Khas University/ Fall 2020

FB509 Midterm

Each question is worth 25 points. Please give your answers in the space
provided. Answers are due by midnight this Sunday 15 November.

1. As of February 2011, with 594.9 million subscribers, China Mobile is the

world’s largest mobile telephone service provider. China Mobile offers nine
price plans for its “Worldwide Connect” service in the city of Nanjing. The
cheapest plan provides 350 “free minutes” of calls for ¥36 per month, while
the next cheapest plan provides 450 minutes of calls for ¥96 per month.
Under both plans, the price of additional calls is ¥0.29 per minute.

a. Lin Jun’s demand curve for mobile calling is a straight line. Under
uniform pricing, at a price of ¥1.29 per minute, she would buy 0
minutes, while, at a price of ¥0.29 per minute, she would buy 400
minutes. Illustrate Lin Jun’s demand curve. P=1.29 – (1/400)*Q

Price

1.29

Lin Jun’s demand

0.29 curve

0.165

0 350 400 450 Minutes

b. Suppose that Lin Jun subscribes to the ¥68 per month plan. (i) How
much calling time would she consume? (ii) What would be her total
benefit? (iii) What would be her buyer surplus (benefit less
charges)? Note that she might decide to buy additional minutes
beyond the free minutes.

The plan involves two-part pricing.

(i) The plan provides 350 free minutes. At the 351th minute, her
marginal benefit exceeds 0.29 Yuan per minute. Accordingly,
she would consume beyond 350 minutes. She would
purchase an additional 50 minutes to consume 400 minutes
 per month. At that point, her marginal benefit = 0.29 Yuan
per minute.

(ii) Total benefit: 0.29 x 400 + 0.5 x 1.00 x 400 = 116 + 200 = 316.

(iii) Buyer surplus = total benefit – monthly fee – airtime charge =

316 – 36 – 0.29 x 50 = 265.50.

c. Replicate (b) assuming that Lin Jun subscribes to the ¥88 per month
plan.

The plan involves two-part pricing.

(iv) The plan provides 450 free minutes. At the 451th minute, her
marginal benefit is less than 0.29 Yuan per minute. So, she
would consume 450 minutes, and not consume any
additional minutes.

(v) Total benefit: 0.165 x 450 + 0.5 x 1.125 x 450 = 74.25 + 253.125
= 327.4

(vi) Buyer surplus = total benefit – monthly fee – airtime charge =

327.4 – 96 = 231.4

d. Which plan would she choose?

She would choose the package deal that provides larger buyer
surplus, which is the ¥36 per month plan.

2. Cathay Pacific Airways operates international passenger and cargo

services from Hong Kong. In its Annual Report for the year 2012 (page
27), the airline reported buying 40.1 million barrels of fuel. Its net fuel cost
was HK$40,470 million, comprising gross fuel cost of HK$41,014 million,
less HK$544 million in gains from hedging. The following table presents
financial information.

Table: Cathay Pacific Airways (HK$ million)

2011 2012
Revenue 98,406 99,376
Net fuel cost 38,877 40,470
Other operating expenses 54,029 57,118
Operating profit 5,500 1,788
Source: Annual Report, 2012

a. The airline hedges the future price of oil through derivatives. If the
price of oil rises above the hedged price, the airline would realize a
hedging gain. The derivatives are not related to actual
purchases of fuel. This means hedging gains/losses occur even
 when no fuel is actually purchased In 2012, if the airline did not
operate, what would be its net fuel cost?

With no operations, the gross fuel cost would be zero. So, the net
fuel cost would be just the gains from hedging, $544 million.

b. Suppose that, in 2012, the airline had bought one more barrel of oil.
What would be the (marginal) cost of that barrel? (Hint: use the cost
concept closest to “marginal cost”)

Best estimate is the average variable cost = gross fuel cost ÷

purchases = 41,014 million ÷ 40.1 million = HK$1,023 per barrel.

c. Owing to weak demand for cargo service, Cathay Pacific removed

three Boeing 747-400BCF freighters from service, and “parked” the
planes. Explain this decision in terms of short-run revenues and
costs.

The short-run revenues from the aircraft were less than the
variable cost of operation, so, the airline preferred to remove
them from service.

d. Eventually, Cathay Pacific sold the three parked aircraft to Boeing in

a trade-in deal. Explain this decision in terms of long-run revenues
and costs.

The long-run revenues from the aircraft were less than the
variable and fixed cost of operation, so, the airline preferred to
sell the planes.

3. Mercy Hospital provides healthcare at subsidized prices and is so popular

that patients wait in long queues. Revenue is $75 million a year, while the
cost of providing service is $100 million a year. A government subsidy
covers the difference. Some critics argue that, since Mercy Hospital is
losing money, it should be shut down. The management of Mercy Hospital
argues that the long waiting times justify a larger government subsidy to
expand staff and facilities. (Hint: first identify the chapter, this question is
coming from).

(a) What is Mercy Hospital’s economic profit?

(b) What is the minimum benefit that Mercy Hospital must provide to add
value?
(c) Do you agree that Mercy Hospital should be shut down?
(d) What information do you need to decide whether Mercy Hospital should
expand or reduce service?
Answer
(a) Economic profit = $75 million – $100 million, which is a loss of $25 million.

(b) Value added = buyer benefit – seller cost. For value added ≥ 0, the
hospital needs buyer benefit ≥ seller cost, or buyer benefit ≥ $100
million.

(c) The rubric does not provide sufficient information. It does not state the
buyer benefit.

(d) Information on how expansion or reduction of service would affect the

value added, i.e., the marginal value added, or marginal buyer benefit –
marginal seller cost.

4. Suppose that at the current price of $1.50 per gallon and average
household income of $100,000 a year, the quantity demanded of bottled
water is 200 million gallons a week. If the price were increased to $1.68
the quantity demanded would fall to 158.7 million gallons a week. If the
household income were increased to $110,500 a year, the quantity
demanded would rise to 208 million gallons a week.

a) Calculate the own price elasticity of demand.

(158.7-200)/200= -0.2065
(1.68-1.5)/1.5 = 0.12
-0.2065/0.12= -1.72 (side note: as one would expect, it is own price elastic)

b) Calculate the income elasticity of demand.

(208-200)/200= 0.04
(110,500-100,000)/100 = 0.105
0.04/0.105 = 0.38

c) According to these estimates, is bottled water a normal or inferior

product?

A positive income elasticity of demand indicates a normal good.