Assignment #1: Demand Theory, Consumer Behaviour, Rational Choice, and

Production Theory

1. The Sharpie Knitting Needle Company has estimated the demand for its
product as:

QN = 40 – 2 PN – PW + 0.05 I + 0.01 A

Where QN is the quantity demanded of pairs of knitting needles per month, PN is the price of a
pair of knitting needles, PW is the price of a ball of wool, I is monthly per capita disposable
income (in dollars) and A is monthly advertising expenditure (in dollars). Currently, PN = $12,
PW = $11, I = $1,500 and A = $200.
a) What is the current quantity demanded of pairs of knitting needles per month? [1]

Substituting the given values for prices, income and advertising expenditure into the
demand equation yields:

Q = 40 – 2(12) – 11 + 0.05(1,500) + 0.01(200)

Q = 40 – 24 – 11 + 75 + 2

Q = 82

b) What is the own price elasticity of demand for knitting needles? [2]

The own price elasticity of demand for knitting needles equals:

𝒅𝒅 𝑷𝑵 𝟏𝟏
× = −𝟐 × = −𝟎. 𝟐𝟐
𝒅𝑷𝑵 𝑸 𝟖𝟖

c) What is the cross price elasticity of demand between knitting needles and wool? [2]

The cross price elasticity of demand between knitting needles and wool equals:

𝒅𝒅 𝑷𝑾 𝟏𝟏
× = −𝟏 × = −𝟎. 𝟏𝟏
𝒅𝑷𝑾 𝑸 𝟖𝟖
 d) What does the cross price elasticity of demand you calculated in c) tell us about the
relationship between knitting needles and wool? [1]

Because the cross price elasticity of demand between knitting needles and wool
is negative, it tells us that knitting needles and wool are complementary goods.

e) What is the income elasticity of demand for knitting needles? [2]

The income elasticity of demand for knitting needles equals:

𝒅𝒅 𝑰 𝟏, 𝟓𝟓𝟓
× = 𝟎. 𝟎𝟎 × = 𝟎. 𝟗𝟗
𝒅𝒅 𝑸 𝟖𝟖

f) What is the advertising elasticity of demand for knitting needles? [2]

The advertising elasticity of demand for knitting needles equals:

𝒅𝒅 𝑨 𝟐𝟐𝟐
𝒅𝒅
× 𝑸 = 𝟎. 𝟎𝟎 × 𝟖𝟖
= 𝟎. 𝟎𝟎4
2. Stay-Fit Mom’s marketing managers estimate that the demand curve for the company’s baby
joggers in 2013 is:

P = 800 – 2Q

where P is the price of a baby jogger and Q is the number sold per month.

a) To sell 300 baby joggers a month, what price should the firm charge? [2]

Substitute Q = 300 into the demand equation for baby joggers to solve for price:

P = 800 – 2(300) = $200

The firm should charge a price of $200 if it wants to sell 300 baby joggers a month.

b) If managers set a price of $500, how many baby joggers will Stay-Fit Mom sell per
month? [2]

Substitute P = $500 into the demand equation to solve for Q:

500 = 800 – 2Q

Q = (800 – 500)/2 = 150

If the firm charges a price of $500, it will sell 150 baby joggers a month.

c) Derive the marginal revenue curve for the firm. [2]

Total revenue is equal to P×Q:

TR = (800 – 2Q)Q = 800Q – 2Q2

To find marginal revenue, differentiate the TR curve with respect to Q:

MR = 800 – 4Q

d) In what price range is the demand for the firm’s product price elastic? [2]

From the course notes (and also refer to figure 2.6 on page 38), we know that the
elasticity of demand for a linear demand curve is elastic from 0 ≤ Q < a/2b where a
and b are the coefficients in the demand equation of the form:

P = a – bQ

So our elasticity of demand will be elastic from Q = 0 to just below Q = 800/2(2) = 200

Now we use the demand equation to find the price range that corresponds to this.
When Q = 0, P = $800 and when Q = 200, P = 800 – 2(200) = $400

So the firm’s product is price elastic from $400 < P ≤ $800.

 e) If the firm wants to maximize its dollar sales volume, what price should it charge? [2]

TR is at a maximum at the point where MR = 0 (refer to figure 2.7 on page 50 to see a

visual depiction of this). This yields:

MR = 800 – 4Q = 0

Q = 800/4

Q = 200

which as we saw above corresponds to a price of $400. So in order to maximize dollar

sales, the firm should charge a price of $400.
3. The following diagram shows Victoria’s budget line and one of her indifference curves for
shoes and purses. We assume Victoria spends all of her income on these two goods.

a) If the price of a pair of shoes is $100, what is Victoria’s income? [2]

Assuming Victoria spends all of her income on shoes and purses, we can state that:

QSPS + QPPP = I

This can be rearranged, to yield the following equation for the quantity of shoes:

𝑰 𝑷𝑷
𝑸𝑺 = − 𝑸
𝑷𝑺 𝑷𝑺 𝑷

Looking at our diagram, we see that this is the equation of the light blue line. The y
intercept, 12, is therefore equal to I/PS. We can now solve for I given the fact that the
price of a pair of shoes is $100:

𝑰
= 𝟏𝟏
𝟏𝟏𝟏
I = 1,200

b) What is the slope of Victoria’s budget line? [1]

The light blue line in our diagram is Victoria’s budget line. Its slope is equal to:

𝟏𝟏
− = −𝟏. 𝟐
𝟏𝟏

c) What is the equation for Victoria’s budget line? [2]

The equation for Victoria’s budget line is:

𝑸𝑺 = 𝟏𝟏 − 𝟏. 𝟐𝑸𝑷

d) What is the price of a purse? [2]

The slope of the budget line is equal to:

𝑷𝑷
− = −𝟏. 𝟐
𝑷𝑺

We know the price of a pair of shoes is $100. Substituting this into the equation
above allows us to solve for the price of a purse:

𝑷𝑷 = 𝟏. 𝟐 × 𝟏𝟏𝟏 = $𝟏𝟏𝟏
 e) What is Victoria’s marginal rate of substitution in equilibrium? [1]

At equilibrium, Victoria’s marginal rate of substitution will be equal to -1 times the

slope of her budget line:

𝑷𝑷
𝑴𝑴𝑴 = = 𝟏. 𝟐
𝑷𝑺

f) If Victoria’s equilibrium quantity of pairs of shoes is 6 units, what is her equilibrium

quantity of purses? [2]

At the equilibrium quantity, the indifference curve is tangent to the budget line, so
substituting 6 for QS in the equation of the budget line yields:

𝟔 = 𝟏𝟏 − 𝟏. 𝟐𝑸𝑷

𝟔 − 𝟏𝟏
𝑸𝑷 = =𝟓
−𝟏. 𝟐

Victoria’s equilibrium quantity of purses is 5.

4. Martin Furniture produces wooden chairs. They have estimated the relationship between
output (Q) and the number of units of labour (L) and wood (W) as:

Q = 4L + 10W –0.0025L2 – 0.005W2

The price of one unit of labour is $25 and the price of one unit of wood is $100.

a ) What is the marginal product of labour? [1]

𝒅𝒅
𝑴𝑴𝑳 = = 𝟒 − 𝟎. 𝟎𝟎𝟎𝟎
𝒅𝒅
b) What is the marginal product of wood? [1]
𝒅𝒅
𝑴𝑴𝑾 = = 𝟏𝟏 − 𝟎. 𝟎𝟎𝟎
𝒅𝒅
c) If Martin Furniture budgets $30,000 on labour and wood, what is its budget equation? [1]

The company’s budget equation can be expressed as:

𝟐𝟐𝟐 + 𝟏𝟏𝟏𝟏 = 𝟑𝟑, 𝟎𝟎𝟎

d) How much of each input should the company employ given its budget? [5]

To maximize profits, the company should produce where the following condition
holds:

𝑴𝑴𝑳 𝑴𝑴𝑾
=
𝑷𝑳 𝑷𝑾

Substituting our expressions for MPL and MPW yields:

𝟒 − 𝟎. 𝟎𝟎𝟎𝟎 𝟏𝟏−. 𝟎𝟎𝟎

=
𝟐𝟐 𝟏𝟏𝟏
Solving for W as a function of L yields:

𝟏𝟏𝟏(𝟒 − 𝟎. 𝟎𝟎𝟎𝟎) = 𝟐𝟐(𝟏𝟏 − 𝟎. 𝟎𝟎𝟎)

𝟎. 𝟐𝟐𝟐 = 𝟐𝟐𝟐 − 𝟒𝟒𝟒 + 𝟎. 𝟓𝟓

𝑾 = 𝟐𝑳 − 𝟔𝟔𝟔

If we substitute our expression for W into the budget constraint, we can solve for L:

𝟐𝟐𝟐 + 𝟏𝟏𝟏(𝟐𝟐 − 𝟔𝟔𝟔) = 𝟑𝟑, 𝟎𝟎𝟎

𝟐𝟐𝟐𝟐 = 𝟗𝟗, 𝟎𝟎𝟎

𝑳 = 𝟒𝟒𝟒
Solving for W:

𝑾 = 𝟐(𝟒𝟒𝟒) − 𝟔𝟔𝟔 = 𝟐𝟐𝟐

The company should employ 400 units of labour and 200 units of wood given its
budget.

e) What output will result from the combination of inputs you determined in part d)? [2]

Substitute the values calculated in part a) for L and W into the production function:

𝑸 = 𝟒(𝟒𝟒𝟒) + 𝟏𝟏(𝟐𝟐𝟐) − 𝟎. 𝟎𝟎𝟎𝟎(𝟒𝟒𝟒)𝟐 − 𝟎. 𝟎𝟎𝟎(𝟐𝟐𝟐)𝟐

𝑸 = 𝟏, 𝟔𝟔𝟔 + 𝟐, 𝟎𝟎𝟎 − 𝟒𝟒𝟒 − 𝟐𝟐𝟐 = 𝟑, 𝟎𝟎𝟎

The company will produce 3,000 chairs.

5. The relationship between apple output (in tonnes) and the number of hours of labour hired by
the farmer is presented in the table below:

Labour Apple Yield

(hours) (tonnes)
2,500 50
3,700 100
5,000 150
6,800 200
10,000 250
15,000 300

Your answers for parts a) and b) below can be presented in a single table.
a) Calculate the average product of labour when each amount is used. [3]
Average product is found using the formula:
AP = Q/X
where Q is apple yield and X is labour usage

Labour Apple Yield AP MP

(hours) (tonnes)
2,500 50 0.020
3,700 100 0.027 0.042
5,000 150 0.030 0.038
6,800 200 0.029 0.028
10,000 250 0.025 0.016
15,000 300 0.020 0.010
b) Estimate the marginal product of labour when between 2,500 and 3,700 hours are hired,
when between 3,700 and 5,000 hours are hired, when between 5,000 and 6,800 hours are
hired, when between 6,800 and 10,000 hours are hired, and when between 10,000 and 15,000
hours are hired. [5]
See table above noting that MP is found using the formula:
MP = (Q2 – Q1)/(X2 – X1)
c) Does this production function exhibit diminishing marginal returns (very briefly explain your
answer)? [2]
Yes the production function exhibits diminishing marginal returns since although the
apple yield increases as more labour is used, it increases by less and less as more of
the input is used.