ANSWER KEY 2 – HINTS TO PROBLEM SET 2

Numerical Problems

1. (i) EuroWings’ January 1999 demand curve is given by: Q(E) = 9600 – 5P(E).
(ii) July 1999 quantity demand is 8100, and total revenues are 3240000 Marks.

2. In Ruritania in 2010, the equilibrium price of rice would be determined by equating

demand and supply: 700 – 20P = 100 + 100P  equilibrium price is P* = 5 Roubles/kg.
It follows that equilibrium volume of trade was 600 kgs, and aggregate sellers’ revenue was
3,000 Roubles. Note that own-price elasticity of demand for rice at the 2010 equilibrium was
(–20)×(5/600) = –(1/6). As demand was inelastic at this point, an x% decrease in
equilibrium price would cause total sales to increase by less than x%, causing a fall in
aggregate sales revenue. This is what happened as a result of the favourable weather shock in
2011: with a “shifting out” of the supply curve, equilibrium price fell to 4.5 Roubles/kg and
equilibrium volume of trade rose to 610 kgs, causing the aggregate sellers’ revenue to fall to
2,745 Roubles. This is an example of the “bumper harvest paradox”.

3. The demand curve for Hamara PC will be a step function: quantity demanded will be zero
for any price > Rs. 20,000; quantity demanded will be 200,000 for any price ≤ Rs. 20,000
and > Rs. 15,000; quantity demanded will be 300,000 for any price ≤ Rs.15,000 and >
Rs. 10,000; quantity demanded will be 600,000 for any price ≤ Rs. 10,000 and > Rs. 5,000;
quantity demanded will be 800,000 for any price ≤ Rs. 5,000 and > Rs. 1,000; and quantity
demanded will be 1,000,000 for any price ≤ Rs. 1,000. If Hamara PC prices its desk-tops at
Rs. 10,000, the top 60% of the households in town will buy these PCs.

4. Prior to trade restrictions, aggregate supply curve in France was the horizontal summation
of domestic and foreign supply: QS = 4P + 2P = 6P. Then in equilibrium, price = 10,000;
domestic sellers sold 40,000 cars and Japanese sellers sold 20,000 cars. The total sales
revenue of all the Japanese exporters was 200,000,000.
Starting from this situation, a VER of 14,000 cars would “bind” for the Japanese precisely
because at the original price of 10,000, the Japanese would want to sell more than 14,000
cars. Post-VER, the aggregate supply curve in the French market will be: QS = 4P + 14,000.
Thus the new equilibrium price will be higher at 11,000, the domestic sellers will sell 44,000
cars and the Japanese sellers will export up to the VER, i.e., 14,000 cars. The total sales
revenue of all the Japanese exporters will now be 154,000,000. So the Japanese exporters
will lose in total sales revenue from the VER.
[This need not always be the case. Suppose that pre-VER, competitive pressures lead to a
demand-supply intersection on the inelastic part of the demand curve. Then a small VER
exogenously restricts supply and thus raises prices more than proportionately. A group of
competitive exporters as a whole may then welcome the VER as it will lead to increased
aggregate sales revenue and necessarily increased aggregate profits.
Recognize the connection between these arguments and the bumper harvest paradox.]
Thought Problems

A. The coefficient on (Price in 2019) tells us that if the price where higher by one unit in
2019, current annual demand in 2020 would be lower by 0.3 units. We recognize that
consumers take time to adjust their consumption patterns in response to price changes, i.e.,
demand adjusts with a lag. That is the reason for including “lagged prices” in the demand
function. Long-run price elasticity of demand will be average of yearly price elasticities over
multiple consecutive years.

B. Suppose Apple bought X million DRAM chips in May 1998. Then in January 1999
(ignoring inflation) its sunk cost is $(38 – 23).X, and its opportunity cost of using every
DRAM chip in January 1999 is $23. Its pricing strategy in January 1999 should not only
have reflected these “true economic costs”, it should have also taken into account its
perceived consumer demand elasticity for the Mac II PCs.