Problem Set 1 (Solution)

Managerial Economics - MGE(BJ23-1)

XLRI - Xavier School of Management

1. Plot a demand curve following mathematical convention (with price on the horizontal
axis). Then calculate and plot its inverse.

(a) Drawa graph of the linear demand curve q(p) = 20 − 31 p, with price p on the
horizontal axis and demand on the vertical axis. Be sure to label the units on the
axes or at least the values of the intercepts.
Solution:
q

20

p
60

(b) Now calculate the inverse p = p(q) of this demand curve. You are solving the
equation q = 20 − 13 p for p. What is p(9)?
Solution:
p(q) = 60 − 3q
p(9) = 33

(c) Graph the inverse demand curve, with quantity on the horizontal axis and price
on the vertical axis. Again, label the values of the intercepts.
Solution:

1
 p

60

q
20

(d) The general form of a linear demand curve is q(p) = a − bp, where a and b are
positive numbers. The price at which demand is 0 is p̄ = ab , which we call the
choke price. Write the general form for the inverse demand curve, using the
coefficients p̄ and b.
Solution:
a 1
p(q) = − q
b b
1
= p̄ − q
b
2. Use supply and demand curves to illustrate how each of the following events would
affect the price of butter and the quantity of butter bought and sold:

(a) An increase in the price of margarine

Solution:
Most people consider butter and margarine to be substitute goods. An increase in
the price of margarine will cause people to increase their consumption of butter,
thereby shifting the demand curve for butter out from D1 to D2 in the following
figure. This shift in demand will cause the equilibrium price to rise from p1 to p2
and the equilibrium quantity to increase from Q1 to Q2 .

2
 p

p2

p1

D1 D2

Q
Q1 Q2

(b) An increase in the price of milk.

Solution:
Milk is the main ingredient in butter. An increase in the price of milk will increase
the cost of producing butter. The supply curve for butter will shift from S1 to
S2 in depicted in the following figure, resulting in a higher equilibrium price, p2 ,
covering the higher production costs, and a lower equilibrium quantity, Q2 .
p

S2

S1

p2
p1

D1

Q
Q2 Q1

(c) A decrease in average income levels.

Solution:
Assume that butter is a normal good. A decrease in the average income level will
cause the demand curve for butter to shift from D1 to D2 . This will result in a

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 decline in the equilibrium price from p1 to p2 , and a decline in the equilibrium
quantity from Q1 to Q2 . See the following figure:
p

S1
p1

p2

D2 D1

Q
Q2 Q1

3. Suppose the supply function for the product x is given by qxs = −30 + 2px − 4pz .

(a) How much of product x is produced when px = 600 rupees and pz = 60 rupees?
Solution:
qxs = 930 at px = 600 and pz = 60

(b) How much of product x is produced when px = 80 rupees and pz = 60 rupees?

Solution:
qxs = 0 at px = 80 and pz = 60

(c) Suppose pz = 60. Determine the supply function and inverse supply function for
good x. Graph the inverse supply curve.
Solution:
Inverse Supply function
1
ps = 135 + q
2

4
 p

135

4. Assume that the demand and supply of sandwiches can be represented in Figure 1.

3.5
Supply
H B
2.5
G C
2
F
1.5 D
Demand
0.5

200 300 q

Figure 1

(a) What is the equilibrium price and quantity?

Solution:

p∗ = 2, q ∗ = 300

(b) Calculate consumer surplus, producer surplus and social surplus.

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 Solution:
CS = 225, P S = 225, SS = 450

(c) Suppose the quantity supplied is restricted by government regulation to 200 units
per month. Calculate the new price, the consumer surplus, producer surplus and
social surplus.
Solution:
Now price p = 2.5

CS = 100, P S = 300, SS = 400

5. The demand for Barfi, in kilograms, is ln D(p) = 1, 000 − p + ln m, where p is the price
of Barfi and m is income

(a) What is the price elasticity of demand for Barfi when p = 2 and m = 500? When
p = 3 and m = 500? When p = 4 and m = 1, 500?
Solution:

d ln D(p)
= −1
dp
dD(p) 1
= −1
dp D
dD(p) p
= −p
dp D
Eq,p = −p

where q = D. Thus, Eq,p = −2 at p = 2, Eq,p = −3 at p = 3 and Eq,p = −4 at

p=4
(b) What is the income elasticity of demand for Barfi when p = 24 and m = 500?
When p = 2 and m = 1, 000? When p = 3 and m = 1, 500?
Solution:

d ln D(p) 1
=
dm m
dD(p) 1 1
=
dm D m
dD(p) m
=1
dm D
Eq,m =1

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 where q = D.
Thus, income elasticity is constant whatever is the income level.
(c) What is the price elasticity of demand when price is p and income is m? The
income elasticity of demand?
Solution:
The price elasticity of demand Eq,p = −p and income elasticity of demand Eq,m =
1 at price p and income level m.

6. Suppose that the demand function for good X is given by q(p) = (p + a)−b where a > 0
and b > 1. Calculate an expression for the price elasticity of demand at price p. At
what price is the price elasticity of demand equal to −1?
Solution:
dq p
Eq,p =
dp q
p p
= −b(p + a)−b−1 = −b(p + a)−b−1
q (p + a)−b
−bp
=
p+a

When Eq,p = −1, then

−bp
= −1
p+a
a
p=
(b − 1)

7. The supply and demand equations for hockey are given below, where p is the price in
rupees:

q d (p) = 40 − p
q s (p) = 10 + p.

(a) What are the equilibrium quantity and price for hockey?
Solution:

p∗ = 15, q ∗ = 25.

(b) Suppose that the government decides to restrict the industry to selling only 20
hockeys. At what price would 20 hockeys be demanded? How many hockeys

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 would suppliers supply at that price? At what price would the suppliers supply
only 20 units?
Solution: 20 hockey will be demand at p = 20.
At p = 20, suppliers will supply q = 30. When p = 10, then the supply will be 20
hockey.
(c) The government wants to make sure that only 20 hockeys are bought, but it
doesn’t want the firms in the industry to receive more than the minimum price
that it would take to have them supply 20 hockeys. One way to do this is for the
government to issue 20 ration coupons. Then in order to buy a hockey, a consumer
would need to present a ration coupon along with the necessary amount of money
to pay for the good. If the ration coupons were freely bought and sold on the
open market, what would be the equilibrium price of these coupons?
Solution:
The equilibrium price of coupon is 10.
(d) On a graph, shade the area that represents the dead weight loss from restricting
the supply of hockeys to 20. How much is this ex-pressed in rupees?
Solution:
p

40 Deadweight loss

30

15

10

Q
10 20 25 40

The dead-weight loss is 25.

8. When demand is estimated to be p = 500 − 0.5x, calculate the loss in consumer surplus
when a tax drives price from 5 to 10.
Solution:

8
 p

500

10
5
Q
980 990 100

The loss in consumer surplus is the area of gray rectangle plus the area of green triangle.
Thus, loss in consumer surplus is 4925.

9. The demand curve for product x is given by qxd = 300 − 2px .

(a) Find the inverse demand curve.

Solution: Inverse demand function is
1
p = 150 − q
2

(b) How much consumer surplus do consumers receive when px = 45 rupees?

Solution:
p

150

CS= 11025

45

Q
210 300

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 (c) How much consumer surplus do consumers receive when px = 30 rupees?
Solution:
p

150

CS= 14400

30

Q
240 300

(d) In general what happens to the level of consumer surplus as the price of a good
falls?
Solution: As price falls consumers’ surplus increases.

10. Suppose the demand curve for a product is given by Q = 300 − 2p + 4m, where m is
average income measured in thousands of rupees. The supply curve is Q = 3P − 50.

(a) If m = 25, find the market-clearing price and quantity for the product.
Solution: At m = 25 demand function becomes Qd = 400 − 2p. Thus, p∗ = 90
and Q∗ = 210
(b) If m = 50, find the market-clearing price and quantity for the product.
Solution: At m = 50 demand function becomes Qd = 500 − 2p. Thus, p∗ = 110
and Q∗ = 280
(c) Draw a graph to illustrate your answers.
Solution:

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 p

110
90

Dm=25 Dm=50
Q
210 280

11. The price elasticity of demand for oatmeal is constant and equal to −1. When the
price of oatmeal is Rs.100 per unit, the total amount demanded is 6,000 units.

(a) Write an equation for the demand function and graph this demand function.
Solution: Since price elasticity of demand is constant and remains −1, the demand
function has the following shape Q = Ap−1 . Since Q = 6000 at p = 100, therefore
6000 = A(100)− 1. Thus, we have A = 600, 000.
(b) If the supply is perfectly inelastic at 5,000 units, what is the equilibrium price?
Show the supply curve on your graph and label the equilibrium with an E.
Solution:

5000 = 600.000p−1
p∗ = 120

12. Consider a competitive market for which the quantities demanded and supplied (per
year) at various prices are given as follows:

Price (rupees) Demands (million) Supply (millions)

60 22 14
80 20 16
100 18 18
120 16 20

(a) Calculate the price elasticity of demand when the price is 80 rupees and when the
price is 100 rupees.

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 (b) Calculate the price elasticity of supply when the price is 80 rupees and when the
price is 100 rupees.
(c) What are the equilibrium price and quantity?
(d) Suppose the government sets a price ceiling of 80 rupees. Will there be a shortage,
and if so, how large will it be?.

13. Maximum price schemes are often called price controls and are typically developed to
protect consumers. Here the main concern is that prices are too high. We can show
that price controls set to protect consumers by pegging prices below market equilibrium
levels impose deadweight loss on society in terms of lost social surplus. Consider Figure
2, where a maximum price pmax is set below the market equilibrium price p∗ and answer
the following questions:

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Supply

A B
5
C E
pmax = 2
F
Demand

qmax = 125 250 q

Figure 2

(a) What is the total loss of the producer because of the price ceilings?
(b) What is the net change in consumer surplus? Is it positive or negative?
(c) What is the change in the social surplus?

14. The demand and supply for Orange juice are given by Q = 20 − P and Q = 3P ,
respectively.

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(a) What are the equilibrium price and quantity?
Solution: p∗ = 5 and Q∗ = 15
Suppose now the government imposes a per-unit tax of Rs. 4 on the sellers.
(b) What are the new quantity, net price sellers received, and price consumers paid?
Solution: We now the following four equations:

Qd = 20 − pd
Qs = 3ps
Qd = Qs
pd = ps + 4

Solving them, we get

p∗d = 8, p∗s = 4, Q∗ = 12

(c) What is the government revenue from the taxation?

Solution: Government revenue = t × Q = 4 × 12 = 48
(d) Calculate the deadweight loss resulting from the taxation. Point out what portion
of the deadweight loss used to belong to each party.
Solution:
p

20

8 S
5
4

Q
12 15 20

The area of green (loss in CS) and red (loss in PS) triangles are deadwight loss
because of tax. The total deadweight loss = 6.
(e) What fraction of the economic incidence of the tax is borne by consumers?
36
Solution: Consumers are bearing total tax burden is 3×12 = 36 which is 48
×100 =
75%.

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 (f) Answer verbally, what would happen to your analysis in Part (b)-(e) if instead of
imposing tax on the sellers, the government divides the legal burden of Rs. 1.11
per unit to consumers and Rs. 2.89 per unit to producers.
Solution:
Now the price that consumers pay is pd = p + 1.11 and the price that producer
receives is ps = p − 2.89.
20 − (p + 1.11) = 3(p − 2.89)
p = 6.8825
Now see pd = 6.8825 + 1.11 = 7.9925 ≈ 8 and ps = 6.8825 − 2.89 = 3.9925 ≈ 4.
There will no change in CS and PS.

15. You are the manager of a midsized company that assembles personal computers. You
purchase most components - such as random access memory (RAM) - in a competitive
market. Based on your marketing research, consumers earning over 800,000 rupees
purchase 1.5 times more RAM than consumers with lower incomes. One morning,
you pick up a copy of The Economic Times and read an article indicating that input
components for RAM are expected to rise in price, forcing manufacturers to produce
RAM at a higher unit cost. Based on this information, what can you expect to happen
to the price you pay for random access memory? Would your answer change if, in
addition to this change in RAM input prices, the article indicated that consumer
incomes are expected to fall over the next two years as the economy dips into recession?
Explain

16. You are the manager of an organization in India that distributes blood to hospitals
in all 27 states. A recent report indicates that nearly 50 Indian contract HIV each
year through blood transfusions. Although every pint of blood donated in the India
undergoes a battery of nine different tests, existing screening methods can detect only
the antibodies produced by the body’s immune system - not foreign agents in the blood.
Since it takes weeks or even months for these antibodies to build up in the blood, newly
infected HIV donors can pass along the virus through blood that has passed existing
screening tests. Happily, researchers have developed a series of new tests aimed at
detecting and removing infections from donated blood before it is used in transfusions.
The obvious benefit of these tests is the reduced incidence of infection through blood
transfusions. The report indicates that the current price of decontaminated blood
is 6000 rupees per pint. However, if the new screening methods are adopted, the
demand and supply for decontaminated blood will change to Qd = 21000 − 1.5p and
Qs = 2.5p − 15000. What price do you expect to prevail if the new screening methods
are adopted? How many units of blood will be used in India? What is the level of
consumer and producer surplus? Illustrate your findings in a graph.

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