MBA-DFB

The Firm and the Consumer

Instructions: Maximum Marks: 50

 This is an open book/open notes exam.

 All questions are compulsory.

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Question 1 (15 marks)

My wife and I have wine with almost every dinner at home in Texas. We prefer Australian
wines, because we have found European wines, especially Italian and French, to be high-
priced in Texas. We even drink an occasional good Texas wine (yes, there are some!). The
high prices have meant that we go through a bottle in three dinners—hardly major drinkers!
While visiting Germany we’ve been going through a bottle in two dinners only—a 50 percent
increase in the quantity of wine consumed per night. I like to think it is due to substitution, to
a move along the demand curve, as good European wines are incredibly inexpensive (I think)
in Germany. For example, I bought a 2004 Barolo, one of the fanciest Italian wines I know,
for €11 (about $15 these days), and I think it would have cost twice as much at home. But is
our increased consumption due to the drop in price; or are we consuming more because our
taste for wine has increased due to the joie de vivre of the European ambiance? I believe it’s
the former—I don’t believe tastes change much; but my dilemma illustrates a common
problem in empirical economics (and life generally), separating changes in amounts
demanded from changes in demand. And, sadly, most non-economists will argue that
behaviour like mine results from taste changes; too few people think prices matter.

Draw a graph of the author’s demand curve for wine. Show what happens when he moves
along the curve as a result of the lower price of wine in Europe. Now suppose that the change
in the amount of wine consumed is due to the fact that living in Europe and drinking wine are
complements. How would this change the demand curve?

Question 2 (10 marks)

In 2019, ABC Company, the largest company in the funeral business with 14% of total
industry revenue, saw its average revenue per service (its product price) rise by 9 percent. At
the same time, the number of funeral services performed fell by 5.8 percent. We can thus
calculate the price elasticity of demand for its services directly as -(5.8/9) = -0.64. Its price
and quantity demanded last year suggest that its demand is inelastic— and we thus know
from this calculation that its total revenue from these services increased.

What should ABC Company do if it wants to raise its total revenue still further?
Question 3 (10 marks)

“For smaller firms managed by their owners, profit is likely to dominate almost all decisions.
In larger firms, however, managers who make day-to-day decisions usually have little contact
with the owners. As a result, owners cannot monitor the managers’ behaviour on a regular
basis. Managers then have some leeway in how they run the firm and can deviate from profit-
maximizing behaviour.”

Do you agree with this statement? Justify your answer.

Question 4 (15 marks)

In 1896, Colgate dental cream was introduced in tubes similar to those we use now. Today,
the Colgate-Palmolive Company’s brand of toothpaste is the best-selling toothpaste in the
world (ahead of the Crest brand marketed by Procter & Gamble, which was introduced in
1955).

While Colgate and Crest enjoy the lion’s share of the toothpaste market, if you view the oral
care shelf at your local drugstore or supermarket, you will find over a hundred different
varieties of toothpaste. Colgate alone sells over 40 different varieties that are marketed under
names ranging from Shrek Bubble Fruit to Colgate Total Advanced Whitening.

The high level of product differentiation in the toothpaste market stems from firms
introducing new varieties in an attempt to boost their economic profits. In environments
where makers of other brands (such as Crest) can easily enter profitable segments of the
market, a profitable strategy is to attempt to quickly cover that segment (introducing Shrek
Bubble Fruit toothpaste, for instance) in order to earn short-run profits until other firms enter
to steal a share of that segment. While introducing new varieties may cannibalize sales of
your existing products, cannibalizing your own sales is better than having them stolen by a
hungry competitor.

a) What kind of market structure is described in the above paragraphs? Describe the
key characteristics of this type of market structure? (4 marks)

b) Colgate toothpaste has an infinite cross price elasticity of demand. True or False?
Explain. (3 marks)

c) Why would a major company like Colgate choose to sell so many different
varieties of toothpaste that compete against each other for consumers’ rupees?
(3 marks)
d) Is there any deadweight loss associated with this market structure? Why or why
not? Use a diagram to explain this. (5 marks)