Managerial Economics

Indian School of Business

Homework 2 Answer Key

Problem 1
The market demand for Economics textbooks is given by Q = 160 – 4P. Total cost of the firm is given by
TC = 6Q2+15Q+5
a) Find the profit maximizing level of output, price, and profit if this firm is the only firm in the
market. (3 Points)

If this firm is the only firm in the market, it’s a monopoly. For obtaining profit maximizing level of output, set

𝑀𝐶 = 𝑀𝑅

The demand curve is given by: QD = 160 – 4P, this can be expressed as:
𝑄
𝑃 = 40 −
4

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑇𝑅) = 𝑃 × 𝑄

𝑄
𝑇𝑅 = 𝑄 (40 − )
4

𝑄2
𝑇𝑅 = 40𝑄 −
4

𝑑𝑇𝑅
𝑀𝑅 =
𝑑𝑄

2𝑄
𝑀𝑅 = 40 −
4

𝑄
𝑀𝑅 = 40 −
2

Marginal Cost (MC) can be obtained by differentiating the total cost function with respect to Q

𝑇𝐶 = 6𝑄 2 + 15𝑄 + 5

𝑀𝐶 = 12 𝑄 + 15

Profit will be maximized at 𝑀𝐶 = 𝑀𝑅

𝑄
12 𝑄 + 15 = 40 −
2

1
 Solving for Q, Q = 2
𝑄
Profit maximizing price can be found by plugging Q=2 in the demand function; 𝑃 = 40 − 4
P = 39.5

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 𝑇𝑅 − 𝑇𝐶

𝑄2
𝑇𝑅 = 40𝑄 −
4

𝑇𝐶 = 6𝑄 2 + 15𝑄 + 5

Plugging the value of Q = 2 in the above equations, TR = 79 and TC = 59

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 79 − 59

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 20

b) Find the short-run profit maximizing level of output and profit of the firm assuming the market is
perfectly competitive and the market price is 27. (2 Points)

In perfect competition, P=AR=MR.

As calculated in part (a), 𝑀𝐶 = 12 𝑄 + 15
For a firm in perfect competition, the short-run profit maximizing level of output can be found by setting
𝑀𝐶 = 𝑀𝑅

12 𝑄 + 15 = 27

𝑄=1

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 𝑇𝑅 − 𝑇𝐶

𝑇𝑅 = 𝑃 × 𝑄 = 27 × 1 = 27

𝑇𝐶 = 6𝑄 2 + 15𝑄 + 5

𝑇𝐶 = 26

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 27 − 26

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 1

c) If the market is perfectly competitive and the market price is 75, what will happen in the long run?
(1 Point)

2
The economic profit for a perfectly competitive firm, in equilibrium is 0. Increasing the price to 75 in the short run,
will lead to even higher profits (than at the price level of 27) and many firms will enter the industry and drive the
price down till it reaches a price level corresponding to zero economic profits.
Just to corroborate; if the market price is 75, then again the short-run profit maximizing level of output would be
found by setting
𝑀𝐶 = 𝑀𝑅

12 𝑄 + 15 = 75
𝑄=5

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 𝑇𝑅 − 𝑇𝐶

𝑇𝑅 = 𝑃 × 𝑄 = 75 × 5 = 375

𝑇𝐶 = 6𝑄 2 + 15𝑄 + 5

𝑇𝐶 = 230

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 375 − 230

𝑃𝑟𝑜𝑓𝑖𝑡 (𝜋) = 145

Since firms are earning economic profit, more firms will enter the market and drive the price down to the level
where industry is in long term equilibrium.

3
Problem 2
Consider the market for biryani in Hyderabad. In this market, the supply curve is given by Qs = 10PB − 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

4
 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

5
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:

6
 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

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Problem 3
The market demand curve for a monopolist is given by P = 40-2Q.

a) What are the marginal revenue and average revenue functions for the firm? (2 points)
Average Revenue = Price function; 𝐴𝑅 = 40 − 2𝑄

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑇𝑅) = 𝑃 × 𝑄

𝑇𝑅 = 𝑄 (40 − 2𝑄)

𝑇𝑅 = 40𝑄 − 2𝑄 2

𝑑𝑇𝑅
𝑀𝑅 =
𝑑𝑄

𝑀𝑅 = 40 − 4𝑄

b) What will be the profit maximizing price and quantity for this firm if average cost is given by Q? (1
point)

If AC = Q, Total Cost = AC×Q = Q2

𝑑𝑇𝐶
𝑀𝐶 =
𝑑𝑄

𝑀𝐶 = 2𝑄

The monopolist maximizes profits at 𝑀𝐶 = 𝑀𝑅

2𝑄 = 40 − 4𝑄
20
𝑄=
3

Price can be found by plugging this value in the demand equation; P = 40-2Q
80
𝑃=
3

Thus, the monopolist maximizes profits at price of 80/3 and quantity of 20/3

8
Problem 4
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 = 𝑑𝑃 × 𝑄
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

9
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

𝑄𝑀
And MRM = 230 – 2
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 – 2
= 30; QM = 400; Plug this value into the demand function;

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 from 1:15 pm. Hence, their demand curve
is less elastic compared to morning section students, who are done with their classes by lunch time.

10
Problem 5
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 11

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

12
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

13
Problem 6
Suppose that Air India has a monopoly on the route between Delhi and Srinagar. During the winter months,
the monthly demand on this route is given by P = a1 – bQ; and during the summer months, it is given by P =
a2 – bQ, where a2 > a1. Assume that Air India’s marginal cost is constant, and is given by c.
What will be the equilibrium price and quantity in each season? (4 points)

To find the equilibrium price and quantity in each season, Air India will equate MR for winter months and
MR for summer months to marginal cost; MRS = MRW = MC

For winter months, monthly demand is given by the equation: P = a1 – bQ

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑇𝑅) = 𝑃 × 𝑄

𝑇𝑅 = 𝑄 (𝑎1 − 𝑏𝑄)

𝑇𝑅 = 𝑎1 𝑄 − 𝑏𝑄 2

𝑑𝑇𝑅
𝑀𝑅 =
𝑑𝑄

𝑀𝑅 = 𝑎1 − 2𝑏𝑄
Profit is maximized at MR = MC, where MR is given above and MC = c

𝑎1 − 2𝑏𝑄 = 𝑐

𝑎1 −𝑐
Equilibrium quantity in winters is 𝑄 = 2𝑏

Equilibrium price in winters can be found by plugging this value in the demand function; P = a1 – bQ

𝑎1 − 𝑐
𝑃 = 𝑎1 − 𝑏( )
2𝑏

𝑎1 + 𝑐
𝑃 =
2

Likewise, for summer months, monthly demand is given by the equation: P = a2 – bQ

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑇𝑅) = 𝑃 × 𝑄

𝑇𝑅 = 𝑄 (𝑎2 − 𝑏𝑄)

𝑇𝑅 = 𝑎2 𝑄 − 𝑏𝑄 2

𝑑𝑇𝑅
𝑀𝑅 =
𝑑𝑄

14
 𝑀𝑅 = 𝑎2 − 2𝑏𝑄

Profit is maximized at MR = MC, where MR is given above and MC = c

𝑎2 − 2𝑏𝑄 = 𝑐

𝑎2 −𝑐
Equilibrium quantity in summers is 𝑄 = 2𝑏

Equilibrium price in summers can be found by plugging this value in the demand function; P = a2 – bQ

𝑎2 − 𝑐
𝑃 = 𝑎2 − 𝑏( )
2𝑏

𝑎2 + 𝑐
𝑃 =
2

15
Problem 7 [12 points]

Consider the labor market and specifically the demand and supply for unskilled workers. Assume that the
market is competitive. The labor supply and labor demand curves are as follows:
Ls = 10W – 1,000
Ld = 3,000 – 10W
Where, L is measured in terms of number of workers and W is the wage rate paid to each worker per day
(in Rs).

a. What is the market clearing wage and employment that would exist in equilibrium? [1 point]

b. The current minimum wage for unskilled workers is Rs 180 per day. What impact does this minimum
wage on the market? [1 point]

c. The government is considering increasing the minimum wage to Rs. 220 per day. Calculate the impact of
the proposed minimum wage on the quantity of labor that will be demanded and supplied at this revised
minimum wage. [2 points]

d. Calculate the producer surplus (workers’ surplus) at the market clearing wage rate and under the
proposed Rs 220 minimum wage. [2 points]

e. What is the effect of the proposed minimum wage on individual workers vis-à-vis the net effect on
unskilled workers as a whole? No additional calculations are required to answer this part of the question.
Explain your answer in no more than 1-2 sentences. [2 points]

f. How would this minimum wage policy differ from a minimum support price program for workers. Support
prices are often used in agriculture but if a similar program was operationalized in the labor market would
your answer to part (d) change? No additional calculations are required to answer this part of the question.
Explain your answer in no more than 1-2 sentences. [2 points]

g. Are either of the policies (minimum wage or price support) efficient from an economist's point of view? No
additional calculations are required to answer this part of the question. Explain your answer in no more than
1-2 sentences. [2 points]

Answer:
a.
Equate LD to Ls:
3000 – 10W = 10W – 1000
20W= 4000
W* = Rs 200 per day [0.5 point]
L* = 3000 – 10(200) = 1000 workers
Or, L* = 10(200) – 1000 = 1000 workers [0.5 point]

b.
No effect of minimum wage because Rs 180 is lower than W*. [1 point]

16
Or, A minimum wage of Rs 180 per day would not be binding, and therefore the market would attain its free
market equilibrium. [1 point]

c.
At the Rs 220 proposed minimum:
LD = 3000 - 10(220)
LD = 800
LS = 10(220) - 1000
LS = 1200

Ld = 800 and Ls = 1200 [2 points]

The new minimum wage would create unemployment of 400 workers. [2 points]

d.
Rewrite LS and LD with W on left-hand side:
LD = 3000 – 10W
Or, W = 300 – 0.1 LD
LS = 10W – 1000
Or, W = 100 + 0.1 LS

wage

300

220

200

180

100

800 1000

Original producer surplus at market clearing wage:

Old P. S. = 0.5 × (200 – 100) × 1,000 = 50,000 [1 point]
Determine reservation wage when there are 800 workers in the market
W = 100 + 0.1(800)
W = 180
Producer surplus at Rs 220 wage:
New P. S. = 0.5 × (180-100) × 800 + (220-180) × 800 = 64,000 [1 point]

17
PS at original market clearing wage is Rs 50,000 and PS under proposed minimum wage is Rs 64,000. [2 points]

Or,

Workers as a whole have been made better off as indicated by the increase in producer surplus by Rs. 14,000 [2
points]

e.
Individual workers who are displaced from labor force are worse off. Thus, some individual workers might suffer
but overall, workers as a group benefit because the net change in producer surplus is positive. [1 point for yes/no, 1
point for explanation]

f.
Under minimum support price program, all workers would be better off unambiguously but that is not the case with
minimum wage.

Or,

This policy differs from agricultural supports in that government does not buy up the surplus. When government
buys the surplus, every producer is better off from the policy. [1 point for yes/no, 1 point for explanation]

g.
No, there is a loss in consumer surplus (employer surplus) that has not been calculated. When the loss in consumer
surplus is accounted for, it is apparent that there is a deadweight loss from the minimum wage.

Or,

Any intervention that takes market away from W* and L* (the market clearing wage and employment) is inefficient
because it imposes a deadweight loss.

[1 point for yes/no, 1 point for explanation]

18