Answer for Homework #2 of Managerial Economics

1. Consider the market for minivans. For each of the events listed here, identify which
of the determinants of demand or supply are affected. Also indicate whether demand
or supply increases or decreases. Then draw a diagram to show the effect on the price
and quantity of minivans.
(A)people decide to have more children.
(B)Engineers develop new automated machinery for the production of minivans.
(C)The price of sports utility vehicles rises.
(D)A stock-market crash lowers people's wealth and a strike by steelworkers raises
steel prices.
Answer:
(A) Demand increases, so the price rises and the quantity rises.
(B) Supply increases, so the price falls and the quantity rises.
(C) Demand increases, so the price rises and the quantity rises.
(D) Demand decreases and supply decreases, so the quantity certainly falls and the
change in the price is ambiguous.
2.A survey shows an increase in drug use by young people. In the ensuing debate, two
hypotheses are proposed:
Hypothesis I: Reduced police efforts have increased the availability of drug on the
street.
Hypothesis II: Cutbacks in education efforts have decreased awareness of the dangers
of drug addiction.
(A)Use supply-and-demand diagrams to show how each of these hypotheses could
lead to an increase in the quantity of drugs consumed.
(B)How could information on what has happened to the price of drugs help us to
distinguish between these explanations?
Answer:
(A) Hypothesis I: Supply increases and the supply curve shifts to the right, so the
price falls and the quantity rises. Hypothesis II: Demand increases and the demand
curve shifts to the right, so the price rises and the quantity rises.
(B) Hypothesis I: the price falls; Hypothesis II: the price rises.

3.Explain why the following might be true: A drought around the world raises the
total revenue that farmers receive from the sale of grain, but a drought only in Kansas
reduces the total revenue that Kansas farmers receive.
Answer: The demand for the world grain is relatively inelastic, while the demand for
the Kansas grain is relatively more elastic. As a worldwide drought reduces the supply
of the world grain, the world price of grain rises significantly and the quantity of grain
falls insignificantly. Therefore, total revenue that world farmers receive rises. On the
other hand, as a drought only in Kansas reduces the supply of Kansas grain, the price
of grain rises insignificantly and the quantity falls significantly. Therefore, total
revenue that Kansas farmers receive falls.
4.Congress and the president decide that the United States should reduce air pollution
by reducing its use of gasoline. They impose a $0.50 tax for each gallon of gasoline
sold.
(A)Should they impose this tax on producers or consumers? Explain carefully using a
supply-and-demand diagram.
(B)If the demand for gasoline were more elastic, would this tax be more effective or
less effective in reducing the quantity of gasoline consumed? Explain with both words
and a diagram.
(C)Are consumers of gasoline helped or hurt by this tax? Why?
(D)Are workers in the oil industry helped or hurt by this tax? Why?
Answer:
(A) Both ways lead to the same results.
(B) More effective in reducing the quantity of gasoline consumed
(C) Hurt, because consumer surplus certainly falls due to this tax.
(D)Hurt, because the reduction in the sale quantity of gasoline results in a decrease in
the demand for workers in the oil industry. Therefore, the wage that workers receive
falls and the employment falls as well.
5.Qantas operates a fleet of over 100 Boeing jet aircraft. Commercial passenger jets
must be operated by a pilot and co-pilot. Many jets carry cargo in their "bellies",
under the passenger seating areas. Consider each of the following costs. Identify
which are joint costs of passenger and belly cargo services, which are fixed costs of
passenger service, and which are both.
(A)Cockpit personnel: All jets, large and small, require a pilot and co-pilot. Belly
cargo service requires no additional officers in the cockpit.

(B)Airport landing fees: Some airports charge landing fees by weight of the aircraft,
while others levy a fixed fee, regardless of weight.
(C)Fuel: Larger aircraft and those carrying heavier loads will consume relatively more
fuel.
Answer:
(A) Joint cost, and also a fixed cost.
(B)If the landing fee varies with weight, then it is not joint or fixed. If a jet carries
an additional 100 pounds of cargo, the airline must pay additional fees. Similarly, if
the jet carries an additional passenger.
If the landing fee is fixed, then it is a joint
cost and a fixed cost.
(C)Neither a joint cost, nor a fixed cost. If a jet carries an additional 100 pounds of
cargo, the airline must spend more on fuel. Similarly, if the jet carries an additional
passenger.

6.In the 1970s, members of OPEC decided to raise the world price of oil to increase
their incomes. These countries accomplished this goal by jointly reducing the amount
of oil they supplied. From 1973 to 1974, the price of oil rose more than 50%. Then a
few years later, OPEC did the same thing again. From 1979 to 1981, the price of oil
approximately doubled. Yet, OPEC found it difficult to maintain a high price. From
1982 to 1985, the price of oil steadily declined about 10% per year. In 1990, the price
of oil was back to where it began in 1970, and stayed at that low level throughout
most of the 1990s. Use the demand-and- supply diagrams to show the short run and
long run effects of the reduction in the oil production.
Answer: The short-run demand for oil is inelastic (Short-run demand curve is steeper),
while the long-run demand for oil is more elastic (Long-run demand curve is flatter or
even flat). As the supply of oil decreases, the price rises significantly in the short run.
However, the price falls back to almost the original level in the long run.
7.Typical real-estate broker: "In California, the seller always pays the broker's
commission, so, buyers get brokerage services free."
MBA: "If the custom were for the buyer to pay the commission, then would sellers
get brokerage services free?"

Real-estate broker, clearly losing patience: "That is a purely hypothetical scenario, but
if that situation were to arise, yes, I guess you're right."
(A)Assume that each seller pays a brokers' commission of $18,000. Then, the
supply of houses includes the cost of brokerage. Illustrate the market equilibrium
with a price of $310,000 per house and sale of 200,000 houses a year.
(B)Now suppose that buyers rather than sellers pay the $18,000 commission. Using
your figure, illustrate the following: (i) shift the supply curve down by $18,000 since
sellers do not pay the commission, and (ii) shift the demand curve down by $18,000
since buyers now pay the commission.
(C)Compare the market equilibria of (A) and (B) in terms of (i) the net price received
by sellers, and (ii) the net price paid by buyers. (Net prices are net of brokerage
commission, if any).
Answer:
The net price would not be affected for either buyer or seller.

price ($000)

310

(b)(i) supply
curve shifts down

(b) (ii) demand

200

Quantity (000
houses per year)

8.In 2004, U.S. consumer products manufacturers distributed 27.548 billion coupons,
with a face value of over $280 billion, of which a mere 1.2% were redeemed by
consumers. Why do manufacturers spend millions of dollars to distribute coupons
when the redemption rate is so low? Why dont they manufacturers directly cut the
wholesale prices of the products, which would be much cheaper to administer?
(A)Some say that retailers would absorb a direct wholesale price cut instead of
passing it on to consumers. They argue that, by contrast, retailers cannot absorb the
value of coupons. Suppose that the retail sector is perfectly competitive. Compare
the demand-supply equilibrium in the retail market with (i) a wholesale price cut of
50 cents and (ii) widespread distribution of 50-cent coupons. For this part, you

should apply the analysis of tax incidence from chapter 6, treating a price cut or
coupon like a negative tax, and may assume that all consumers use coupons.
(B) Would there be any difference between the wholesale price cut and using
coupons if the retailer were a monopoly? (Continue to treat a price cut or coupon
like a negative tax, and assume that all consumers use coupons.)
(C)Explain how coupons may be used to discriminate among consumers on price.
Compare this explanation to the argument that retailers would absorb a wholesale
price cut.
Answer:
(A)Competitive retail market (i) The 50-cent wholesale price cut will shift down
the retail supply curve by 50 cents (increase the supply), resulting in a lower retail
price and larger quantity. Referring to the Figure, the original equilibrium is at a.
The new equilibrium is at c, with price P and quantity Q. How much the retail price
falls will depend on the price elasticities of demand and supply. (ii) The issuance of
coupons will affect the demand side. Assuming that all consumers use 50-cent
coupons, this will shift the retail demand up by 50 cents (increase the demand),
resulting in a higher retail price and larger quantity. Referring to the Figure, the
original equilibrium is at a. The new equilibrium is at b, with price P and quantity
Q. The net price to the consumer is P - 50 = P. Comparing (i) and (ii), the final
equilibrium in the retail market will be the same -- the new quantity of sales and the
net price to the consumer will be the same.

cents per unit

original supply
50 cents

p
p
p

supply with wholesale

a
50 cents

demand with coupons

0
quantity

(B)Monopoly retail industry (i) Then, a wholesale price cut would reduce the
monopolys marginal cost by 50 cents. The monopoly would maximize profit at the
sales quantity where the (unchanged) MR = the new MC. The new price is P and
the sales are Q. (ii) Assuming all consumers use the 50-cent coupons, then the
coupons would shift the retail demand up by 50 cents. This would shift up the
monopolys MR by 50 cents also. The monopoly would maximize profit at the sales
quantity where the new MR = the (unchanged) MC.
The new price is P and the
sales are Q. The net price to the consumer is P - 50 = P. The figure shows the
impact on the retail market will be the same -- the new quantity of sales and the net
price to the consumer will be the same. Hence, there is no difference between the
wholesale price cut and using coupons.

cents per unit

p
p
p

original marg. cost

marginal cost after

Q
sales

(C)In reality, not all consumers use coupons. Assuming that consumers with
more elastic demand are more likely to use coupons, the retailer can use coupons
to target a discount (and hence a lower price) at the consumer segment with the
more elastic demand. This is a case of indirect segment discrimination.