Question 1:

The following Table lists the cross-price elasticities of demand for several goods, where the percent quantity change
is measured for the first good of the pair, and the percent price change is measured for the second good.

Goods Cross-Price Elasticity of Demand

Air-conditioning units and kilowatts of electricity -0.34
Coke and Pepsi 0.63
High-fuel-consuming sport-utility vehicles (SUVs) and -0.28
gasoline 0.82
McDonalds burgers and Burger King burgers
Butter and margarine 1.54

a. Explain the sign of each of the cross-price elasticities. What does it imply about the relationship
between the two goods in question?

A negative cross-price elasticity of demand implies that the two goods are gross complements. So air-
conditioning units and kilowatts of electricity are gross complements, as are sport-utility vehicles and
gasoline. A positive cross-price elasticity of demand implies that the two goods are gross substitutes. So
Coke and Pepsi are gross substitutes, as are McDonalds and Burger King burgers as well as butter and
margarine

b. Compare the absolute values of the cross-price elasticities and explain their magnitudes. For
example, why is the cross-price elasticity of McDonalds burgers and Burger King burgers less than
the cross-price elasticity of butter and margarine?

The larger (and positive) the cross-price elasticity of demand is, the more closely the two goods are gross
substitutes. Since the cross-price elasticity of butter and margarine is larger than the cross-price elasticity of
McDonalds burgers and Burger King burgers, butter and margarine are closer gross substitutes than are
McDonalds and Burger King burgers. Similarly, the greater (and negative) the cross-price elasticity of
demand is, the more strongly the two goods are gross complements.

c. Use the information in the table to calculate how a 5 percent increase in the price of Pepsi affects
the quantity of Coke demanded.

A cross-price elasticity of 0.63 implies that a 1% increase in the price of Pepsi would increase the quantity of
Coke demanded by 0.63%. Therefore, a 5% increase in the price of Pepsi would increase the quantity of
Coke demanded by five times as much, that is, by 5 0.63% = 3.15%.

d. Use the information in the table to calculate how a 10 percent decrease in the price of gasoline
affects the quantity of SUVs demanded.

A cross-price elasticity of 0.28 implies that a 1% fall in the price of gasoline would increase the quantity of
SUVs demanded by 0.28%. Therefore, a 10% fall in the price of gasoline would increase the quantity of
SUVs demanded by 10 times as much, that is, by 10 0.28% = 2.8%.

1
Question 2:
A monopolistic producer of two goods, G1 and G2, has a joint total cost function TC 10Q Q1 Q2 10Q2 where
Q1 and Q2 denote the quantities of G1 and G2 respectively. If P1 and P2 denote the corresponding prices, then
demand equations are

P 50 Q1 Q2
P 30 2Q1 Q2
Find the maximum profit if the firm is contracted to produce a total of 15 goods of eithertype. Estimate the new
optimal profit if the production quota rises by 1 unit.

Solution:

2
Question 3:

A firms unit capital and labor costs are $1 and $2 respectively. If production function is given by Q=4LK+L2
Find the maximum output and the levels of K and L at which it is achieved when the total input costs are fixed at
$105. Verify that the ratio of marginal product to price is the same for both inputs at the optimum.

Solution:

We are told that 1 unit of capital costs $1 and 1 unit of labor costs $2. If the firm uses K units of capital and L unit dog
labor, the total input costs are

K+2L
Which has solution L=30 differentiating a second time
This is fixed at 105, so gives

K + 2L = 105
D2Q/ dL2 =-14<0
Subject to the constraint
Confirming the stationery point is a maximum
K + 2L = 105
The maximum output is found by substituting L=30
The three step strategy is as follows: into the objective function

Step 1: Rearranging the constraints to express K in Q=420L- 7L2

terms of L gives

K= 105 - 2L To get

Step 2: Substituting this into the objective function Q= 420 (30)-7 (30)2=6300

Q=4LK + L2 The corresponding level of capita found is by

substituting L=30 into the constraint
Gives

Q = 4L (105 - 2L) + L22

K=105 2L
2
=420L 7L
To get
And so output is now a function of the one variable L
K=105 2(30) =45
Step 3: At stationery point
The firm should therefore use 30 units of labor and 45
units of capital to produce a maximum output of 6300
dQ
dL =0 Finally, we are asked to check that the ratio of the
marginal product price is the same for both inputs.
From the formula
That is
Q=4LK +L2
420 14L=0

3
We see the marginal products are given by: - MPK=4(30) =120

MPL=DQ/DL=4k+2L The ratios of the marginal products to prices are then

and
MPL/PL=240/2=120
MPK=DQ/DK=4L
MPK/PK=120/1=120
So the optimum
Which are seen to be the same
MPL= 4(45) +2(30) =240

4
Question 4:
In the Stackelberg model, the firm that sets output first has an advantage. Explain why.

The Stackelberg leader gains an advantage because the second firm must accept the leaders large output as given
and produce a smaller output for itself. If the second firm decided to produce a larger quantity, this would reduce
price and profit for both firms. The first firm knows that the second firm will have no choice but to produce a smaller
output in order to maximize profit, and thus the first firm is able to capture a larger share of industry profits.

Question 5:
What do the Cournot and Bertrand models have in common? What is different about the two models?

Both are oligopoly models in which firms produce a homogeneous good. In the Cournot model, each firm assumes its
rivals will not change the quantity they produce. In the Bertrand model, each firm assumes its rivals will not change
the price they charge. In both models, each firm takes some aspect of its rivals behavior (either quantity or price) as
fixed when making its own decision. The difference between the two is that in the Bertrand model firms end up
producing where price equals marginal cost, whereas in the Cournot model the firms will produce more than the
monopoly output but less than the competitive output.

Question 6:
Explain the meaning of a Nash equilibrium when firms are competing with respect to price. Why is the equilibrium
stable? Why dont the firms raise prices to the level that maximizes joint profits?

A Nash equilibrium in price competition occurs when each firm chooses its price, assuming its competitors prices will
not change. In equilibrium, each firm is doing the best it can, conditional on its competitors prices. The equilibrium is
stable because each firm is maximizing its profit, and therefore no firm has an incentive to raise or lower its price. No
individual firm would raise its price to the level that maximizes joint profit if the other firms do not do the same,
because it would lose sales to the firms with lower prices. It is also difficult to collude. A cartel agreement is difficult to
enforce because each firm has an incentive to cheat. By lowering price, the cheating firm can increase its market
share and profits. A second reason that firms do not collude is that such behavior violates antitrust laws. In particular,
price fixing violates Section 1 of the Sherman Act. Of course, there are attempts to circumvent antitrust laws through
tacit collusion.

Question 7:
Explain (i) the reason business firms exist and (ii) the reason they do not continue to grow indefinitely

(i) the reason business firms exist

Firms exist because it would be very inefficient and costly for entrepreneurs to enter into and enforce contracts with
workers and owners of capital, and, and other resources to perform each separate step pf production and distribution
prices. By entering into long term broader contracts with labor and other resources, contractual costs are sharply
reduced. The resulting increase in efficiency leads to higher profits by performing many functions within the firm. The
firm also saves on sales taxes and is not subject to other government regulations that apply only to transactions
among firms

(ii) the reason they do not continue to grow indefinitely

The reason firms do not grow larger indefinitely is that there are limitations to management ability to effectively
control and direct the operations of the firm as it becomes larger. It is true that up to a point, a firm can overcome
these internal disadvantages of large size or diseconomies of scale by establishing a number of semi-autonomous
divisions (i.e. by decentralizing). Eventually, however, the increased communications traffic that is generated and the
ever increasing distancing of top management from operation of each division imposes sufficient diseconomies of
scale to limit the growth of the firm. Furthermore, the firm will reach a point at which he cost of supplying affectional
services within the firm exceeds the cost of purchasing those services from other firms. An example of this is some
highly technical (legal, medical, or engineering) service that the firm may need only occasionally.

Question 8:
Some economists have advanced a theory of the firm that postulates that firms seek to maximize sales rather than
profits or the value of the firm.

(i) Explain the motivation of managers might be in seeking to maximize sales rather than profits.

According to the sales maximization model introduced by William Baumol and others, managers of modern
corporations, after generating an "adequate" rate of profit to satisfy stockholders, seek to maximize sales rather than
profits because managers' salaries are more closely correlated with sales than with profits. Indeed, some early
empirical studies found a strong correlation between executives' salaries and sales but not between salaries and
profits. More recent empirical studies, however, found the opposite.

(ii) Explain the reason that we retain the theory of the firm in terms of value rather than sales maximization.

One reason for favoring the theory of the firm that postulates value maximizing is that the results of some recent
empirical studies seem to indicate a stronger correlation between executives' salaries and profits than between
salaries and sales. Another reason is that the value-maximization model predicts the behavior of the firm more
accurately than the sales-maximization model. Thus, we retain the theory of the firm presented in Section 1.3.

Question 9:
Electronic Data Processing (EDP), Inc. is a small but rapidly growing firm that provides electronic data processing
services to companies, hospitals, and other organizations. EPDs main business is to maintain and monitor payroll
records on a contractual basis, and to issue payroll checks, W-2 forms, and so on to employees of client customers.
During the past year, the company has aggressively expanded its personal selling efforts and experienced a rapid
expansion in annual revenue. In tough economic environment, year-end sales revenue grew to $5.2 million, a rate of
$62.4 million per year. Potential influences of important independent variables can be studied in a multiple regression
analysis of EDP data on contract sales (Q), personal selling expenses (PSE), advertising expenditures (AD), and
average contract price (P). Because of a stagnant national economy, industry-wide growth was halted during the
year, and the usually positive effect of income growth on demand was missing. Thus, the trend in national income
was not relevant during this period. For simplicity, assume the relevant factors influencing EDPs monthly sales are
as follows:

If a linear relationship between unit sales, contract price, advertising, and persona selling expenditures is
hypothesized, the EDP regression equation takes the following form:

where Y is the number of contracts sold, P is the average contract price per month, AD is advertising expenditures,
PSE is personal selling expenses, and is a random disturbance term-all measured on a monthly basis over past
year. When this linear regression model is estimated over the EDP data, the following regression equation is
estimated (t-statistics in parenthesis):
Solution

a) What is the economic meaning of the b0 = -117.513 intercept term? B) How would you interpret the value
for each independent variable's coefficient estimate?

The intercept term b0 = -117.513 has no clear economic meaning. Caution must always be exercised when
interpreting points outside the range of observed data and this intercept, like most, lies far from typical values. This
intercept cannot be interpreted as the expected level of unit sales at a zero price, assuming both advertising and
personal selling expenses are completely eliminated. Similarly, it would be hazardous to use this regression model to
predict sales at prices, selling expenses, or advertising levels well in excess of sample norms. Slope coefficients
provide estimates of the change in sales that might be expected following a one-unit increase in price, advertising, or
personal selling expenditures. In this example, sales are measured in units, and each independent variable is
measured in dollars. Therefore, a one-dollar increase in price can be expected to lead to a 0.296-unit reduction in
sales volume per month. Similarly, a one-dollar increase in advertising can be expected to lead to a 0.036-unit
increase in sales; a one-dollar increase in personal selling expenditures can be expected to lead to a 0.066-unit
increase in units sold. In each instance, the effect of independent X variables appears quite consistent over the entire
sample. The t statistics for price and advertising exceed the value of two, meaning that there can be 95% confidence
that price and advertising have an effect on sales. The chance of observing such high t statistics for these two
variables when in fact price and advertising have no effect on sales is less than 5%. The t statistic for the personal
selling expense variable exceeds the value of 3, the critical t value for the = 0.01 (99% confidence level). The
probability of observing such a high t statistic when in fact no relation exists between sales and personal selling
expenditures is less than 1%.1 Again, caution must be used when interpreting these individual regression
coefficients. It is important not to extend the analysis beyond the range of data used to estimate the regression
coefficients.

c) Describe the meaning of the coefficient of determination, R2, and the adjusted coefficient of
determination, R2

he coefficient of determination is R2 = 97.0%; it indicates that 97% of the variation in EDP demand is explained by
the regression model. Only 3% is left unexplained. Moreover, the adjusted coefficient of determination is = 95.8%;
this reflects only a R2 modest downward adjustment to R2 based upon the size of the sample analyzed relative to
the number of estimated coefficients. This suggests that the regression model explains a significant share of demand
variation--a suggestion that is supported by the F statistic. F3,8 = 85.4 and is far greater than five, meaning that the
hypothesis of no relation between sales and this group of independent X variables can be rejected with 99%
confidence. There is less than a 1% chance of encountering such a large F statistic when in fact there is no relation
between sales and these X variables as a group

Question 10:
Solution
A)
P = f(Q),
TR(Q) = QP = Qf(Q)
MR = R(Q) = f(Q) + Qf (Q).
Suppose we now both divide and multiply the right-hand-side of MR by P = f(Q):

MR = P( ) = P(1 + ).
At this point we make use of the facts that demand is monotonically decreasing and f (Q) = dP/dQ to assert that

so that Ed = = .

Inverting both sides, we see that = -1/Ed.

Substituting this into our equation for MR we obtain the following:

MR =P(1 - 1/Ed).

We now have an expression that relates MR to the elasticity of demand:

MR = P(1 - 1/Ed).

If demand is inelastic, Ed < 1 and MR < 0. As profit maximization requires that MR = MC and MC is always positive,
we see that a monopolist must always price in the elastic portion of the demand curve. MR > 0 if and only if Ed > 1.
Question 11:

Pharmed caplets is an antibiotic product with monthly revenues and costs of

(a) Set up a spreadsheet (table) for output (Q), price (P), total revenue (TR), marginal revenue (MR), total cost (TC),
marginal cost (MC), average cost (AC), total profit ( ), and marginal profit ( M ). Establish a range for Q from 0 to
1,000 (i.e. 0. 100, 200,1,000).

(b) Using the spreadsheet, create a graph with MR, MC, and AC as dependent variables and units of output (Q) as
the independent variable. At what price-output combination is total profit maximized? Why? At what price-output
combination is average cost minimized? Why?
(c) Determine these profit-maximizing and average cost-minimizing price-output combinations analytically. In other
words, use revenue and cost equations to confirm your answers to part (b)
 (d) Compare the profit-maximizing and average-cost minimizing price-output combinations and discuss the
differences. When will average cost minimization lead to long-run profit maximization?

Question 12:
A firm is allowed to charge different prices for its domestic and industrial customers. If P1 and Q1 denote the price
and demand for the domestic market, then the demand equation is market then the demand equation is P1 + Q1 =
500. If P2 and Q2 denote the price and demand for the industrial market, then the demand equation is 2P2 + 3Q2 =
720. The total cost of production is T C = 50, 000 + 20 Q where Q Q1 Q2 .
Determine the prices (in dollars) that the firm should charge to maximize profit (a) With price discrimination (b)
Without price discrimination (c) Compare the profits obtained in parts (a) and (b)

Solution
Question 13:
When the demand curve is a straight line, the marginal revenue curve will also be a straight line. The marginal
revenue curve will cut the horizontal axis half way between original and the point where the demand curve cuts this
axis. Explain why it must be like this by using graphic reasoning.

Answer:

Graphically, the marginal revenue curve is always below the demand curve when the demand curve is downward
sloping, since when a producer has to lower his price in order to sell more of an item, marginal revenue is less than
price. In the case of straight-line demand curves, it turns out that the marginal revenue curve has the same intercept
on the P axis as the demand curve but it twice as steep, as illustrated in the diagram above.

Question 14:
In the short run the demand for cigarette is totally inelastic. In the long run, suppose that it is perfectly elastic. What is
the impact of a cigarette tax on the price that consumers pay in the short run and in the long run?

Answer:

Question 15:
The Haas Corporations executive vice president circulates a memo to the firms management in which he argues for
a reduction in the price of the firms product. He says that such a price cut will increase the firms sales and profit. (i)
The firms marketing manager responds with a memo printing out that the price elasticity of demand for the firms
product is about 0.5. Why is this fact relevant? (ii) The firms president concurs with the opinion of the executive vice
president. Is he correct?

Answer:
Question 16:
The 2008 sales and profits of seven companies were as follows

(a) Calculate the sample regression line, where profit is the dependent variable (Y) and sales are the independent
variable (X)
(b) Estimate the 2008 average profit of a firm with 2008 sales of $2 billion

Solution:

Question 17:

Answer:
Question 18:
The incidence of heart disease among women aged 30-50 who are smokers has been found to be several times that
of women in the same age bracket who are non-smokers. As a consequence, the Womens Association proposes
that still higher taxes be imposed on every pack of cigarettes. One Member of Parliament argues First, the tax will
cut back dramatically the rate of use of cigarettes. Moreover, it will raise revenue for the Treasury. If the demand for
cigarettes has arc elasticity less than one, will the tax produce the desired twofold effect? Explain
Answer:

Question 19:
In April 1999, Pepsi Cola, Tanzania, reduced the price of all its products from Tshs 2000 to Tshs 150 per bottle. (i)
What do you think this price reduction had on the demand for Coca-Cola?. In June, 1999, Coca-Cola also reduced
the price of its price by exactly the same amount as that of Pepsi-cola. (ii) What do you think is the effect of this on
the demand for Pepsi-Cola and Coca-Cola?

Answer:

Question 20:
You are a marketing manager with the Tanzania Breweries Ltd which has four brands of beer. The elasticity of
demand for the brands has been estimated to be 1.25. Sales revenue has recently observed to slack. What pricing
policy would you advocate to sales revenue?

Answer:

Question 21
A newspaper article points out that the price of Managerial Economics textbooks is up 10 percent this year over last
year, and yet the number of textbooks sold is higher this year. This article claims that these figures show that the law
of demand does not apply to textbook. Is there a flaw in this argument? (Hint: A textbook is not a Giffen good.)

Answer:

????
Question 22:
Changes in the prices of key commodities can have a significant impact on a companys bottom line. According to a
September 27, 2007, article in the Wall Street Journal, Now, with oil, gas and electricity prices soaring, companies
are beginning to realize that saving energy can translate into dramatically lower cogs. Another Wall Street Journal
article, dated September 9, 2007, states, higher grain prices are taking an increasing financial toll. Energy is an
input into virtually all types of production; corn is an input into the production of beef, chicken, high-fructose corn
syrup, and ethanol (the gasoline substitute fuel).

Answer:

(a) Explain how the cost of energy can be both a fixed cost and a variable cost for a company.

Energy required to keep a company operating regardless of how much output is produced represents a fixed cost,
such as the energy costs of operating office buildings, factories, and stores that must be maintained Independent of
the amount of output produced. In addition, energy is a variable cost because produci ng more output almost always
requires using more energy

(b) Suppose energy is a fixed cost and energy prices rise. What happens to the companys average total cost
curve? What happens to its marginal cost curve? Illustrate your answer with a diagram.

When fixed costs increase, so will average total costs The average total cost curve will shift upward. In panel (a) of
the accompanying diagram, this is illustrated by the movement of the average total cost curve from its initial position,
ATC1, to its new position, ATC. The marginal cost curve is not affected if the variable costs do not change. So the
marginal cost curve remains at its initial position, MC

(c) Explain why the cost of corn is a variable cost but not a fixed cost for an ethanol producer.

Since corn is an input into the production of ethanol, producing a larger quantity of ethanol requires a larger quantity
of corn, making corn a variable cost.

(d) When the cost of corn goes up, what happens to the average total cost curve of an ethanol producer?
What happens to its marginal cost curve? Illustrate your answer with a diagram.
When variable costs increase, so do average total costs and marginal costs. Both curves will shift upward. In panel
(b) of the accompanying diagram, the movement of the average total cost curve is illustrated by the shift from its
initial position, ATC1 to its new position, ATC2. The movement of the marginal cost curve is illustrated by the shift from
its initial position, MC1, to its new position, MC2.

Question 23:

Answer:

Question 24:
What are the major assumptions that characterize a perfect competitive market?

Answer:

The perfect competition model is built on five assumptions:

1. The market consists of many buyers. Any single buyer represents a very small fraction of all the purchases
in a market. Due to its insignificant impact on the market, the buyer acts as aprice taker, meaning the buyer
presumes her purchase decision has no impact on the price charged for the good. The buyer takes the price as
given and decides the amount to purchase that best serves the utility of her household.

2. The market consists of many sellers. Any single seller represents a very small fraction of all the purchases
in a market. Due to its insignificant impact on the market, the seller acts as aprice taker, meaning the seller
presumes its production decisions have no impact on the price charged for the good by other sellers. The seller
takes the price as given and decides the amount to produce that will generate the greatest profit.

3. Firms that sell in the market are free to either enter or exit the market. Firms that are not currently sellers in
the market may enter as sellers if they find the market attractive. Firms currently selling in the market may
discontinue participation as sellers if they find the market unattractive. Existing firms may also continue to
participate at different production levels as conditions change.

4. The good sold by all sellers in the market is assumed to be homogeneous. This means every seller sells the
same good, or stated another way, the buyer does not care which seller he uses if all sellers charge the same
price.

5. Buyers and sellers in the market are assumed to have perfect information. Producers understand the
production capabilities known to other producers in the market and have immediate access to any resources
used by other sellers in producing a good. Both buyers and sellers know all the prices being charged by other
sellers.
Question 27:

Answer:

B)

C)
Question 28

Answer:

A)

B)
Question 29

Answer:

a) [2 marks] In equilibrium, how many units will each firm produce?

P=AC=MC
10Q2-5Q+20=30Q2-10Q+20
20Q2-5Q=0
20Q-5=0
Q=0.25

b) [2 marks] What is the market equilibrium price?

P=30Q2-10Q+20
P=30(0.25)2-10(0.25)+20
P=19.375

c) [1 mark] What is the equilibrium number of firms in the long-run?

Since total market demand is 250 and each firm is producing 0.25 units, the total number of firms in the market
in equilibrium will be
N=250/0.25=1,000
Question 30

A)

B)
Question 31

Answer:
Question 33
Why is it generally not socially efficient to set an emission standard allowing zero pollution?

Answer

If the government were to set an emissions standard requiring zero pollution, this standard would probably not be
socially efficient. By setting the standard at zero, the government could reduce pollution by preventing polluting
industries from producing goods that society values. By setting the standard at zero, however, the government will
also eliminate the benefits to society from production of these goods. In general, the social benefits from producing
will likely exceed the social costs up to some non-zero level of production (pollution) implying the socially efficient
level of production is non-zero.

Question 34