MICROECONOMICS

Problem Set 1
1.You are deciding to buy a new air conditioner for your home, and you have narrowed down
your search two models – one an energy efficient model, and the other the standard model. The
energy efficient model sells for Rs. 25,000 and will save you Rs. 1,250 at the end of each of the
next five years in electricity costs. The standard model has features similar to the energy efficient
model but provides no future saving in electricity costs. It is priced at Rs. 20,000. Assuming your
opportunity cost of funds is 5 percent, which air conditioner should you purchase?
A: Effectively, this question boils down to the question of whether it is a good investment to spend
an extra Rs.5000 on a refrigerator that will save you Rs. 1,250 at the end of each year for five
years. The net present value of this investment is
NPV = (1250/1.05) + [1250/(1.05)2] + [1250/(1.05)3] + [1250/(1.05)4] + [1250/(1.05)5] – 5000
= (1190.48 + 1133.79 + 1079.80 + 1028.38 + 979.41) – 5000
= 5411.86 – 5000 = Rs. 411.86
You should buy the energy efficient model, since doing so saves you Rs. 411.86 in present value
terms.
2. Suppose the demand function for corn is Qd =10 − 2p, and supply function is Qs =3p −5 . The
government is concerned that the market equilibrium price of corn is too low and would like to
implement a price support policy to protect the farmers. By implementing the price support
policy, the government sets a support price and purchases the extra supply at the support price.
In this case, the government sets the support price ps = 4.
(a) At the support price ps = 4 find the quantity supplied by the farmers, the quantity demanded
by the market, and the quantity purchased by the government.
A: When the price is ps =4 , the demand is 2, and supply will be 7, so the government need to buy
5.
(b) Calculate the cost to the government to implement the price support policy. Draw a graph to
show the government cost.
A: Cost to the government: PsQg=20
(c) Suppose now the government switches from price support policy to subsidy policy. For each
unit of corn produced, the government subsidizes the farmer s = 5/3. Find the new equilibrium
price under this subsidy policy. How much money will the government have to spend in order to
implement this subsidy policy?
A: Under subsidy, s = 5/3, the suppliers face the price pb = (p + 5/3)and the consumersface the
price pb.
Therefore, 10 - 2pb = 3 (pb + s) - 5
This implies pb = 2
The new amount of supply is Q = 10 – 2pb = 6, which is the amount that the government needs to
subsidize. The government’s total budget is sQ = (5/3)*6 = 10.
3. You are presented with two business opportunities. The first might generate $40,000 after Year
1, $30,000 after Year 2, and $20,000 after Year 3. The second might generate $20,000 after Year
1, $30,000 after Year 2, and $40,000 after Year 3. Which proposition should you choose if the
prevalent interest rate is 8 percent?
A: You only need to compare the present value of the future payments of each of these projects.
The one that generates a higher present value is the project you should choose. The present value
of the stream of future payments of project 1 is given by
PV1 = [40,000/ 1.08] + [30,000/(1.08)2] + [20, 000/(1.08)3]
= 37037.04 + 25720.16 + 15876.64 = 78633.84
The present value of the stream of future payments of project 2 is given by
PV2 = [20, 000/(1.08)] + [30,000/(1.08)2] + [40, 000/(1.08)3]
= 18518.52 + 25720.16 + 31753.29
= 75991.97
At the prevalent interest rates, project 1 is a better proposition.
4. In the market for televisions, Samsung estimates that the price elasticity of demand for its 9000
Series LED TVs’ is -12.64 and the cross-price elasticity of demand is 7.35. The company now
reduces the price of this series by 9 percent of its present price level. Explain what would happen
to (a) sales of Samsung’s 9000 Series LED TVs and (b) the demand for this Series if its close
competitor Sony also reduced price for comparable Bravia series by 11 percent.
A: Given price elasticity of demand for Samsung’s 9000 Series LED TVs’ = -12.64
Let price of Samsung = Px and price of Sony = Py
-12.64 = (ΔQx.Px)/ (ΔPx.Qx)
And cross price elasticity = (ΔQx.Py)/ ΔPy.Qx = 7.35
(a) If price reduces then quantity (i.e. sales of Samsung TVs) will increase as price elasticity is
negative, i.e. -12.64 = % ΔQx/-9
So, % ΔQx (sale of Samsung TV) = (-9) x (-12.64) = 113.76
(b) Cross price elasticity: 7.35 = (ΔQx.Py)/ ΔPy.Qx
or, 7.35 = % ΔQx/-11
Therefore, % ΔQx = (-11) x 7.35 = -80.85

5. Over the past 25 years, technological advances have reduced the cost of computer chips. How
do you think this affected the market for computers? For computer software? For typewriters?
Explain.
A: Technological advances that reduce the cost of producing computer chips represent a decline
in an input price for producing a computer. The result is a shift to the right in the supply of
computers, as shown in Figure 1. The equilibrium price falls and the equilibrium quantity rises,
as the figure shows.
Figure 1
Because computer software is a complement to computers, the lower equilibrium price of
computers increases the demand for software. As Figure 2 shows, the result is a rise in both the
equilibrium price and quantity of software.

Figure 2
Because typewriters are substitutes for computers, the lower equilibrium price of computers
reduces the demand for typewriters. As Figure 3 shows, the result is a decline in both the
equilibrium price and quantity of typewriters.
Figure 3

4. A travel company has hired a management consulting company to analyze demand in 26

regional markets for one of its major products: a guided tour to a particular country. The
consultant uses data to estimate the following equation:
Q = 1,500 – 4P + 5A + 10I + 3PX
where Q = amount of the product demanded; P = price of the product in dollars; A = advertising
expenditures in thousands of dollars; I = income in thousands of dollars; PX = price of some other
travel products offered by a competing travel company
a) Calculate the amount demanded for this product using the following data: P = $ 400; A =
$20,000; I = $15,000; PX = $ 500

A: Q = 1,500 – 4(400) + 25(20) +10(15) + 3(500)

= 1,650
b) Suppose the competitor reduced the price of its travel product to $400 to match the price of
this firm’s product. How much would this firm have to increase its advertising in order to
counteract the drop in its competitor’s price? Would it be worth for them to do so? Explain.

A: Advertising would have to increase by $60,000 in order for the firm to regain the loss of 300
units resulting from its competitor’s reduction in price of $100. Without cost data, it is not
possible to determine whether it would be worthwhile for the firm to increase advertising to
offset the competitor’s move. However, one thing that this firm would probably want is to avoid
is a price war.

c) What other variables might be important in helping estimate the demand for this travel
product?
A: The price of substitute products such as cruise packages. If time series data were collected on
a quarterly basis, then seasonal factors such as summer or winter could be introduced in the form
of dummy variables.
6. Kajal’s utility function is U(x, y) = x2y. She has income M = 240 and faces prices Px = $8
and Py = $2.

(a) Determine her optimal basket given these prices and her income.
A: Given, U(x,y) = x2y, M = 240, Px=$8, and Py=$2, the budget constraint can therefore be written
as, 8x + 2y = 240
We can solve using the three step Lagrangian process here.
First, write the Lagrangian as L = x2y +  (240 - 8x - 2y), where  is the Lagrange multiplier.
Now take the derivative of the Lagrangian w.r.t. the three variables x, y, and .
∂L/ ∂x = 2xy - 8 = 0
 2xy/8 =  ________ (i)
∂L/ ∂y = x2 - 2 = 0
 x2/2= ________(ii)
∂L/ ∂ = 240 - 8x - 2y = 0 ________ (iii)
From equation (i) and (ii)
2xy/8 = x2/2
 x= y/2
From (iii) 8y/2 + 2y = 240
=> 6y=240
y* = 40
x* = 20
Alternatively, an easier method to solve would be to use the Optimality Condition,
MUx/MUy= Px/Py
=> 2xy/ x2 = 8/2
=> y= 2x
From equation (iii),
8x + 4x = 240
12x =240
x*= 20
y*= 40
Kajal’s Optimal Basket (x*, y*) = (20, 40)

(b) If the price of y increases to $8 and Kajal’s income is unchanged, what must the price of
x fall to in order for her to be exactly as well off as before the change in y’s price?

A: First of all we need to determine how well-off Kajal was before the price change

U* (x, y) = U (x*, y*) = U (20, 40) = (20)2. (40) = 16000

To determine how much price of x should fall so that she is on same indifference curve (where
utility derived is same as in (a)). Let us derive her general demand function.

Kajal’s demand for x and y for any Px and Py. The optimality conditions require

1. MUx/MUy= Px/Py
=> 2xy/ x2= Px/Py

=> y = 1/2.Px/Py.x (Demand equation for y)

2. Pxx+pyy=M
 Pxx+ py (1/2.Px/Py.x) = M

x* = 2/3.M/px

y* = (1/2 .Px/Py.2/3.I/px) = 1/3.M/py

Given, M= 240, Py= $8, x*= 2/3. 240/px

=>x* =160/Px

y*= 1/3. 240/8=10

The only unknown now is px. We want px to be such that U(x*, y*) = 16000

U(x*, y*) = (x*) 2. Y*

= > (160/Px) 2.10 = 16000

=> px= 4.