Managerial Economics

Indian School of Business

DHM 1, 2021-22

HOMEWORK 1
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 − 4𝑃

𝑑𝑄
= −4
𝑑𝑃

ϵd = ×

-1 = −4 ×

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

ϵd = ×
 ϵd = −4 ×
ϵd = − or -0.25

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

ϵd = ×

ϵd = −4 ×
ϵd = − or -0.11

Problem 3

Sandhya: There are three different approaches to solving this for Sandhya. All 3 are given below, using any 1 is
fine:

Approach 1: We know that Sandhya is holding her total expenditure (E) on pizza constant at 600, i.e., the
derivative of expenditure with respect to price is going to be 0:

𝐸 = 𝑃. 𝑄

By product rule:

𝑑𝐸 𝑑𝑃
=𝑄+𝑃×
𝑑𝑃 𝑑𝑄

=𝑄[1 + × ]

We know that dE/dP = 0:

0 = 𝑄[1 + × ]

0=1+ ×

0 = 1 + ϵd

ϵd= -1

Therefore, Sandhya’s elasticity of demand is -1.

Approach 2: If Sandhya’s total expenditure on pizza does not change, that implies that an increase (decrease) in
the price of pizza is met by a proportionate decrease (increase) in its quantity demanded, such that the product of
the two remains unchanged. That means that Sandhya’s elasticity is -1 (or 1).
Approach 3: Sandhya is going to spend exactly 600. This means the relationship between quantity demanded by
her (Q) and the price in the market(P) is given by P*Q =600 or Q= 600/P.

Now note that =−

Therefore,ϵd = × = − × = − × = −1

Manhar: Demand is completely inelastic i.e. elasticity is equal to 0. This is because Manhar’s demand is not
sensitive to the price. If you plot Manhar’s demand you will find it to be a vertical line at a quantity of 2.

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 demand
curve. We can use the formula for area of a triangle = × base × height to calculate the 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:

ϵd = ×
ϵd = -4 ×
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 demand
curve. We can use the formula for area of a triangle = × base × height to calculate the 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 nonsense in

Sense Nonsense
terms of nonsense given up terms of sense 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.