MGEC2

HW Answer Key

Problem 1
A computer products retailer purchases laser printers from a manufacturer at a price of Rs. 25,000 per printer.
During the year, the retailer will try to sell the printers at a price greater than Rs. 25,000, but may not be able to
sell all the printers. At the end of the year, the manufacturer will buy back any unsold inventory at 40 percent of
the original price. No one other than the manufacturer would be willing to buy these unsold printers at the end
of the year. (2+2+2 points)
a) At the beginning of the year, before the retailer has purchased any printers, what is the opportunity cost
of a laser printer?

Since a printer costs Rs. 25000, before purchasing any printers, the opportunity cost of a laser printer would
be the next best use of Rs. 25000 for the retailer. For example, this money could be invested elsewhere at a
certain rate of return. This return foregone would be the opportunity cost of the laser printer.

b) After the retailer has purchased the laser printers, what is the opportunity cost associated with selling a
laser printer to a customer? (Assume that if this customer does not buy the printer, it will be unsold at
the end of the year.)

Any unsold inventory will be bought back by the manufacturer at 40% of the original price; Rs.10,000
(25000*.40). Therefore, the opportunity cost associated with selling a laser printer to a customer would be
Rs. 10,000 as this is the next best alternative available to the retailer.

c) Suppose that at the end of the year, the retailer still has a large inventory of unsold printers. The retailer
has set a retail price of Rs. 30,000 per printer. The manager of the store proposes that they should cut the
price by half and sell the printers at Rs. 15,000 each. The owner of the store disagrees, pointing out that
at Rs. 15,000 each, they would lose Rs. 10,000 on each printer sold. Is the owner’s argument correct?

No, the owner has fallen prey to the sunk cost fallacy. He is anchored to the purchase price of Rs. 25000,
and is considering sale of printers at Rs. 15000, as a situation where he would incur a loss of Rs. 10,000
(Purchase price-offer price; 25000-15000). When in fact, he should be comparing the following two
situations;
 cutting the price by half and selling the printers at Rs. 15,000 each
 unsold printers being bought back by manufacturer at Rs. 10,000 each.
Clearly, the best alternative available to him at this juncture is to select the first option, where he would
actually be cutting his losses by Rs. 5000.
Problem 2
Consider the market for biryani in Hyderabad. In this market, the supply curve is given by Qs = 10P B − 5PR
and the demand curve is given by QD = 100 − 15PB + 10PK , where B denotes biryani, R denotes rice, and K
denotes kebabs.
a) Assume that PR is fixed at 1 and PK = 5. Calculate the equilibrium price and quantity in the biryani
market. What is the producer and consumer surplus generated by the biryani market at these prices?
(1+1.5+1.5 points)

If PR = 1 and PK = 5, the demand curve can be rewritten as: QD = 150 − 15PB and the supply curve can be
rewritten as Qs = 10PB – 5
Equilibrium price and quantity can be calculated by equating the demand and supply curves:

150 − 15𝑃𝐵 = 10𝑃𝐵 – 5

𝑃𝐵 = 6.2

Plug this value into demand curve to get equilibrium quantity: QD = 150 – 15 (6.2)

𝑄𝐷 = 57

Consumer and Producer Surplus can be shown graphically as:

𝑄𝐷 = 150 − 15𝑃𝐵
Price 𝑄𝑆 = 10𝑃𝐵 – 5

10

Consumer Surplus QS

6.2 Producer Surplus

0.5
QD
-5 0 57 150 Quantity

Consumer surplus is given by the area of the triangle; above market price (P=6.2) and below the demand
1
curve. We can use the formula for area of a triangle = 2 × base × height to calculate the consumer surplus.
In this case the base of the triangle is 57 and the height is 3.8 (10-6.2), therefore

1
Consumer Surplus = × 57 × 3.8 = 108.3
2
 Similarly, producer surplus is given by the area of the triangle; below market price (P=6.2) and above the
1
supply curve. We can use the formula for area of a triangle = 2 × base × height to calculate the producer
surplus. In this case the base of the triangle is 57 and the height is 5.7 (6.2-0.5), therefore

1
Producer Surplus = × 57 × 5.7 = 162.45
2

b) Suppose that a poor harvest season raises the price of rice to PR = 2. The price of kebabs remains the
same as in part a. Find the new equilibrium price and quantity of biryani. Draw a graph to illustrate
your answer. (2 points)

Given that PR = 2, new supply curve for biryanis can be rewritten as; Qs = 10PB – 10
The demand curve remains the same; QD = 150 − 15PB

Equilibrium price and quantity can be calculated by equating the demand and supply curves:

150 − 15𝑃𝐵 = 10𝑃𝐵 – 10

𝑃𝐵 = 6.4

Plug this value into demand curve to get equilibrium quantity: QD = 150 – 15 (6.4)

𝑄𝐷 = 54
This can be shown graphically as:

𝑄𝐷 = 150 − 15𝑃𝐵
Price 𝑄𝑆 = 10𝑃𝐵 – 10

10
QS2

QS1

E2
6.2
E1

1
0.5 QD
-5 0 54 57 150 Quantity

c) Suppose PR = 1 but the price of kebabs drops to PK = 3. Find the new equilibrium price and quantity
of biryani. (2 points)

At PK = 3, the demand curve can be rewritten as QD = 130 − 15PB while the supply curve remains the same;
Qs = 10PB – 5
Equilibrium price and quantity can be calculated by equating the demand and supply curves:

130 − 15𝑃𝐵 = 10𝑃𝐵 – 5

𝑃𝐵 = 5.4

Plug this value into demand curve to get equilibrium quantity: QD = 150 – 15 (5.4)

𝑄𝐷 = 49

d) Suppose PR = 1, PK = 5, and the local government mandates that since a lot of tourists like to eat
biryani when they visit Hyderabad, in the interest of promoting tourism, the price of biryani cannot
exceed 5. How much is the shortage of biryani as a result? Draw a graph to illustrate your answer.
(2 points)

As in part (a), if PR = 1 and PK = 5, the demand curve will be: QD = 150 − 15PB and the supply curve will be
Qs = 10PB – 5

Given that 𝑃𝐵 = 5 as mandated by the government. Quantity demanded and supplied can be found by
plugging 𝑃𝐵 = 5 in the demand and supply equations.

𝑄𝐷 = 75
𝑄𝑆 = 45
𝑆ℎ𝑜𝑟𝑡𝑎𝑔𝑒 = 30 𝑢𝑛𝑖𝑡𝑠
This can be illustrated graphically as:

𝑄𝐷 = 150 − 15𝑃𝐵
Price 𝑄𝑆 = 10𝑃𝐵 – 5

10

QS

E1
6.2

0.5 Shortage of 30 units

QD
-5 0 45 57 75 150 Quantity
Problem 3
It is lunch time and there are 2 kinds of customers at the Goel dining hall: students from the afternoon
sections, and students from the morning sections. Their respective demand curves for lunch per week are
given by QA = 800 – 2P and QM = 920 – 4P. The dining hall’s marginal cost of each lunch served is 30.

a) Assume that the dining hall can price discriminate. What is the profit maximizing price that the
dining hall can charge from each type of student? (4 points)

Method 1:

Recall that the mark-up that a firm can charge over the marginal cost is given by:

𝑃 ∗ −𝑀𝐶 ∗ 1
= −
𝑃∗ ∈𝐷

𝑑𝑄 𝑃
Where ϵd = ×𝑄
𝑑𝑃
Since the dining hall can price discriminate, it will charge each type of student a mark-up that is the inverse of
their elasticity of demand. Let the price charged to the afternoon section students be PA and the price charged to
the morning section students be PM.
𝑑𝑄
Therefore for the afternoon section students, PA can be found by plugging the values MC = 30 and = −2
𝑑𝑃
and Q = QA = 800 – 2PA in the equation:

𝑃𝐴 − 𝑀𝐶 𝑑𝑃 𝑄
= − ×
𝑃𝐴 𝑑𝑄 𝑃

𝑃𝐴 − 30 1 800 – 2𝑃𝐴
= −(− × )
𝑃𝐴 2 𝑃𝐴

𝑃𝐴 − 30 = 400 − 𝑃𝐴

𝑃𝐴 = 𝑅𝑠. 215

𝑑𝑄
Similarly, for the morning section students, PM can be found by plugging the values MC = 30 and = −4
𝑑𝑃
and Q = QM = 920 – 4PM in the equation:

𝑃𝑀 − 𝑀𝐶 𝑑𝑃 𝑄
= − ×
𝑃𝑀 𝑑𝑄 𝑃

𝑃𝑀 − 30 1 920 – 4𝑃𝑀
= −(− × )
𝑃𝑀 4 𝑃𝑀

𝑃𝑀 − 30 = 230 − 𝑃𝑀

𝑃𝑀 = 𝑅𝑠. 130

Morning section students are being charged Rs. 130 and afternoon section students are charged Rs. 215

Method 2:
We can also find profit maximizing price and output by setting MRM = MRA = MC
 Given Demand curves:
QA = 800 – 2PA and QM = 920 – 4PM
Rewriting the demand curves:
𝑄𝐴
𝑃𝐴 = 400 –
2
𝑄𝑀
𝑃𝑀 = 230 –
4
𝑑𝑇𝑅
TR = P× 𝑄 and MR = 𝑑𝑄
Therefore, MRA = 400 - QA
𝑄
And MRM = 230 – 2𝑀
Setting MRA = MC; 400 - QA = 30; QA = 370; Plug this value into the demand function;

370
𝑃𝐴 = 400 –
2

𝑃𝐴 = 215
𝑄𝑀
Similarly, setting MRM = MC; 230 – = 30; QM = 400; Plug this value into the demand function;
2

400
𝑃𝑀 = 230 –
4

𝑃𝑀 = 130

b) Why do you think the elasticity of demand is different for the two types of students? (2 points)

Afternoon section students are time constrained as their classes start after lunch. Hence, their demand curve is
less elastic compared to morning section students, who are done with their classes by lunch time.

Problem 4
Suppose that the market for calcium is perfectly competitive. Consider the following information about its
price:
• Between 2000 and 2005, the market price was stable at about Rs. 200 per kilo.
• In the first 3 months of 2006, the market price doubled, reaching a high of Rs. 400 per kilo, where it
remained for the rest of 2006.
• Throughout 2007 and 2008, the market price of calcium declined, eventually reaching Rs. 200 per kilo
by the end of 2008.
• Between 2008 and 2013, the market price was stable at that level
Assuming that the technology for producing calcium did not undergo any changes between 2000 and 2013,
and the input prices faced by calcium producers remained constant, what explains the pattern of prices that
prevailed between 2000 and 2013? Is it likely that there were more producers of calcium in 2013 than there
were in 2000? Explain your answers using graphs. (2 + 1 + 3 points)
Summary

Time Period Market Price Implication

2000-2005 Stable at Rs. 200 per kilo Industry is in long run equilibrium
Given that there was no change in technology or input prices
faced by calcium producers, we can safely assume that market
price increased due to increase in demand.
2006 Doubled to Rs. 400 per kilo
Surge in demand leads to economic profits for firms in the
industry. Market demand curve shifts outwards to MD1 (refer to
figure 2) leading to a higher price.
More firms enter the market to take advantage of high prices and
earn economic profits. However, with increasing number of
Declined and reached Rs.
2007-2008 firms in the market, supply gradually catches up, market supply
200 per kilo
curve moves outwards to MS1 (refer to figure 3) and price
declines to long run equilibrium level.
Industry is in long run equilibrium. It can be said with certainty
2008-2013 Stable at Rs. 200 per kilo that there were more producers of calcium in 2013 than there
were in 2000.

Figure 1: Perfectly competitive market for Calcium from 2000-2005 and 2008-2013

Time Period: 2000-2005 and 2008-2013

MC
Price

Price

MS
AC

200 200 AR=MR

MD

Quantity Quantity
Market Demand and Supply Individual Firm
Figure 2: Perfectly competitive market for Calcium for 2006

Time Period: 2006

Price

Price
MC
MS
AC
400 400
Economic Profits

200 200 AR=MR

MD1

MD

Quantity Quantity
Market Demand and Supply
Individual Firm
Figure 3: Perfectly competitive market for Calcium from 2007-2008

Time Period: 2007-2008

Price

Price
MC
MS
MS1 AC
400

200 200 AR=MR

MD1

MD

Quantity Quantity
Market Demand and Supply
Individual Firm
Problem 5
An annuity provides insurance against out-living one’s financial resources. LEICO, a life insurance
company, takes a deposit from customers at age 60 years, and returns an annual payment of Rs.
5000 till their death. (2+2+3 points)

a. Calculate the break-even deposit for LEICO if average population-wide life expectancy is 80
years. Assume a 5% interest rate.

We need to calculate nothing but the present value of an annual cash flow of 5000 for 20 years at a
discount rate of 5%, This is given by 62264.

b. If potential customers have a sense of their life expectancy, based on factors such as the
longevity of their parents, who will purchase the annuity with the deposit you have calculated
above?

Customers who expect to live for a long time, in particular, for those whose life expectancy is
greater than 80 years.

c. If life expectancy is uniformly distributed in the population (up to a maximum of 100 years)
and potential customers have a sense of their life expectancy, what is the deposit that LEICO
will ultimately end up charging? Who will finally buy this annuity?

Only those who live for 100 years will end up buying the annuity. LEICO will charge then
85795 which is the break-even value for those customers.

Problem 6

An old lady is looking for help crossing the street.1 Only one person is needed to help her; more are
okay but no better that one. Sunny and Simran are the two people in the vicinity who can help; each
has to choose simultaneously whether to do so. Each of the two will get utility worth 3 from the old
lady’s success (no matter who helps her). But each one who goes to help will bear a cost of 1, this
being the utility value of the person’s time taken up in helping. Set this up as a game. Write the
payoff table and find all pure-strategy Nash equilibria. (4+2 points)

Simran
Help Don’t Help
Sunny Help 2,2 2,3
Don’t Help 3,2 0, 0

There are 2 pure strategy Nash equilibria: {Help, Don’t Help} and {Don’t Help, Help}
Problem 7
Having muscled out the other bhelpuri vendors on Chowpatty Beach in Bombay, the proprietors of
Royal Bhelpuri and Modern Bhelpuri have to decide where to locate their stalls. Customers are
situated uniformly along the beach and will purchase from the vendor closest to them. (4+4 points)

a. If the beach is 1 km long, what are the Nash equilibrium locations for Royal and
Modern?

Both will locate right next to each other at the 0.5 kilometers point.
Suppose both locate at either end of the beach. Then each has an incentive to move slightly inwards so as
to capture all the customers located between the end closest to his location and himself, as well as some
customers on the other side (for whom he is closer). Both will keep doing this, till they’re located right
next to each other and have half of the market share (Nash equilibrium).

b. If a new entrant, Tasty Bhelpuri, enters the market, what are the equilibrium locations?

There is no equilibrium location as everyone has an incentive to deviate at all possible choices.