Finance 30210

Problem Set #2

1) Suppose you are thinking about starting a lawn service in your area. The lawn service market
can be considered perfectly competitive. You own a $200 lawnmower. You have a fixed
cost of $90 (maintenance costs on the mower, etc.). Your variable costs are as follows:

# of Total Variable Fixed Cost Total Average Average Marginal

Lawns Costs Costs Total Variable Costs
Mowed Costs Costs
1 $5 90 95 95 5 5
2 $15 90 105 52.5 7.5 10
3 $30 90 120 40 10 15
4 $50 90 140 35 12.50 20
5 $75 90 165 33 15 25
6 $105 90 195 32.5 17.5 30
7 $140 90 230 32.8 20 35
8 $180 90 270 33.75 22.5 40
9 $225 90 315 35 25 45
10 $275 90 365 36.5 27.5 50

a) Calculate total costs, average total costs, average variable costs, and marginal costs.
b) Suppose that the going rate for lawns is $35 per lawn. How many lawns would you
mow?
At a price of $35, we only want to supply lawns as long as our marginal cost is at or
below $35. In this case, we could supply 7 lawns.

c) Calculate your producer surplus, and your profit. Are you earning economic profit?

# of Marginal Cost Price Producer

Lawns Surplus
Mowed
1 5 35 30
2 10 35 25
3 15 35 20
4 20 35 15
5 25 35 10
6 30 35 5
7 35 35 0
8 40 35 --
9 45 35 --
10 50 35 --
Total 105
 Profit = Total Revenues – Total Costs = (7)(35) – 230 = $15

Not that profit is also producer surplus – fixed cost – 105 – 90 – $15.

$15 of profit would be a ($15/$200)*100 = 7.5% return. Is that a high enough return
to take on the risk involved in mowing lawns? If not, supply will drop and the price
will rise. If it is, then supply will rise and the price will fall.

d) How would your production decision change if the price fell to $20 per lawn?

At a $20 price, only 4 lawns would be supplied.

e) Sketch out your supply curve for lawns.

Price Lawns
Supplied
5 1
10 2
15 3
20 4
25 5
30 6
35 7
40 8
45 9
50 10

Price
20

35

20

Quantity
4 7
2) Explain how each of the following events would influence market prices/quantities
a) The surgeon general announces that eating oranges lowers the risk of a heart attack
(market for oranges)

The announcement should increase demand for oranges. This increase in

demand should raise the market price and increases sales.

Price S

P’

D’
D
Quantity
Q Q’

b) Terrorists destroy a major oil pipeline in Iraq (market for oil)

The drop in supply will raise price and lower sales.

Price S

P’

D
Quantity
Q’ Q
c) Immigration increases in the US by 20% (market for labor – what’s the price here?)

The rise in supply should lower wages (the price of labor) and increase
employment.

Wages S

w’
D
Employment
Q Q’

d) Consumers start getting their news from the internet (market for newspapers)

The drop in demand should lower price and lower sales.

Price S

P’

D
Quantity
Q’ Q
 e) Real income in the US increases (the market for BMW’s)

The rise in income should increase demand for BMWs. This increase in demand
should raise the market price and increases sales.

Price S

P’

D’
D
Quantity
Q Q’

3) Explain how each of the following events would affect the supply curve for education (by
colleges), the demand curve for education (by potential students), total enrollments, and
tuition rates. (Assume a perfectly competitive market). Note that there is not necessarily one
correct answer.
(Note: There is not necessarily one correct answer for these questions. What I am
interested in is that you can recognize how a change in supply or demand influences
market price and market sales)

a) University professors unionize and use their increased bargaining power to increase
their salaries by 20%.

The main question here is: “Can we say that an increase in professor salaries affects
the universities at the margin, or will this simply represent an increase in a fixed
cost”. If costs are affected at the margin, then the increase in costs lowers supply,
raises price, and lowers enrollments.
Tuition S

P’

D
Enrollments
Q’ Q
b) Legislation is passed raising the minimum wage.

The rise in minimum wage will increase costs at the margin. Supply decreases, price
rises, and enrollments drop.

Tuition S

P’

D
Enrollments
Q’ Q

c) Students nationwide file a class action lawsuit charging universities with unfair
tuition policies. The result is that each university nationwide is fined $200M.

In this case, the settlement represents an increase in a fixed cost. No decisions are
affected.

Tuition S

D
Enrollments
Q
 d) Universities increase the availability of student aid.

The availability of aid raises demand. This will raise price and raise enrollments.

Tuition S

P’

D’
D
Enrollments
Q Q’

4) Suppose that you have the following demand and supply curve for rental cars:

Qd = 500 − 2 P
Qs = 100 + 6 P

a) Solve for the equilibrium price and quantity.

Qd = Q s
500 − 2 P = 100 + 6 P
400 = 8P
P = 50
Q = 400

b) Calculate consumer expenditures on rental cars

Expenditures = P*Q = $50*400 = $20,000

5) Suppose that you estimated the following demand curve for footballs.

Q = 400 − 6 P + .005I

Q Represents quantity demanded, P represents price and I represents average income.

You know that the current market price is $50 and average income is $20,000
a) Calculate current demand.

Q = 400 − 6(50) + .005(20000) = 200

b) Calculate the price elasticity of demand.

There are one of two was to do this. First, we could simply alter price by some
percentage, say, 10% and then calculate the new quantity demanded:

A 10% price increase would result in a new market price of $55.

Q = 400 − 6(55) + .005(20,000) = 170

Now, calculate the percentage drop in sales:

 170 − 200 
%∆Q =   * 100 = −15%
 200 

Now, calculate elasticity:

%∆Q − 15
ε= = = −1.5
%∆P 10

Alternative: We can take the definition of elasticity and move some things around:

∆Q
%∆Q Q  ∆Q  P 
ε= = =  
%∆P ∆P  ∆P  Q 
P

The first expression in parentheses represents the change in quantity per dollar
change in price which is the interpretation of the coefficient in front of price on
the demand curve. The second term is the current price and quantity. Plugging
everything in, we get

%∆Q  ∆Q  P   50 
ε= =   = −6  = −1.5
%∆P  ∆P  Q   200 
6) Now, suppose, we know what demand and supply look like for restaurant meals:

Qd = 40 − 2 P + 3I
Qs = 20 + 2 P
Where Q is the number of meals sold (in thousands) per month, P is the average meal price
and I is average income (in thousands). Assume that average income is equal to $20,000.
a) Calculate the equilibrium price and quantity.

In equilibrium, supply will equal demand:

Qd = Qs
40 − 2 P + 3I = 20 + 2 P

Plug in 20 for income and solve for price:

40 − 2 P + 3I = 20 + 2 P
40 − 2 P + 3(20 ) = 20 + 2 P
100 − 2 P = 20 + 2 P
80 = 4 P
P = 20

Now, plug 20 into the supply curve to get sales: Qs = 20 + 2(20) = 60

b) Calculate the elasticity of demand at the equilibrium price.

Just like in question #4:

The first expression in parentheses represents the change in quantity per dollar
change in price which is the interpretation of the coefficient in front of price on
the demand curve. The second term is the current price and quantity. Plugging
everything in, we get

%∆Q  ∆Q  P   20 
ε= =   = −2  = −.67
%∆P  ∆P  Q   60 

c) What effect would a 10% increase in average income have on the price of
restaurant meals?

Repeat part (a) with Income = 22

 40 − 2 P + 3I = 20 + 2 P
40 − 2 P + 3(22 ) = 20 + 2 P
106 − 2 P = 20 + 2 P
86 = 4 P
P = 21.50

Now, plug 20 into the supply curve to get sales: Qs = 20 + 2(21.50) = 63

7) Suppose that we have the following information about wheat production (assume that each
producer will operate at full capacity as long as it is strictly profitable):

Producer Capacity (in Cost per bushel

Bushels)
1 100 $3
2 200 $4
3 200 $5
4 400 $6

Further, we also have some consumer information (Reservation price refers to the
maximum price each consumer would pay). Assume that consumers will make their
full purchase as long as the price is below their reservation price.

Consumer Reservation Price Wheat Purchases (in

Bushels)
1 $2 150
2 $3 170
3 $4 100
4 $5 130
5 $6 200
6 $7 90

a) What should be the market price of wheat?

To answer this question, look at each price and ask yourself how much will consumers be
willing to buy (consumers will buy the full amount as long as the market price is strictly
below their reservation price. If the market price equals their reservation price, they will
buy anywhere from zero to their full amount). For example, if the market price is $5,
consumers five and six will buy their full amounts (for a total of 290). Consumer 4 will
buy anywhere from zero to 130. Therefore the possible range for quantity demanded will
be 290 -420. Next, how much will be supplied at every market price (producers will
supply their full capacity if the market price is strictly above their unit cost. If the market
price is equal to their unit cost, they will supply anywhere from zero to their full
capacity). For example, if the market price is $4, producer 1 will supply 100 and
producer 2 will supply anywhere from zero to 200. Therefore total supply will be
between 100 and 300.

If we do this for all prices, we get the following:

Price Quantity Demanded Quantity Supplied

1 840 0
2 690-840 0
3 520-690 0-100
4 420-520 100-300
5 290-420 300-500
6 90-290 500-900
7 0-90 900
8 0 900

Finally, in equilibrium, quantity supplied should equal quantity demanded, so look at the
chart above and find where the ranges for demand and supply overlap – this happens at a
market price of $5. Below, I have put the chart in graph form. Note that the maximum
consumers will buy at a $5 price is 420.
 Price

2
4 1

Quantity
100 200 300 400 500 600 700 800 900

b) Calculate the profits of the wheat producers

For each produce, profit will be quantity supplied times profit margin per sale:

Producer #1 operates at full capacity of 100 and earns a profit of $2 per bushel
for a total profit of $200 (indicated in the graph above by shaded area 1.

Producer #2 operates at full capacity of 200 and earns a profit of $1 per bushel
for a total of $200 (indicated by shaded area 2 above).

Producer #3 operates at limited capacity (produces 120) and earns a profit of

zero (the market price is equal to unit cost).
8) Suppose that it costs $40,000/yr to get an MBA degree and that non MBAs expect to earn
$60,000/yr while MBAs earn $80,000/yr. Assuming an MBA takes two years to finish and
that all other costs are negligible, are wages and tuitions in equilibrium (i.e. would your
average person strictly prefer one activity (getting an MBA) over another activity (not getting
an MBA?). If not, how will markets adjust?

If we were to calculate the opportunity of getting an MBA, we would include two years worth
of tuition as well as two years of lost wages. If we assume that the value of your time is
$60,000 per year (Non MBA salary), your total opportunity cost would be $200,000.
Therefore, the $20,000 per year extra that an MBA earns would be a 10% return. If that
makes a MBA strictly preferred, everyone would go back to school. With a shortage of Non-
MBAs. The non-MBA salaries would rise, when the new MBAs hit the market, MBA salaries
should fall and with higher demand for business school, tuitions should rise. This would
lower the return to an MBA.

9) Suppose that you are concerned about teenage smoking in the US. You are interested in what
the impact would be if a $1 federal tax was added to each pack of cigarettes sold. You have
the following data available:
• Elasticity of Demand (General Public): -.45
• Elasticity of Demand (Teenagers): -.7
• Elasticity of Supply: 7.0
• Current Market Price of Cigarettes: $5.51
• Current Cigarette Sales: 17.4B

a) First, we need to estimate the model. We are using a simply supply/demand

framework:

Qd = a − bP
Qs = c + dP

Use the data above (use elasticity for the general population) to find the parameters
a,b,c, and d.

From the notes, we have:

 Q  17.4 
b = ε d   = −.45  = −1.42
P  5.51 
a = Q + bP = 17.4 + 1.42(5.51) = 25.2
Q  17.4 
d = ε s   = 7  = 22.1
P  5.51 
c = Q − dP = 17.4 − 22.1(5.51) = −104.4

b) Using your estimated model, solve for the equilibrium price and quantity. We
already know this, but you should double check to make sure you did part (a) right.

So the model we have is:

Qd = 25.2 − 1.42 P
Qs = −104.4 + 22.1P

Set demand equal to supply and solve for price:

25.2 − 1.42 P = −104.4 + 22.1P

129.6 = 23.52 P
P = 5.51
Q = 25.2 − 1.42(5.51) = 17.4

Good. We got what we should!

c) To put in the effect of the tax, we need to do the following:

1 c
• We have Qs = c + dP . Now, solve this for price: P =  Qs −  
d  d 
1 c
• Now, add in the tax: P =  Qs −   +$1
d  d 
• Now, Take the above and solve for Quantity: Qs = (c − d ) + dP

Therefore, our new supply curve is:

Qs = −126.5 + 22.1P

d) Now, use your new supply curve and solve for the new equilibrium price and
quantity. By what percentage do cigarette sales fall?
Now, resolve the model for price and quantity:
 Qd = 25.2 − 1.42 P
Qs = −126.5 + 22.1P

25.2 − 1.42 P = −126.5 + 22.1P

151.7 = 23.52 P
P = 6.45
Q = 25.2 − 1.42(6.45) = 16.04

Note that the price does not rise by the full dollar. Cigarette suppliers absorb some of
the tax by dropping their price a little.
Cigarette sales fall by 6% from 17.4B to 16.04B

e) Given the price increase, by what percentage should teenage smoking fall?

Given a 16% rise in price from $5.51 to $6.45 and an elasticity of demand for
teenagers of -.7, teenage sales fall by -.7*16% = -11%

f) How much would you raise in taxes revenues?

$1 per pack on 16.04B sales = $16.04B