1. This problem is loosely based on homework problem #4 in chapter 3 on D and S but delves much deeper into the implications behind S and D.

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                                                           Examination #1

     

Be brief and to the point. Grade does not depend upon the length of your answer.

 

Note: This first mid-term exam is designed for you to understand efficiency as well as downsides of market economy through S and D.  Your answer should clearly demonstrate your understanding of market economy, not a simple regurgitation of what you read.  

                                  

 

1.      This problem is loosely based on homework problem #4 in chapter 3 on D and S but delves much deeper into the implications behind S and D. 

 

The following relations describe demand and supply.  

 

                                     Qd = 30,000 - 100P

                                     Qs  = -10,000 + 100P

 

     Where P is the price in dollar and Q is quantity in unit.

Find the market clearing (equilibrium) price and quantity algebraically and show them graphically using S and D curves. A free hand graph instead of excel (be sure to be in PDF) will do as long as you identify clearly market clearing P and Q.

What would be the quantity demanded and the quantity supplied when P = $110?

Why is demand curve negatively sloped whereas is supply curve positively sloped? What is the implication behind negatively sloped demand curve and positively sloped supply curve respectively?

What would happen to price in (b) and explain why the price of $110 could not be sustained in view of the market clearing P and Q in (a)? Incorporate short run rationing function of price in your answer.

Suppose this is prescription drug that a terminally ill patient desperately needs. If P of $110 is the only price the patient can afford to pay, would the patient be able to get it and why or why not? What is the downside of market economy in this connection?

What would be the quantity demanded and supplied when P = $290.  

What would happen to price in (e) and explain why the price of $290 could not be sustained in the same fashion as you did in (c). Incorporate short run rationing function of price in your answer as you did in (c).

During the reconstruction period of Iraq, US government awarded a contract at P = $290 without an open bidding process. In view of the market clearing price in (a), what is negative implication of such a non-bidding contract at P = $290 in terms of market efficiency?  

At what price would the demand be zero and at what price would supply be zero?

What does the spread between two prices (the price where quantity demanded is zero and the price where quantity supplied is zero) imply in this market? Explain clearly.

Calculate the price when the quantity demanded is 1,000 units and also the price when the quantity supplied is 1,000 units.  

 

Following questions are designed to understand the rationale behind market clearing quantity.  

 

Plot the price for 1,000 units of quantity demanded and the price for 1,000 units of quantity supplied in (j) on the same diagram in (a). Would there be buyers for the quantity of 1,000 units and would be sellers for the quantity of 1,000 considering the market clearing P and Q you got in (a)? Provide the basis of your answer with numerical support. How about 5,000 units? What is the difference in your numerical support for the case of 1,000 units and 5,000 units?

Using the rationale you used in explaining why there are buyers and sellers for 1,000 and 5,000 units in (k), explain why eBay emerged. Ability to get the best deal is not the answer since it could happen at any yard sales on weekend. Remember eBay emerged only after a wide use of internet to expand the benefits of S and D. Case in point: someone bought a grilled cheese at a price more than $1,000 on eBay simply because it [grilled cheese] looked like Virgin Mary, a true story. In free market economy, market is non-judgmental indeed.

Using the price you got in (j) for the quantity demanded of 1,000, calculate the quantity supplied at the price. Explain why this quantity will not be sold in view of market clearing and quantity obtained in (a). On the other hand, the quantity of 1,000 above will be sold in view of market clearing P and Q obtained in (a).  Provide numerical support for your answer for the two cases above.   

Would there be “buyer’s remorse” at Q = 1,000?  How about at Q = 19,000? Be sure to understand what does “buyer’s remorse” means. This is why we have a generous return policy in retail sale such as in Kohl.

Explain why the market clearing price and quantity obtained in (a) is Pareto’s optimum whereas quantities of 1,000 and 19,000 are not Pareto optimal, i.e.  Pareto’s inefficiency and why? Use your understanding of Pareto’s optimality why market economy is truly efficient. In the past students regurgitate what they found about Pareto’s optimality on internet without really understanding it.  

Explain why market efficiency alone is not enough to improve welfare of a society? Give a specific example. Hint: consider your answer in (d).

Suppose the demand for the product in question increases, which leads to a new demand equation given below (i.e. a shift in demand)  

 

                              Qd =  = 35,000 - 100P

 

Find new market clearing price and quantity using new demand equation given above and the old supply equation. Show the result in the same graph with the market clearing price and quantity you obtained in question (a).   

r. Compare the new market clearing price and quantity to the one in (a) and discuss how does market eliminate the resulting disequilibrium (surplus or shortage). Also explain how sellers (or producers) would make a short run adjustment in quantity so that new market clearing is achieved. Use short run rationing function of price again in its adjustment process.

s. Below is the new (increased) supply equation (i.e. a shift in supply). Find new market clearing price and quantity using the new supply equation above and the new demand equation in (q).

 

                               Q= -5,000 + 100P

 

Compare the new market clearing price and quantity above to that in (q) and discuss disequilibrium adjustment process in terms of long run adjustment by sellers (or producers).  Incorporate long run rationing function of price.

t. Discuss the difference in the role of price in taking care of shortage/surplus in short run in (r) v. scarcity/abundance in long run in (s).

u. Briefly explain how Wal-Mart created a shift in demand as in (q) by building its first Wal-Mart in a small town, Bentonville, AR, and then how did they engineer shifts (increase) in supply in (s), which made Wal-Mart the world largest retailer.  

v. Please return to the original supply and demand equation at the beginning. Because of entry of foreign suppliers into the market, now supply curve shifted to: This question covers the issues associated with outsourcing.

 

                                                 Qs = 8,000 + 100P

 

There is no change in the original demand equation. Find the new market clearing price and quantity and compare them to (a) at the beginning of the question. What happens to price and quantity demanded in this country and the quantity supplied by the domestic suppliers in such an open economy? How much is imported?

      w. Who benefits and who loses as a result of this open economy in this country focusing on this economy and ignoring foreign countries. Is there any net gain as a result of open economy in this country and why?

     x. Explain how the impact of outsourcing covered in (v) and (w) is Pareto’s optimal in spite of negative impact of outsourcing has on domestic suppliers above?

     y. Suppose the original demand and supply equation at the beginning describe hypothetical demand and supply equations of market for human organ (kidney). Because of moral implication of such a human organ market, supply is limited in our society by voluntary donation, which will be 1,000 kidneys in this case. Remember that Q of 1,000 is considered to be Pareto’s inefficient earlier. What would be the benefits lost for kidney patients relying upon donated kidneys, which creates perennial problem of kidneys shortage ignoring negative moral implication behind such a market for human organ. Use the same numbers used in your answer in (k).

 

 

 

2.      The following is a full-blown demand equation for Pizza. This problem is loosely based on problem #6 of Joy’s Frozen Yogurt of chapter 3 on D and S.

 

QD =  - 200P + 1.5Phd - 5Psd + 20A + 15Pop

P =  Price of pizza

Phd = Price of hot dogs ($2.00, use 200 cents)

Psd = Price of soft drink ($1.50, use 150 cents)

A =  Advertising 40 ($40,000, use 40)

Pop = Percentage of population for pizza, 70%, using 70

 

  1. Interpret all the coefficients in the above demand equation and then find the reduced demand equation, Q in terms of P only assuming the above values of non-price determinants. What does the constant term in this reduced demand equation (Q in terms of P only) represent?

 

  1. At a price of $5, what is price elasticity? Based upon the price elasticity you got at P = $5.00, is it better to reduce price or raise price and why or why not?

The price elasticity is given by the formula (dQ/Q) / (dP/P) = dQ*P/dP*Q = (dQ/dP)*(P/Q)

dQ/dP = -200 and P/Q = 5/1000, so the price elasticity is -1

Because revenue is maximized at unit elasticity, and because we are at unit elasticity, the price should not be reduced nor raised as it is already at its maximum value. Thus, it is neither better to raise nor reduce the prices; the firm should just keep on doing what it is doing.

 

  1. How far further down from the current price of $5.00 could you reduce the price without hurting revenue? (i.e., MR should not be negative). Find that price level and then express this price reduction in percentage using $5.00 as base.

Total revenue is at a maximum at unit elasticity, which is the point we operate at with a price of $5. As such, any movement from this price-point would reduce marginal revenue and thus we cannot change the price without reducing marginal revenue. Thus, the price reduction that we could do would be 0%, since any movement would reduce marginal revenue.

 

  1. Compute the cross elasticity between hot dog/pizza as well as soft drink/pizza using Q you found in (b) and interpret the results. Please read my elasticity comments on my answer file for homework problems of chapter 3.
  2. If price is reduced further from $5.00 by the percentage you got in (c), compute the impact of this further price reduction on soft drink and hot dog using the cross elasticity figures you got in (d) and interpret the results. You may consider soft drink may include alcoholic drink such as beer/wine.
  3. Is it a good idea to reduce price further based upon your answer (e)? Why or why not?
  4. With the advertising budget of $40,000 (use 40), calculate the elasticity of advertising using Q you obtained in (b)? Interpret the result. What would happen to a constant term in a new reduced demand equation as a result an increase in advertising budget?

(dQ/dA) * (A/Q) = Advertising Elasticity
dQ/dA = 20
A/Q = 40/1000
Advertising Elasticity = 600/1000 = .6

Remember that elasticity is also represented by (dQ/Q)/(dA/A), or the change in quantity over the change in advertising. Because the elasticity is less than one, that means the change in advertisement must be greater than the change in quantity; thus, the advertising is not worth it because it costs more than it yields. We should only advertise more when the elasticity is above 1, and should stop advertising elasticity is 1. When the elasticity is below 1, we should advertise less. If the advertising budget increased, the reduced demand function would shift up, because for every price the constant would be higher, yielding a higher quantity. The reduced demand curve would shift up by the exact change in the advertising budget.

 

 

  1. Due to the health consciousness on the part of the population concerned, there is 10% drop (use 10) in the pizza population from 70%. What would be its impact on the demand?
  2. How much would the advertising expenditure have to be increased to compensate for the drop in population?
  3. Do you think the above increase in the advertising expenditure is worthwhile or not? Provide number for your argument.
    • 8 years ago
    This problem is loosely based on homework problem #4 in chapter 3 on D and S but delves much deeper into the implications behind S and D.
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