple has to
pay Samsung.) (2 points)

If Apple must pay Samsung a royalty on each mobile device produced, then the marginal cost of each
product would be higher.

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 The effect would be the same as with the increase in Foxconn’s pricing, i.e., increase in P and decrease in
Q.

c. How would your answer in (b) change if Apple must pay Samsung a lump sum in damages rather than a
royalty per unit produced? A diagram is not required. (4 points)

If Apple must pay Samsung a lump sum in damages, it is similar to an increase in fixed costs.

In this case, Apple should not adjust its production and price (the profit-maximizing sales and
price do not depend on the level of fixed costs).

Problem 6 (12 points: 2 points each)

Explain how each of the following events would influence the market in the short run. Assume standard demand and
supply curves, i.e., a downward sloping demand curve and an upward sloping supply curve. The market that needs
to be analyzed is indicated in parentheses against each event.
For each event, you have to indicate the direction of movement of the demand curve (outward, inward, or no
change; alternatively, rightward, leftward, or no change), the supply curve (outward, inward, or no change;
alternatively, rightward, leftward, or no change), equilibrium price (up, down, or no change), and equilibrium
quantity (up, down, or no change)
For all the parts below, assume that other than the event being described, nothing else has changed.

Note: For demand and supply curves, allow all types of terms: increase/outward/rightward and analogously for
decrease

a. A major war breaks out due to which several civilians join the army and are deployed at the front (labour
market)

Demand curve _____no change______________________

Supply curve ___________decrease_________________

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 Equilibrium price __________increase_______________

Equilibrium quantity ___________decrease____________

b. The scenario described in the course pack reading on coconuts (market for conventional coconut oil)

Demand curve _______no change_________________

Supply curve ________________decrease____________

Equilibrium price ____________increase_____________

Equilibrium quantity ______ decrease

c. An increase in the price of movie tickets (market for movie theatre popcorn)

Demand curve ___________decrease________________

Supply curve ___________no change_________________

Equilibrium price ________decrease_________________

Equilibrium quantity __________decrease_____________

d. A new technology that makes it cheaper to extract juice from oranges (market for orange juice)

Demand curve _____________no change______________

Supply curve ______________increase______________

Equilibrium price _______decrease__________________

Equilibrium quantity _________increase______________

e. An increase in the proportion of twins relative to singletons among newborns (market for baby clothes)

Demand curve _______increase____________________

Supply curve ____________no change________________

Equilibrium price _________increase________________

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 Equilibrium quantity _______increase________________

f. A prediction by the Indian Meteorological Department that the monsoon is going to be “below normal”
(market for food grains)

Demand curve ____________increase_______________

Supply curve ____________________decrease________

Equilibrium price _____________increase____________

Equilibrium quantity _________ambiguous______________

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