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2. 1. Decide whether each of the following statements is True, False, or
Uncertain, and give a brief but clear explanation of your answer. (Most of
the credit will be given for the explanation.)
1a) (NOTE: 1a) not covered any more ) The market demand for diamond glazed skillets in
quarter t is described by
ln Qt = 3.60 - .643 ln (Pt) – .231 ln (PCt) + 1.12 ln (It-1) + .646 ln (Qt-1) + et ,
where P is price in dollars (of a standard size skillet), PC is an index of other cookware
prices, I is the average income of the wealthiest households (top 10% of the wealth
distribution) and the “t-1” subscript denotes the previous quarter.
The demand for diamond glazed skillets is price inelastic.
(Note: you do not need to calculate logarithms to answer this question.)
Solution: UNCERTAIN.
This is a dynamic demand equation (note the presence of ln (Qt-1) on the right.) The
SR price elasticity is -.643, so that demand is price inelastic in the short run. The LR
price elasticity is -.643/(1 - .646) = - 1.82, so the demand is price elastic in the long
run.
Common Mistakes :
• Many students did not differentiate between SR and LR own-price elasticities. The
SR elasticity can be read directly from the given equation while the LR elasticity can be
calculated as indicated above.
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3. • Another common mistake was not defining, or incorrectly defining, the SR and LR
elasticities as either elastic or inelastic. Elasticities are elastic when (|E|>1) and
inelastic when (|E|<1).
• Some students discussed elasticities (such as income) other than (own) price elasticities,
and some students mis-identified price elasticity as 0.231 0.646 rather than as –0.643
(SR).
1b) A start-up U.S. biotech manufacturer purchases 30 heavy processing machines, and
may buy more as output increases. These machines are made only in Germany, but
are widely used in the biotech industry. They have an average life of 10 years, and
there is an active resale market. Two years after this purchase, the U.S. imposes a
50% tariff on all imported equipment of this kind. All else equal, the tariff will cause
the biotech firm’s variable costs to rise.
Solution: TRUE.
The machines represent a variable cost, as more machines will be acquired as the
firm’s output increases and there is an active resale market for selling machines if the
firm’s output declines. The tariff raises the market value of the machines, and
therefore raises variable (economic) costs.
Common Mistakes :
• The common mistake here was thinking that the machines would ALWAYS be a fixed
cost for the biotech company. Some people said that while they were probably fixed in
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4. the short run, in the long run all costs are variable so the tariff should be factored in. In
addition, even in the short run, the tariff raises the market value of the machines, which
implies higher opportunity costs, raising the firm's User Cost of Capital, which is a
component of variable costs. The machines would not be sunk costs because there is an
active resale market and the higher market value means that the firm could receive a
higher return than before if it chose to sell. Finally, as the question said, the firm could
buy more if output increased (or sell them if output decreased), implying that it would be
a variable cost.
1c) Your company lost a court case and has to pay $20 for every snowmobile it produces.
The verdict cannot be overturned. That implies that this is a sunk cost and should not
play a role in further decision making.
Solution: FALSE.
The $ 20 fee is charged for each snowmobile to be produced: it is a variable cost of
production and is not a sunk cost.
Common Mistakes :
• The most common mistake was not realizing that the $20 fine per snowmobile was a
variable cost rather than a sunk cost. Sunk costs are unrecoverable and should not
influence future economic decisions. However, the $20 fine varies with output and does
affect future decisions. If the manufacturer does not produce snowmobiles, the $20 cost
is avoided. Alternatively, the manufacturer could increase the price of the snowmobiles
to try to recoup all or part of the $20 cost.
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5. 1d) If you suspect the market for your new product could exhibit positive network
externalities, it makes sense for you to price your product lower at launch than you
normally would. .
Solution: TRUE.
If you suspect that your product will exhibit positive network externalities, you want to set
price and quantity to reflect that an additional unit sold now will add to installed base in
the future, which will increase future revenue. This means that current MR does not
reflect all marginal revenue, and that “current MR = current MC” will result in too low an
output value. For example, in a two period example, the firm should operate in period 1
such that
so that for current values only, we have that MR1 < MC1 so that for current values only,
we have that positive network externality.
Common Mistakes :
• Most people answered this question correctly. Those that did not thought that price
should be higher or that you should wait after the product launch to decrease price. For
network externalities, you price where marginal cost equals the marginal revenue plus the
future benefit (revenue) from production today. Thus, you want to decrease price at the
launch to increase quantity demanded via the bandwagon effect, and reap higher revenues
in the future. You need to consider the effect of future revenues when pricing today which
is why you should lower the price at launch.
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6. 2. Suppose that market for loaves of bread in Freedonia has demand D(p) = 20,000 –
1,000 p and supply S(p) = 1,000 p, where p is price per loaf..
(a) What are the price and total quantity of bread supplied? What are the demand price
elasticity and supply price elasticity at this price?
Solution: The market equilibrium requires 20,000 – 1,000 p = 1,000 p, which gives
p=$10.0. At this price, supply is 10,000 loaves. Price elasticity of demand equals –
b*p/Q = - 1,000 * 10 / 10,000 = -1. Price elasticity of demand equals d*p/Q = 1,000 *
10 / 10,000 = 1.
Common Mistakes :
• Most students correctly answered this question. A few students forgot to compute the
demand and supply elasticities. Some other students forgot that the demand elasticity
was negative (an increase in price results in a reduction in demand), while the supply
elasticity is positive (an increase in price results in an increase in production).
(b) The government of Freedonia imposes a price band : the price of bread cannot be lower
than $1.00 nor higher than $2.00. What are the new price and total quantity supplied?
What is the deadweight loss? How much do producers gain or lose because of the price
band? How about consumers?
Solution: With the price band, the new price is is at the price ceiling $2.00. At this price,
supply is 2,000 loaves.
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7. Note (for further calculation) that the willingness to pay of the marginal consumer who is
still able to buy bread is determined by 20,000 – 1,000 p = 2,000. This implies that
that person’s willingness to pay is $18.00. The deadweight loss is now simply (18-
2)*(10,000-2,000)/2 = 64,000, with $32,000 lost from previous consumer surplus and
$ 32,000 lost from previous producer surplus. In addition, producer’s lose 2,000 * (10 –
2) = $16,000 in surplus on the 2,000 units sold (at $2 instead of $10), so the total loss of
producers is $32,000 + $16,000 = $48,000.
Consumers who can still buy bread gain (10-2)*2,000 = $16,000. The dead weight loss of
$32,000 plus this gain of $16,000 means that overall, consumers lose 16,000.
Common Mistakes :
• Many students did not recognize that the price after the band would be $2. Even at this
price, demand is greater than supply. Hence, if the price were below $2, suppliers would
increase price to better meet demand. Some students also thought that the price band
meant that suppliers could not produce below $1. Most students correctly computed
DWL. However, many students divided the DWL evenly between the change in CS and
PS. This is not a tax and so the pass through formula does not apply. Some students
forgot that the area bound by $2 and $10 for the 2000 loaves of bread sold moved from
producer surplus to consumer surplus.
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8. (c) Due to the introduction of a new technology, the supply curve shifts and becomes S(p)
= 9,000 p. What are the new price and total quantity supplied? What is the
deadweight loss now? How much do producers gain or lose because of the price band
now? How about consumers?
Solution: With the new supply curve, the unrestricted outcome is a price of $2.00 and a
quantity of 18,000. Since $2.00 falls within the price band, the band has no effect.
There is no deadweight loss. Suppliers and consumers get exactly the same surplus
with or without the price band policy.
Common Mistakes :
• As in b), some students did not recognize that the equilibrium price would be $2. Many
students did not recognize that the deadweight loss should be computed for the new
technology with a price band relative to the new technology without a price band. It
does not make sense to compute the deadweight loss of a technology relative to the
absence of a technology. The two scenarios represent different markets. Given that
the band does not modify the equilibrium, one could immediately answer that there
was no DWL and no change in CS/PS.
(d) Give a dollar amount of the value to Freedonia of the new technology described in
part (c), relative to the situation of part (a), absent any government intervention.
Solution: The total worth to society of bread is 10*10,000/2 + (20-10)*10,000/2 =
100,000 under the parameters as described in (a).
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9. Total worth of bread under (b) is 2*18,000/2 + (20-2)*18,000/2 = 180,000. So the
invention is worth 80,000.
Common Mistakes :
• For this question, many students did not recognize that the value to Freedonia would be
the change in total surplus under the two scenarios. The new technology increases the
value to society consisting of both the producer surplus and the consumer surplus. Many
students incorrectly used change in DWL (question specifically says “absent any gov’t
intervention”) or change in suppliers’ revenues (does not include supply curve or change
in consumer surplus) to calculate the value of technology.
3. The rock band Pink Floyd is coming to Boston to perform at Foxboro Stadium once
again (the last time Pink Floyd was in Boston was in the summer of 1994), and you are in
charge of pricing and selling the tickets (assume all seats are the same and you only need
to set a single price). Independent of the number of seats sold, you must pay the
administration of Foxboro Stadium a fixed amount of $ 500,000 (to cover security and
cleaning costs), which represents the only cost. There are 50,000 seats in Foxboro
Stadium.
(a) Based on historical data, you estimate the demand for this event to be is given as
Qd = 80 – .8 P
Where Qd is in thousands of tickets and P is the price per ticket in dollars. What price
P should you charge? How many tickets will you sell and what are your profits?
(Don’t worry if there are empty seats, you can always give those seats away to worthy
charities.) economicshomeworkhelper.com

10. (a) The total cost is $500,000 independent of the number of seats sold (up to
capacity 50,000). The marginal cost is therefore $0 up to capacity and
infinite thereafter. The inverse demand is P=100 – 1.25 Q, which gives
marginal revenue MR=100-2.5 Q. The optimal solution can thus be found by
setting MR=MC=0, which gives Q=100/2.5=40. So we want to sell 40,000
tickets, which requires us to set a price of P=100- 40*1.25= $50. Profit is
then 50*40,000-500,000=1,500,000.
Common Mistakes :
• Failure to recognize this as a monopolist problem, and therefore assuming Qs
= 50,000 and determining equilibrium price from and profit from that, or
setting price = MC.
• Improper calculation of marginal cost. Many confused marginal cost with
average cost, and set MC=$10 (=$500,000 / 50,000 seats). Some thought
the marginal cost was $500,000.
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11. (b) One month prior to the concert, Pink Floyd’s newest album is released, with rave
reviews about how the band is much better than they have ever been before. Because of
this, you now believe that demand will be given as
Qd = 120 – .8 P
Where again Qd is in thousands of tickets and P is the price per ticket in dollars. What
price P should you charge? How many tickets will you sell and what are your profits?
(Again, don’t worry if there are empty seats, you can always give those seats away to
worthy charities.)
Solution: In this case, the inverse demand curve equals P=150-1.25 Q, and thus
MR=150- 2.5 Q. If you solve the problem without taking into account the capacity
constraint, then the optimal quantity of seats to sell is 60,000. This is beyond the
capacity of Foxboro Stadium. This implies that we will set the price such that the quantity
sold is exactly 50,000. (Note, from the figure below, that that is indeed the quantity
where MR=MC.) The price is thus 150-1.25*50 = 87.5. The profit becomes
50,000*87.5500,000 = 3,875,000. Note, for later reference, that MR=25 at Q=50,000.
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12. Common Mistakes:
• Failure to recognize the capacity limitation after calculating the profit maximizing
quantity at 60,000.
• After recognizing the capacity limitation, using $75 price rather than recalculating the
price using the reduced quantity of 50,000.
(c) Suppose with demand as in b), you have the option of adding some temporary seats
on the grass field for $10 a seat (assume these seats have the same view as the other seats
and tickets for them would sell for the same price). Would you add any seats? If so, what
price would you charge, how many tickets would you sell and what would your profits be?
Solution: The MC curve becomes as depicted below. Beyond 50,000 seats, the MC is
thus $10. It follows that we find the optimal quantity by setting MR=MC=10. This gives
150-2.5 Q=10 or Q = 140/2.5= 56. To sell these 56,000 seats, we need to set price at 150-
1.25*56= 80. We will pay $60,000 for the extra seats, so profits become 56,000*80-
500,000-60,000 = 3,920,000.
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13. Common Mistakes:
• Incorrectly assuming that the excess demand calculated in (b) would be the additional
seating you would want. This would only be correct if marginal cost of extra seats stayed
at zero, but the marginal cost increases to $10, and therefore need to reassess MR=MC
to determine Q.
• Incorrectly assume you can price discriminate such that the price of additional seats
would be different that the exiting seats.
• Confused $10 costs of seats with $10 price of seats, i.e., assuming that you would
collect $10 for every additional seat added.
• Failed to account for the variable costs ($10/chair) associated with additional chairs in
the profit calculation.
(d) How would your answer to (c) change if extra seats cost $30 (state in words,
including your reason -- do not do any more algebra)?
Solution: Given that, as we calculated at the end of part b, the MR at 50,000 seats is 25
< 30, we would never want to rent extra seats at that price. The results would therefore
be the same as those we obtained in part b.
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14. Common Mistakes :
• It is difficult to correctly answer this part intuitively if you have not properly
considered the rest of the problem.
• Many students recognized intuitively that if MC rises, quantity would fall, but
were unable to see that the quantity of additional seats would actually be zero at
MC=30.
• Given that price calculated in (c) is still higher than MC of $30, add as many
seats as possible, incorrectly assuming price remains fixed no matter how many
seats you add or assuming demand is infinite.
• Incorrectly assuming that cost of additional seats rises as you add more and
more, thereby recommending the addition of seats until the marginal cost rises
to equal the previously calculated price. • Add no chairs (right answer) because
optimal price was improperly calculated previously at a level below the marginal
cost of $30 (wrong reason).
4. Discuss the following quote: “In any urban area, there is a single market for
local phone calls, regardless of whether they are made using a cellular phone or
a local (conventional) telephone phone.” Be sure to include your criteria for
market definition. Also, indicate whether your view would depend on whether
cellular phone calls have similar prices to those of local (conventional) calls, or
not.
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15. Solution: In this question you give a cogent discussion of whether cellular
phone calls are substitutes for conventional calls in local areas. The first
criterion for defining the market is to ask whether the products in question are
substitutable in the eyes of the buyers. On those grounds, the two types of calls
are imperfect substitutes. They both fulfill needs for communication. Cellular
phone calls provide mobility, convenience and flexibility, but somewhat poorer
sound quality and reliability than conventional phone calls, so they are not
perfect substitutes. A quantitative way to determine whether the two products
are demand substitutes is to check whether the cross price elasticity is positive.
Knowledge that cellular phone calls are priced much higher than conventional
phone calls stresses the imperfections in their substitutability --- as in the ADM
case (with sugar and HFCS), one could argue that consumers who are
indifferent between conventional and cellular calls at similar prices would have
switched to conventional, so that consumers remaining with higher priced
cellular calls do not view them as perfect substitutes for conventional phone
calls.
Common Mistakes :
• Failed to identify key market definition criteria.
• Failure to mention demand and supply substitutability as relevant criteria for
market definition.
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16. • Incorrectly argued for clear supply substitutability – actually, supply
substitutability would be fairly low as telecommunication companies can not
easily deploy the technology infrastructure needed to provide cellular service.
• Failure to mention positive cross-price elasticity as an indication of the
existence of demand substitutability (two products are substitutes).
• Stated that negative cross-price elasticity as an indication that two products
are substitutes – actually, negative cross-price elasticity is an indication that
two products are complements.
• Incorrectly identified cellular and conventional phones as complements or
perfect substitutes – in fact, cellular and conventional phones are imperfect
substitutes as mentioned in the answer key.
• Failed to answer the question regarding price gap between cellular and
conventional phones.
• Failure to identify that price differential of the two products, cellular and
conventional phones, is important in determining market definition.
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