[ ]Fundamental concepts of economics and the theories and application of marginal utility.

2011

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LOVELY PROFESSIONAL UNIVERSITY

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School: LIM Department of Management

Name of the faculty member: Palwinder Kaur

Course No. ECO515 Course Title: Managerial Economics

Class: MBA Semester I Section: T1001 Batch 2009-11

Max. Marks: 15

S.no.

1. Rohan consumes two commodities, wheat and rice. The marginal utility derived by him from rice is two and half time the utility derived from the marginal utility of wheat. If wheat is available for Rs.12 /kg, what price will he be willing to pay for rice in order to maximize his utility?

Ans. Suppose Marginal utility for wheat is 1 util.Hence marginal utility for rice is 2.5 utils.Price for wheat is Rs. 12.So, according to law of diminishing marginal utility:-to maximize Rohan’s utility the price for rice must be fixed at MU1÷P1=MU2÷P2 1÷12=2.5÷P2Hence P2=Rs.30

2 The fundamental economic problems of what to produce, how to produce and for whom to produce are solved differently by different economic systems. Discuss how a capitalist Economy solves these problems.

Ans. Capitalism is an economic system in which the means of production and distribution are privately owned and operated for profit; decisions regarding supply, demand, price, distribution, and investments are not made by the government; Profit is distributed to owners who invest in businesses, and wages are paid to workers employed by businesses.

1) WHAT TO PRODUCE:

This problem is what the economy should produce in order to satisfy consumer wants (as seen by demand curves) as best as possible using the limited resources available. If a country produces goods in a way that maximizes consumer satisfaction then the economy is allocatively efficient.

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2) HOW TO PRODUCE:

This problem is how to combine production inputs to produce the goods decided in problem 1 as most efficiently as possible. An economy achieves productive efficiency if it produces goods using the least resources possible. A productively efficient economy is represented by an economy that is able to produce a combination of goods on the actual curve of the PPF.

3) FOR WHOM TO PRODUCE:

Should the economy produce goods targeted towards those who have high incomes or those who have low incomes? What sort of demographic group should the goods in the economy that are produced be targeted towards? If the economy is addresses this problem then it has reached petro efficiency or petro optimality.

If all three problems are addressed at any one time then the economy has achieved static efficiency. If the economy achieves static efficiency over a period of time then it is dynamically efficient.

All these problems are focused around the problem of unlimited wants and limited resources. Where resources are the factors of production (such as labor, capital, technology, land..) which are used to produce the products that satisfy the wants.

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3 Tomatoes and potatoes are available for Rs. 7/kg and Rs. 10 /kg respectively. If you have an income of Rs. 35000, draw the budget line as graph.

Ans. A good is demanded by the consumer if he has: (i) a preference for that good and (ii) purchasing power to buy the good. His preference pattern is represented by a set of indifference curves, while his purchasing power depends upon his money income and market prices of tomatoes and potatoes where his money income is set at Rs. 35000. Then his purchasing power can be represented in terms of a budget equation: E=!Syntax Error, .. Where E= Expenditure on tomatoes and potatoes;

Qx and Qy= Quantity of tomatoes and potatoes respectively; and

Px and Py= Prices of tomatoes and potatoes respectively.

The budget equation gives us a budget line.

The maximum quantity of tomatoes can be found from the budget equation: 35,000=5,000×Rs.7+Rs.0×10; Qx=5,000.Similarly, the maximum quantity of potatoes can be found from the budget equation: 35,000=0×Rs.7+3,500×Rs×10; Qy=3,500.

B Units of tomatoes 5000 E/Px

Budget Line

E/Py Units of potatoes O A 3500 F IG. THE BUDGET LINE So, the combinations (5000,0) and (0,3500) are possible consumption bundles within the budgeted amount of money. By joining these two points in a graph we get the budget line AB. All combinations of tomatoes and potatoes on the budget line can be purchased by the consumer if he spends whole of his allocated money on tomatoes and potatoes given prices of both of them.

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4 Suppose you are the manager of California winey. How would you expect the following events to affect the price you receive for a bottle of wine?

a. The price of French wines decreasesb. One hundred new wineries open in Californiac. The unemployment rate in USA decreasesd. The price of cheese increasese. The price of a glass bottle increases significantly due to government anti-shatter

regulations

Ans. a. This is the case of price discrimination by a firm segmenting the geographical location i.e., the firm often charges different prices in different locations and regions selling the same product.As a monopolist, we may be able to charge discriminating prices but it need not necessarily be profitable. It must therefore be analyzed as to “under what conditions is it profitable to discriminate”. It is only where the elasticity of demand in one market is different from the elasticity in the other market that we will find the policy of price discrimination to our advantage. Thus, it will be benefit to us to charge higher price in a low elastic market and a low price in a high elastic market i.e., where the French wines’ prices has decreased. This will enable us to maintain a fair return to our product in comparison with the French wines selling at the same price as the French and hence it will ensure a safe and fair competition in that market.

b. Assuming that our market is a perfectly competitive market by the given conditions, in the short run, we end up making huge profits or losses, but in the long run the free entry and exit features of the perfect competition assure us that these profits will disappear. As the industry was profitable 100 new wineries was in the local market and compete with already existing firms including our firm. Consequently, supply of the product will increase and the market price will be driven downwards, thereby eliminating excessive profits for the remaining firms. Also, since more firms will be bidding for the inputs, the input price and hence production costs will rise. Thus, decrease in product price and increase in input prices will eliminate excessive profits. Thus, the entry of 100 wineries in California will take all firms in a competitive situation having identical costs, even though they may be using different production and operating techniques. Hence our price is forced to reduce to the price set by other firms, also called as the “equilibrium price” of all firms or industry.

c. Assuming that other factors determining demand and supply of our firm is constant but the unemployment rate in USA decreases so we can set a higher price for wine. The basic assumption is that more consumers will be able to consume more. More consumers mean more demand for wine. In order to increase our supply we have to increase our inputs, labor and other factors of production. All these factors involve huge costs so to cover such costs prices of wine have to be increased.

d. Adopting the most safe and popular method of pricing i.e., cost-plus pricing we increase the price of our wine to cover up the increase in the price of cheese to ensure a fair amount of return with less complaints from consumers. In this case, cheese which is the major component in production becomes relatively costly it raises the costs of wine significantly.

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e. There are alternatives available to us to ensure a fair price- either we continue selling wine in glass bottles at a higher price or resort to some other cheaper material containers e.g. Plastic bottles and selling at lower price.

5 Other things being the same what would happen to the supply of a particular product if

a. price of the product decreases

b. a technological breakthrough enables the good to be produced at a significantly lower cost

c. the price of inputs used to produce the product increases

d. the price of substitute commodity decreases

e. the managers of the firms that produce that good expect the rise in price of that product in near future

Ans.

a. Since higher money income is necessary to induce producers to produce more, the amount supplied therefore decreases when producers get a lower price for their product.

b. A technological improvement enables the goods to be produced at significantly lower costs and hence there is an ease in supplying more goods.

c. An increase in the price of a factor, say, labor, may lead to a larger increase in the costs of making those commodities that use relatively more labor, but only a small rise in the costs of producing those commodities that use a small amount of labor. This will lead to changes in relative profitability and hence the amount supplied.

d. As the price of substitute commodity decreases the producer will produce more of his product to earn more profits.

e. In the given condition, with all other factors remaining the same, the manager must propose to increase its factors of production to meet the forecasted demand for their goods.

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6. A) What is income consumption curve? Draw income consumption curve for a normal and inferior goods.

B) Suppose the supply curve for allu tikki passes through the point P= Rs.25 and Qs=500. Give two interpretations of this point on the supply curve.

Ans. A) The points of tangency of a set of indifference curves to the respective budget lines gives different equilibrium points. These points when joined makes a curve known as the Income Consumption Curve which shows the way in which consumption varies as income of the consumer changes(price remaining constant).

B3

B2

Income consumption curve (IIC)

B

E3

B1 E2

Units E

Of E1

Good

Y

O A1 A A2 A3

Units of Good X

INCOME CONSUMPTION CURVE: NORMAL GOODS CASE

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B3 ICC

B2

B1

Units I 3

Of

Good I 2

X

I 1

O A1 A2 A3

Units of Good X

INCOME EFFECT: INFERIOR GOOD CASE

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Ans.

B) The following graph can help us show the effect of the above condition on the supply curve:-

S

35 P2 T2

25 P T

20 T1

PRICE

O 500 Q1 550 Q 600 Q2

QUANTITY OF ALOO TIKKI

FROM THE DIAGRAM IT IS CLEAR THAT IF WE INCREASE THE PRICE OF IKKI ALOO THE SUPPLY FALLS AND VICE-VERSA. THUS, THE MORE THE PRICE OF A COMMODITY MORE WILL BE ITS SUPPLY (ACCORDING TO THE LAW OF SUPPLY).

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In 2003, the Men`s Hair company increased the price of its shampoo and subsequently sold more shampoo than 2002. Is the demand curve for this company positively sloped? When the demand curve slopes positively? Give an example of a product in whose case demand curve slopes positively and also explain the exceptions of law of demand.

The demand curve in this case will slope upwards as it is made clear by the increase in the sale of shampoo. This is the exception where the consumers will buy more of the product due to some of the following reasons- goodwill of the firm, good quality, the ego status, the environmental factors etc. it is also known as the Griffin goods.

Demand curve will slope positively in the following circumstances:-

1. Law of diminishing marginal utility.

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2. Substitution effect.3. Income effect.4. New consumers.5. Several users.

A demand curve is said to slope positively when the price increases demand for a commodity falls and vice-versa. It can be illustrated by the following example:-Suppose price of potato is Rs.12/kg and its demand is, say, 50 but if we increase the price to Rs.15/kg its demand is 40 and 60 if price is Rs.10/kg. it can be better illustrated by the following graph:-

15 P1 T1

12 P T

PRICE 10 T2

O 40 Q1 50 Q 60 Q2

QUANTITY DEMANDED FOR POTATO

FOLLOWING ARE THE EXCEPTIONS TO THE LAW OF DEMAND:-

1. Goods of display or distribution.2. Fear of shortage.3. Necessities.4. Future expectations.5. Illusions.6. Importance.

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Shweta spends her whole weekly food allowance of $42 on Pizza and soft drinks. The price of single pizza is $2 and of soft drinks is $1.Shweta buys 12 pizzas and 18 soft drinks and her marginal rate of substitution between pizza and soft drinks is 1. Is Shweta in equilibrium? Explain.

The given budget of Shweta is Rs.42 and her given combination for goods makes a budget line. Now, if her marginal rate of substation is 1 which implies that the indifference curve will be straight line downward sloping there will be an equilibrium point for given level of combination only as it will match her budget line. But, if she reduces her consumption on any of the commodity, the indifference curve will no longer intersect with the budget line and hence she will not be in equilibrium.

Suppose that a study has found that the price elasticity of demand for subway rides is 0.7 in Washington D.C., and the mayor wants to cut the operating subway system. Should the mayor contemplate increasing or decreasing the price of subway ride. Why?

According to the price elasticity of demand i.e., relatively inelastic demand to be specific states that a small change in price causes a less than proportionate change in demand. So, it will be to the best interest of the mayor to increase the price of subway ride.

The price of chocolate is Rs.10 and you have to analyze the consumer behavior under cardinal utility analysis. By the assumption of constant marginal utility of money show the consumer equilibrium with the help of table and diagram.

Units of Chocolate Total Utility (TUJ) Discrete Marginal UtilityMUJ=∆TUJ/∆QJ

Continuous Marginal UtilityMUJ=dTUJ/dQJ

0 0 0 01` 9 9 02 16 7 8

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3 21 5 64 24 3 45 25 1 26 24 -1 07 21 -3 -2

Following is the diagrammatical representation of the above table:-

30 -

25 -

20 -

TUJ

UTILITY 15 -

UTILS

10 -

5 - 0 1 1 1 1 1 1 1

1 2 3 4 5 6 7 MUJ

FIG: DIMINISHING MARGINAL UTILITY

You are working for Coca-Cola as the market head. The company is planning to float a new drink which is white in color. What lessons from the concept of elasticity can you draw while fixing the price for this new drink?

The given case relates with the demand elasticity of substitution. It can be defined as “the degree to which one good can be substituted for another as a consequence of a given change in their price ratio, if the consumer is to enjoy the same satisfaction.”

The price setting of the new product will be more suitable using the demand elasticity of substitution. Recall that incase of substitution effect, change in relative prices (p1/p2) results in a new equilibrium point or the same indifference curve, i.e., it involves change in the ratio of products q1 and q2 when level of satisfaction is held constant. Using this argument, the elasticity

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Ans.

13.

of substitution (α) between q1 and q2 is given by

Proportionate change in the quantity ratios of Coca-Cola and X

α= Proportionate change in the price ratios of Coca-Cola and X

=∆ (QX/QY) ÷ (∆PX/∆PY)

(QX/QY) (PX/PY)

Where (QX/QY) is the ratio of the quantities of goods QX and QY and ∆ (QX/QY) is the change in

the quantity ratio. Similarly (PX/PY) is the price ratio of the two goods and (∆PX/∆PY) is the change in the price ratio.

If we do not have scarce resources, will we have a law of demand? Will we observe price rationing for goods? Give your arguments.

The theory of economics came into existence due to the problem of allocation of the scarce resources. If there were no scarce resources, everything would have available abundantly. Hence, no allocation the resources are mandatory. In other words economics deals with solving the basic problem of proper allocation and distribution of resources. All the law relating to solve the economic problem mainly deals with the scarce resources. Hence it can be concluded that law of demand is dependent or related with the allocation and distribution of scarce resources.

Price rationing is meaningless in case of goods available abundantly. For e.g. The air we breathe: we cannot fix price for air as it is available abundantly. Moreover, as mention above all scarce resources give rise to economic problem which makes many thinkers and scholars to come up with various theories and ideas in solving these problems which is mainly concerned with money as it is one of the scarcest resources.

For each of the following ,state whether economists would consider it as a resource and if they would identify which of the four types of resources the item isa. A computer used by CBI agent to track the whereabouts of suspected criminals.b. The office building in which CBI agent worksc. The time that a CBI agent spends on a cased. A farmer’s tractore. Crude oilf. A package of frozen vegetablesg. plastic bags used by a company for holding its products

A. It is not a resource in economic sense.B. The building is a scarce resource.

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C. Time is not a resource in the above example for the economists.D. A farmer’s tractor may be considered as a resource.E. Crude oil is a scarce resource.F. Frozen vegetables are example of unutilized resources.G. Plastic bags are secondary resources.

A publishing company plans to publish a book .From the sales of data of other publishers of similar books, it works out the demand function for the book as Q=5000-5p. Find out-

a)Demand schedule and demand curve

b)no. of books sold at price Rs. 25

c)price for selling 2500 copies

d)price for zero sales

e)point elasticity of demand at price Rs.20

A) Demand Schedule

Quantity (Q) in units Price(P) in Rs. Sales Of other Co.(in units)

Total amount (in Rs.)Q×P

4500 100 5000 4,50,0004250 150 5000 6,37,5004000 200 5000 8,00,0003750 250 5000 9,37,500

Demand Curve

100 A

150 B

200 C

PRICE 250 D

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A1 4,500 B! 4,250 C1 4,000 D1 3,750 QUANTITY

B) Given Demand function:-Q=5,000-5pNow, price= Rs. 25 Q=5000-5p =5,000-5× Rs. 25 =5,000-125 =4,875

No. of books sold= 4,895/ Rs.25=195 books

C) Given number of books= 2,500Q=5,000-5p2,500= 5,000-5p-2500=-5p-2,500/-5=p500=p

D) Q=5,000-5p0= 5,000-5p-5,000=-5pP=1,000Hence, price for zero books sold is Rs. 1,000 Hence, price is Rs. 500.

E) Point elasticity at price= Rs. 20Formula for point elasticity is given as €=dQ .P=-5× 20/4,900=-0.02 for Q= 5,000-5p. Hence, point elasticity is -0.02. dP Q

A domestic servant spends his total income only on two goods, food and clothing. Analyze the effect of increase in his income on consumption of food and clothing. Illustrate the derivation of his Income Consumption Curve.

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Ans.

INCOME EFFECT:

When income of the consumer rises, the budget line moves outwards be the proportion of change in the purchasing power. While when income declines the budget line moves inwards in accordance with the decrease in the purchasing power. For example, if the consumer’s income increases from Rs. 1,000 to 1,200, PX and PY remaining constant at Rs.50 and Rs. 100 respectively, the points A and B would instead shifts to A1 and B1 respectively. Consequently, the new budget line is the straight line A1B1. There would, on the other hand, be a downward shift like A2B2 when income of the consumer declines

Income consumption curve (ICC) can be used to find Engel curve, which depict the effect of income changes on consumer expenditure pattern. Engel curve for each of the goods food and clothing can be obtained from graph. Each of the points of tangency (which forms the ICC) provides three kinds of information: income, units of consumption of goods food and clothes. By plotting consumption levels of anyone commodity against various income levels (other things held constant) provides an Engel curve. We can thus derive two Engel curve from graph one for the food and other for clothing.

B3 ICC

B2

B1

Units I 3

Of

Good I 2

cloths

I 1

O A1 A2 A3

Units of Good food

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