Managerial Economics

HEC Paris – MBA Program

Problem set 1 – Answer key

Exercise 1 – Review (comparative statics I)

Illustrate in a diagram and explain briefly (by making clear assumptions) how each of the
following events affects the equilibrium price and quantity of ice creams:

1. The price of milk rises.

We’ll assume that this ice cream is necessarily made from milk. If the price of the one of the
inputs increases, the supply for the good will decrease. This means that the supply curve will
move left to SS’ (in blue in the diagram). This has the effect of decreasing the output to Q1 and
increasing the price to P1.

2. A new medical study has shown that chocolate bars are good for your health.

Let’s assume that ice creams and chocolate bars are substitutes and that this medical study
has an effect on the demand for chocolate bars and ice---cream (because both are good, but
it feels better to eat chocolate bars since they are good for your health). In particular, this new
study will drive demand for chocolate bars up and demand for ice creams down. In the
diagram, starting from the initial equilibrium, the demand curve will shift left as a result to
demand curve DD’ (in red in the diagram). This will result in a decrease in price and in a
decrease in output to P2 and Q2 respectively.

3. The incomes of consumers rise and ice creams are a normal good.

If ice cream is a normal good, demand for ice cream will increase as the income of consumers
increase. The latter will trigger the demand curve to shift to the right to DD” (in green in the
diagram). Both output and price will increase: (Q3 ; P3) will be the new equilibrium as a result.

4. Summer suddenly turns out to be very hot.

We’ll assume that demand for ice cream is a function of the temperature. If it becomes
“suddenly” very hot, you could imagine arguing that supply is not elastic in the short run and
cannot adjust. As a result, while demand increases to DD” as in case (c), the supply curve stays
at the same level (in black) and there is an ice cream shortage (in green in the diagram).

5. The government sets a maximum price for ice creams during this very hot summer.

Consider the case just above. One would hope that over time, the supply of ice cream can
adapt and increase to satisfy the greater demand entailed by the hot summer. This would
result in a new equilibrium at point (Q3 ; P3). But suppose that the government, seeking to

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enhance the welfare of consumers, wants to maintain price low, and sets a maximum price at
P*. At that price, firms are only willing to supply a quantity of ice cream equal to Q*. There
will be an ice cream shortage as a result, just as in the case when supply is not able to adapt
in the short run.

6. The price of milk rises AND the summer suddenly turns out to be very hot.

This combines the effects of cases (a) and (d). The rise of the price of milk will shift the supply
curve from the black one to the blue one. The fact that the summer turns out to be very hot
will increase demand and shift the demand curve from the black to the green one. The
resulting equilibrium point is A. In fact, the combined effect of the rise of the price of milk and
the hot temperatures will unambiguously be a rise in prices of ice cream. But contrary to what
we assumed in (d), supply is flexible in this case and will react to the rise of the price of one of
the inputs. The effects on total output are ambiguous. Given the assumptions we made in the
diagram regarding the rates of increase and decrease of demand and supply respectively, we
can predict that output will increase. Other assumptions about those rates could have led to
the opposite conclusion – but about final output only.

Exercise 2 – Review (Comparative statics II)

Consider the market for ice cream in Paris.

1. Represent this market in a diagram. Be specific about what the vertical and the
horizontal axis represent. What is the equilibrium? Be very precise.

Here is the market for ice creams in Paris:

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The horizontal axis is the quantity Q of ice creams (or the number of scoops, or…) and the
vertical axis is the price P per ice cream (or price per scoop, or…). The equilibrium E is defined
by the equilibrium amount of ice creams Q* and the equilibrium price P*.

2. Imagine that the price of milk increases. Explain in words the immediate effects (if
any) on demand and supply. Illustrate this in the same graph or in a new graph. What
is the new equilibrium? Again, be very precise.

Milk is an input here. The increase of the price of milk will mean increased costs. This will
lead supply to shrink and will have no immediate demand on demand. As a result, the supply
curve will shift left while the demand curve should not change. The new equilibrium is
characterized by a lower equilibrium quantity Q’ and a higher price P’.

3. Back to scratch. Imagine a widely reported medical study suggests that eating ice
cream will make you smarter. Explain in words the immediate effects (if any) on

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 demand and supply. Illustrate this in the same graph or in a new graph. What is the
new equilibrium? Again, be very precise.

Let’s assume that this widely reported medical study leads consumer preference for ice cream
to increase. Their demand for ice cream will increase as a result while this won’t have
immediate effects on supply (note: if you argue that the second-hand effect – i.e., after the
increase in demand – is the increase in supply, that works too). This will lead the demand
curve to shift to the right while supply curve will remain unchanged. The new equilibrium is
characterized by a higher equilibrium quantity Q” and a higher price P”.

4. Back to scratch. Imagine that the price of milk increases AND that a widely reported
medical study suggests that eating ice cream will make you smarter. What effects will
this have on the overall equilibrium? Illustrate in a graph.

As argued above, the increase of the milk price will lead supply to shrink and the supply curve
to shift to the left. The study will lead demand to expand and the demand curve to shift to
the right. Both phenomena will lead to an increase in price. So the combination of both will
lead to an unambiguous increase in price. However, while the former leads to a smaller
quantity traded on the market, the latter leads to a higher quantity traded on the market. As
a result, the combination of both phenomena leads to an ambiguous effect on quantity. It all
depends on how big each of the phenomena is.

Graphically, this is what happens:

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 5. Back to scratch. A newly elected government believes ice cream has gotten too costly.
They decide to implement a maximum price. What happens if this price is set above
equilibrium? What happens if the price is set below equilibrium?

If the maximum price is set above the equilibrium price, there is no effect. If suppliers choose
to supply at that price, supply will exceed demand and this excess will lead to a drop in price,
until the price reaches equilibrium price.

If the maximum price is set below the equilibrium price, this means that suppliers will be
willing to supply less than what consumers will be willing to demand (at that price). Scarcity
will result from this. If the market was totally free, the price would have gone up – but it can’t
since the government implemented this maximum price.

6. Why would you criticize the measure described in (5) from a microeconomic
standpoint? Explain in words and illustrate with a graph.

By setting a maximum price, the government is artificially limiting the amount of ice cream
that will get traded on this market. Whereas this amount could have reached Q*, it is limited
to QS because of this maximum price. The measure as a result is creating a deadweight loss
(in yellow in the drawing) that society as a whole suffers from. This is why one could criticize
this measure.

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Exercise 3 – Big drop in oil prices and expected prices

Consider the assigned case study on the big drop in oil prices.

1. Explain, with a graph, the supply-side and demand-side phenomena that led to the
price drop.

We did this in class. What is important to remember here is that on the supply-side, the
combination of new actors and resilient production levels in Iran, Libya and in Iraq drove
supply higher up than expected, while demand only increased moderately (Think of China’s
economic slowdown). The fact that the increase in supply was more significant than the
increase in demand drove quantities traded up and prices significantly down.

2. A theory suggests that low oil prices today will lead to much higher prices tomorrow.
Using the graph in (1), explain why this could be the case.

We did this in class. What is important to remember here is that because of low prices, the
least cost-competitive actors are driven out, projects are delayed and (potentially) individuals
with significant know-how leave the industry. This can lead to a supply crunch. Combined with
a potential pick-up of demand, this would lead to prices to spike up.

3. An alternative theory suggests that prices may be durably low. The other required
reading by Spencer Dale, the Chief Economist at BP, defends this theory. Explain why,
relying on microeconomics.

We did this in class. Dale’s argument relies on four principles that we thought were true, but
aren’t true anymore – or were never true. First, we used to consider that oil was a finite
resource when in fact, for every barrel of oil we consume, we produce two additional ones. In
addition, the supply and demand curves are not as steep as they used to be, making price
adjustments far smoother and limiting the amount of price spikes. Third, demand patterns
have changed, as oil does not flow from East to West but from East to the Far East, making
spikes in demand less likely. Last but not least, OPEQ isn’t in a position to influence markets,
in particular because this isn’t a temporary shock. Quite to the contrary, it’s a structural, long-
term and game-changing shock that will lead prices to be durably low.

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Exercise 4 – Pricing strategies

In a concert room, the number of seats is fixed and constrained by the concert venue.
Demand, on the other hand, follows the usual relationship we saw in class. Imagine you’re
the group manager and you are planning a concert at the Stade de France. For each question,
you should provide a visual for the value that you are creating for yourself (the producer).

1. What does P1 represent? Answer in plain English. Hint: if you are using the word
“equilibrium,” the answer is not in plain English.

P1 is the maximum price you can charge to get a sellout crowd.

2. Why would you ever choose P2 over P1? What revenues would you be forgoing? What
value could you create for yourself (the manager)? Be clear on the strategy that you
would be pursuing in this case.

When you charge P2, some of your clients who are willing to buy the good can’t because you
have ran out. The headlines, in this case, are all about those who wanted to consume but who
couldn’t because the product is so popular and cheap. Essentially, you are creating a buzz
measured by the red segment (or arguably, the light red rectangle). This could mean
additional dates for the concert that you may not have gotten before.

The price of this buzz is measured by the revenue you forgo by charging a lower price. This is
measured by the blue rectangle. Here too, the debate is about making the appropriate
tradeoff.

Remember the McDonald’s Dinner Box (See session 3 slides).

3. Why would you choose P3 over P1? What revenues would you be forgoing? What
value could you create for yourself (the manager)? Be clear on the strategy that you
would be pursuing in this case.

When you charge P3, you are charging a premium worth P3 – P1. This premium can help you
build up your brand and/or achieve other marketing objectives. You are essentially earning
the red rectangle in additional revenues, but you are losing the blue rectangle as a result. This
blue rectangle is the supplier’s cost of charging a premium. In this debate, comparing the red
and blue rectangles can help you determine what the appropriate tradeoff is.

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Exercise 5 – The winners and losers of globalization

Imagine this a local/national economy with no economic ties to the rest of the world. Any
given market – say, for shoes for instance – will reach equilibrium in autarky as discussed in
class. You can identify a consumer surplus and a producer surplus.

Imagine now that the country opens up and that cheaper shoes are available from abroad.
On this market, the price will drop to the level of the world price for the good, which is lower
than the autarky price.

1. Illustrate this in a graph.

See the slides. Pw is below the equilibrium price in autarky. This is simple to illustrate.

2. How much is consumed, how much is produced locally in this economy?

See the slides. This drop in price means the local economy consumes more (Qd) and supplies
less (Qs) both compared to the quantity in autarky.

3. Where is the difference coming from?

See the slides. This economy consumes more than it produces. The difference is coming from
abroad, from imports.

4. Overall, is this good or bad for the economy?

See the slides. This is economically good: whereas the total amount from gains from trade was
equal to A+B+C in yesterday’s world, it is now equal to the same amount, PLUS D and E. Gains
from trade (the “red triangle”) have unambiguously increased as a result.

5. Why will it be hard to sell politically? Consider the reading “The Global Economy’s Next
Winners”. Can you relate the authors’ argument to what you found?

This will be a hard sell because the gains are diffuse and spread over a wide range of people.
Though the gains may be substantial in total, they are small when it comes down to gain per
person. On the contrary, the losses are more concentrated on a specific set of actors who will
bear a disproportionate part of the burden. It will be easier for them to mobilize and to
denounce this.

The article discusses why middles classes in Europe and in the United States have been
particularly hit hard by globalization. This little exercise explains why: Unless the good you’re
selling is unique (which arguably requires skilled labor), it is hard to thrive in a world in which
there is a lot of competition.