MicroeconomicsSolutions to Homework 1.

Prof. Ratul Lahkar

1. In problem 2.2, the demand function is Qd = 15 2P . With the government buying 3.5 billion
s bushels, the new demand function is Qd n = 18.5 2P . The supply function is Q = 5P 6. s The equilibrium price is given by Qd n = Q , or equivalently,

18.5 2P = 5P 6. This implies the equilibrium price is P = 3.5. The equilibrium quantity sold and consumed is therefore Q = 11.5. With the government buying 3.5 billion bushels, private consumption is 8 billion bushels. Note that private consumption has fallen as a result of government involvement. 2. Elasticity is given by E d = obtain
dQ dP P dQ Q dP .

Since it is given that E d = 0.5, P = 2 and Q = 1, we

dP dQ

= 1 4 . We also know that the demand curve is linear and that is passes through = 4 and it is linear, we can deduce that

the point (Q, P ) = (1, 2). Since the slope is

3 the demand curve also passes through the point (Q, P ) = ( 2 , 0). Using standard methods

of deriving the equation of a straight line from two given points, we obtain the equation Q=
3 2

1 4P.

3. (a) Put P = 35 in the two demand equations to obtain Qgp = 325 and Qs = 60. (b) Let
gp

and

be the elasticities of Qgp and Qs respectively with respect to price.

gp

= =

P dQgp P = (5) Qgp dP Qgp P dQs P = (4) Qs dP Qs

If P = 35, Qgp = 325 and Qs = 60. Inserting these values into the above equations, we obtain
gp

= 0.5385 and

= 2.3333.

(c) The movie theatre is not maximizing revenue by charging each group 35. To maximize revenue, it needs to charge prices Pgp and Ps such that the elasticity of demand of each group is 1. Clearly, this condition is not being satised at the current price. (d) To maximize revenue,
gp

= 1 and

= 1. For

gp

= 1, we require

Pgp dQgp Pgp = (5) = 1. Qgp dPgp 500 5Pgp 1

Solving the above equation, we obtain Pgp = 50 and Qgp = 250. Similarly, for we require Ps dQs Ps = (4) = 1. Qs dPs 500 5Ps This equation gives Ps = 25 and Qs = 100.

= 1,

Hence, to maximize revenue, the theatre must charge dierent prices from the general public and students. As a verication, calculate the total revenue when the theatre is charging the common price and when it charges dierent prices. Let T Rgp and T Rs be the total revenues obtained from the general public and students respectively. Then, if Pgp = Ps = 35, then T R = T Rgp + T Rs = (Pgp Qgp ) + (Ps Qs ) = (35 325) + (35 60) = 13475. On the other hand, if Pgp = 50 and Ps = 25, then T R = T Rgp + T Rs = (Pgp Qgp ) + (Ps Qs ) = (50 250) + (25 100) = 15000. Clearly, total revenue is higher under the second scenario. (e) Prot () is equal to total revenue (T R) minus total cost (T C ). Normally, if total revenue increases, total cost also increases since the associated output rises. Hence, maximizing total revenue need not necessarily maximize prot. But for a movie theatre, total cost does not rise with an increase in the audience size. Whether the audience consists of one person or a hundred people, the total cost of showing the movie is the same. Total cost is therefore constant. Since = T R T C, and T C is constant, maximizing total revenue is equivalent to maximizing prots. 4. (a) The demand for a specic brand of toothpaste is much more elastic than the demand for toothpaste in general. Toothpaste in general performs an essential service for consumers and there is no closely available substitute for it. Hence, even if prices rise, consumers will not reduce their demand for toothpaste drastically. Nor will a price fall lead to a great increase in demand since an individual uses only a limited amount for toothpaste. But the demand for a specic brand of toothpaste is much more elastic. All available brands of toothpaste are close substitutes and consumers will generally use the particular brand that has the lower price. (b) The demand for petrol in the long run is much more elastic. Petrol is an essential good and there is no close substitute available in the short run. But in the long run, alternative energy sources like solar energy may emerge that will oer a viable alternative to petrol. Hence, in the long run, the demand for petrol is likely to be much more responsive to 2

prices. 5. (a) Marginal benet is given by M B (H ) =

dC (H ) dH dB (H ) dH

= 100060H 2 . Marginal cost is M C (H ) =

= 100 + 120H .

(b) To nd the optimal H , we solve M B (H ) = M C (H ). This gives the optimal H = 3. (c) With a sunk cost of 100, total cost is now C (H ) = 100+100H +60H 2 . Since marginal cost does not change due to the addition of the sunk cost, the optimal H too is unchanged. The intuition behind this is that since the sunk cost is already incurred, any change in the number of hours worked does not lead to any change in how much the total cost increases or decreases. Hence, the optimal number of hours is independent of the sunk cost.