BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY

Smeal College of Business

PRACTICE PROBLEMS

1. You are considering selling a car that you bought five years ago. Which ofthe following should
not be a factor in your decision?

a. the price that you can get for the car

b. the price that you paid for the car

c. the extra space that you will have in your garage if you get rid of the car
d. the loss in convenience from no longer having an extra car
e. any possible future appreciation in the value of the car

2. The Buchanan family has two identical cars. The gas tank of one was filled when the price of
gasoline was low and the other at a time when gas prices were high. If the family is rational,
which car should they take for a weckend drive to view the fall foliage? (Select an answer and
then briefly explain your choice.)

a. The car with the tank filled when the price of gas was low.
b. The car with the tank filled when the price of gaswas high.
c. Either car, it doesn't matter.

d. They should balance the use of gas on the margin by driving each car half way.
3. Stephen has been standing in the liftline for twenty (20) minutes trying to get on the chairlift. He
paid $30.00for a lift ticket which is good for the entire day and has not yet skied. The weather is
getting bad, but if he waits five more minutes he will definitely get on the chair and be able to ski
for twenty minutes. According to the principles of sunk cost and opportunity cost decision
making, and assuming no other considerations affect his decision, which of the following
statements best describes the rationale he should use to decide whether it is worth waiting the
extra five minutes?

a. He should compare the reduction in his satisfaction caused by twenty-five minutes of waiting
andpaying $30.00for a lift ticket to the increase in satisfaction he will get from skiing twenty
minutes.

b. As in (a), he should compare the reduction in satisfaction caused by waiting for twenty-five
minutes and the benefits he will get from skiing twenty minutes, but he should not consider
the cost of the lift ticket since that is good for the whole day.

C. He should compare the reduction in satisfaction he suffers by waiting five more minutes to
the increase in satisfaction of skiing twenty minutes.

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BA533: Economics for Managers THE PENNSYLVANIA STATEUNIVERSITY
Smeal College of Business

d. He should keep waiting and skiing for the rest of the day so that the money he spent on the
lift ticket will not have been a waste.

4. (1) Give an example of a production process in which the short run is less than a month.
(ii)Give an example of a production process in which the short run lasts anywhere from one to
three years

5. Suppose that a firm must pay an annual franchise fee, which is a fixed sum, independent of
whether it produces any output. How does this fee affect the firm's fixed, marginal, and average
costs?

6. According to a 1989 Wall Street Journal article "MCI, in New Phone War Skimish, Files Suit
Over AT&T Ad Claims," MCI was upset with AT&T over allegedly false claims that AT&T's
service is cheaper than MCI's. The following problem looks at some of the pricing issues that
might arise in this industry, as well as a typical consumer choice problem. Suppose that the
typical consumer is a small business, Woodbrook Electronics. Woodbrook uses MCI as their
long-distance carrier andcurrently places 100 calls per month. MCI charges a price of $0.80 per
phone call. Woodbrook used to subseribe to AT&T and placed 90 calls per month at AT&Ts old
rate of $.90 per phone call, but switched to MCI to take advantage of the lower price. In response
to losing customers like Woodbrook, AT&T recently changed its pricing structure to the
following: $1.00 per call for the first 60 calls, $.80 per call for the next 40 calls, and $.50 per call
for allremaining calls.
a. Assuming Woodbrook's demand curve is linear, how many calls would Woodbrook place
under AT&T's new price schedule? lllustrate.

b. At this number of calls, which company is charging the lower marginal price, AT&T or MCI?
c. Taking Woodbrook as a typical customer, and given their consumption choices, which
company is charging the lower average price?

d. Given your answers above, does MCI have reason to be upset with AT&T's advertising?
e. Should Woodbrook consider switching back to AT&T? Why or why not? Illustrate.

7. Major software companies, after years of providing unlimited free telephone technical support for
their products, have recently begun to charge for these services (typically after an initial start-up
period of 90 days). Most companies offer two pricing plans. For instance, Lotus Development
offers users of their spreadsheet software the option of paying either (i) $2.00 per minute for
telephone support or (ii) a $129 flat charge for a year of unlimited tol]-free calls.

a. Consider acustomer with ayearly demand for service support of P= 1|0.1Q, where P is
the price per minute and Qis the number of minutes of calls made per year. How many calls
would this customer make under plan (i)? Why? How many calls would he or she make
under plan (ii)? What would be the annual cost to this customer under each plan? Illustrate.

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BA533: Economics for Managers THE PENNSYLVANIASTATE UNIVERSITY
Smeal College of Business

b. Which plan would this customer choose? Explain.

8. When the price of electricity was incrcased by 8 percent in California, the demand for natural gas
increased by 3.2 percent in the manufacturing sector and by 6.4 percent in the residential sector.
The demand for electric power tools, however, decreased by I percent. What is the cross-price
elasticity of demand between clectricity and

a. natural gas in the manufacturing sector? natural gas in the residential sector? electric power
tools?

b. Are electricity and natural gas substitutes or complements? How about electricity and
electric power tools? Explain.

9. Consider the following three demand curves (where P is in dollars and Q is in units):

(1) Q= 200 P
(2) Q = 100 - 0.5P
(3) Q= 200 - 0.5SP

a. What is the slope of each of these demand curves? (Be specific as to how you define the
slope.)
b. At a price of $20, how do the price elasticities of demand compare across the three demand
curves?

c. A classmate comes to you and asks whether the elasticity of demand is the same as the slope
of the demand curve. What would your answer be?

10. Suppose the Board of Trustees at London Business School wants to raise additional revenues by
increasing fees for students. There are many possibilities, for example, increasing tuition or
increasing prices for housing or textbooks. If the Board's only objective is to increase revenues in
the most efficient manner (that is, they do not consider the consequences of their decisions on
student income), then they should focus on goods where, at current prices

a. demand for the goods is inelastic.

b. demand for the goods is elastic.

c. they already derive a great deal of revenue; these are the settings that hold out the greatest
promise as additional sources of revenue.

d. both demand and supply have approximately the same elasticity.

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BA533: Economics for Managers THE PENNSYLVANIASTATE UNIVERSITY
Smeal College of Business

11. The owner of asoccer team and local stadium has commissioned a study that showed the demand
by fans for stadium seats (per playing date) to be

P=22- 0.2Q,

where P is the average price of a ticket and Q represents the nunber of seats (expressed in
thousands). The local stadiunn seats a maximum of 56,000 per game. The price has been set at
$10 per ticket. (Note: We are assuming for simplicity that all seats are the same in this problem.
The same analysis would apply for cach typeof seat otherwise.)

a. How much revenue does the owner make at the current price?

b. Assuming that the owner is first and foremnost interested in maximizing revenue, has he
overpriced or underpriced tickets?
c. The owner comes to youand says he will give you 10% of any increase in revenues that you
can generate for hinm this coming season. Given that you can only charge a per ticket price,
how much money can you expect to make per game during the coming season?

d. Is there an optimal number of empty seats (per playing date) from the owner's point of view?
If so, what is it?

12. The demand function for compact Hertz rental cars at Boston's Logan Airport has been estimated
to be:

QHC=26.01 +2.45Pcc + 1.82PHS - 3.60PHC

where QHC represents the number of compact cars rented per day by Hertz, Pcc is the average
rental price of competitors' compacts, PHs is the rental price of Hertz's subcompacts, PHC is the
rental price of Hertz's compacts. All prices are in dollars per day. The current rental prices are
Pcc = 24.50, PHs = 21.95, and PHC = 24.95.

a. What are the cross-price elasticities of demand between Hertz's compact cars and their
competitors' compacts? Between Hertz's compact cars and its own subcompacts?
b. Derive an expression for the demand curve for Hertz's compact cars, setting Pcc and Pus to
their current values. What is the slope of the demand curve? What is the price elasticity at
the current price? Does the magnitude of the price elasticity make economic sense?
C. If you had done the demand estimation,are there other variables you would have included in
the demandcurve? Explain.

d. For each of the variables you chose in c., would you expect an increase in the variable to
cause QHc to rise or fal1? Explain your reasoning.

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 BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY
Smeal College of Business

13. The Shamrock

bad year Company,
financially, Theira firn
total in the perfectly
revcnue competitive
is $I10,000, custom
with total fixedjewelry
costs industry,
of $80,000is and
having
totala
variable costs of $120,000. Their financial advisor tells them: "Despite your losses, you should
stay in business in the short-run. Your revenues are more than enough to cover your fixed costs,
which you have to pay anyway, and you still have $30,000 left over to cover some of your
variable costs." Do you agree with this assessment? Why?

ATC=
14. Suppose a chemical firm is producing 100 units of output with MC $8, AVC= $7, and
$9. The prevailing price of the product in the market is $8.50. There are many substitutes for this
firm's product, so that this firm's sales would fall drannatically if it tried to raise the price. In
order to maximize short-run profits (or minimize short-run losses if that is the best the firn can
do) the fin1 should:

increase the selling price to some point above $9.

b. increase its output until MCequals $8.50.

C. shut down production in the short-run since it is losing moncy,

d. reduce its output so as to lower MC, AVC, and ATC and carn an cconomic profit.

15. Which of the following statements about profit maximization and equilibrium in a perfectly
competitive market are necessarily true in a long-run cquilibriun?

i) price cquals the minimum of long-run average totalcost

ii) price equals long-run marginal cost

ii)economic profit is zero

16. What is the difference between economic profit and producer surplus?

17. Suppose wheat farmers are all perfect competitors in the sense that cach of them individually
faces a perfectly elastic demand curve, Is the following statement true, false, or uncertain? Ifa
drought kills half of the wheat crop in Europe, there will be no change in the price per bushel
received by the farmers whose crops survived.

18. In 1976, a frost in Brazil killed over 500 million coffee trces and damaged nany more. A civil
war in Angola, a major supplier of coffee, cut back its crop. And an earthquake in Guatemala
disrupted the flow of coffeefrom this country. In spite of these calamities, these three producers
reported an increase in export earnings fromcoffee sales. On the basis of this information, whiclh
of the following must be true?
es.
a. The demand for coffee is elastic.

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BA533: Economics for Managers THE PENNSYLVANIASTATE UNIVERISTY
Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS
Module 1

1. (b) By the sunk-cost principle, the price that you paid for the car is irrelevant to the decision you are
considering. All the other factors deseribed here affect the current or potential value of the car to you,
which is relevant to the decision to scll it or not. The key idea in this and the next question is that all
cconomic decisions should be forward looking. The price you paid for the car changes nothing in the
future.

2 () By the opportunity cost principle, and the sunk-cost principle, what matters in determining the cost of
something is not how much you paid for it, but how much it willcost to replace. The opportunity cost of
gasoline here the same for both cars as it will cost you the same amount (the new, higher gas price) to
replace the gasoline you use from either car. Therefore the cost of traveling is the same regardless of
which car you use.
3. (c) The sunk-cost principle says that individuals should only consider costs and bencfits they can still
influence wvith their decisions. The 20 minutes already spent in line should not matter to Stephern. It is a
sunk cost. Similarly, he has already paid for the lift ticket and presumably the cost of the ticket cannot be
recovered if Stephen decides not to ski. Hence, the $30 expense is sunk as well. The decision should be
based on costs he can stillinfluence (standing in line for another 5minutes) and the benefits associated
with it (20 minutes of skiing).
4 () Any small business that uses mostly labor and standard equipment would be an example. In particular,
consulting businesses, real estate brokerages and small trucking companies can all expand capacity
relatively quickly. Other service industries take longer to expand (e.g., restaurants) because expansion
requires custom-built physical space.

(i) Any high fixed-cost operation (any heavy manufacturing business) can take from I to 3 (or more)
years to expandcapacity. Steel manufacturing plants for example take several years to build.
5 The franchise fee will raise the firm's total fixed costs. Therefore, it will increase total cost and average
total cost. Marginal cost, total variable cost, and average variable cost will be unaffected in the short run.

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BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY
Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS:
Module 2

6 In this question, make sure you understand each of the following: I) how to derive and
analyze demand
curves; 2) how to graph non-linear pricing schemes; and 3) how to calculate consumer surplus.
a. We have two observations of price and quantity (P =.9, Q 90) and (P=.8, Q = 100).
points on a line we can find the slope of the demand curve (see the graph below): Given two

AP/AQ = (0.9 - 0.8)/(90 - 100) =-0.01.

Using the slope and either of the two given points we can now find the vertical intercept, a:

P=a-0.01Q => 0.9 = a - 0.01(90) => a= 1.8.

Thus the equation of the line (which is the equation of the inverse demand curve on the graph) is:
P= 1.8 - 01Q.

Graphically,
P
$1.8k

$0.9
$0.8

90 100 180 Q

Now we can add AT&T's new pricing scheme to the graph:

$1.8

$1.0
$0.8
$0.5

60 100 130 180

Therefore, under AT&T's new pricing scheme, Woodbrook willplace Q= 130 calls.

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BA533: Economics for Managers THE PENNSYLVANIASTATE UNIVERSITY
Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS:
Module 2

b. With its new pricing schcdule, AT&T 0s charging the lower marginalprice (for this customer) in the
relevant portion of Woodbrook's demand crve, .50 for AT&T, and 80 for MCI.
c. Average P for MCI -Total Expenditure/Q-|,80(100y100|-80
Average Pfor AT&T-|I(60) +.80(40) +.50(30)]/130 107/130-.82
d. AT&T has a slightly higher average price for this consumer. MCIhas reason to be upset with AT&T's
advertising, although it depends on whether AT&T is stating that its prices are lower for some
subscribers or all subscribers.

e. CS with MCI =.5(100)(1.8 - .80) - $50

CSwith AT&T =[.5(100)(L.8-.8) -60(.20)) +1.5(30)(.3)] 38+4.5 $42.50
=> don't switch back to AT&T: even though Q increases, consumer surplus decreases.
7.

a. Under plan(i), the price is $2 per minute. Solving for Q: 2-|| -.1Q=>Q- 90 minutes. The annual
cost (or total expenditure) under this plan would be TE =2(90) =$180. Under plan (ii), there is a $129
flat charge for unlimited calls. In this case, the per-unit price "p" is zero. Solving for Q: 0 - 1l| - 1Q
=>Q= |10. The annualcost is $129,

P/min
($)

TE = $180
90 110
(# of mins)

b. The customer chooses the plan that maximizes consumer surplus:

CSo =.5(90)(11-2)= $405

CS) =.5(| 10)(11) - 129 = $476

Therefore, the customer should choose plan (ii).

8 The cross-price elasticity of demand for good Ywith respect to the price of good Xis:
EYX = %AQ,/%AP.

a. The cross-price elasticity between clectricity and natural gas, commercial 3.2 /8 -0.4; natural gas,
residential =6.4/8 -0.8, electric power tools -1/8 -0.125.

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 BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY
Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS:
Module 2
b. Electricity and natural gas are substitutes (positive cross-price elasticity), while electricity and electric
power tools are complements(negative cross-price elasticity).
9 This question highlights that we draw inverse demnnd curves in which Price is on the
Quantity is on the horizontal axis. The demand curves in the problem are written in the vertical
form Q
axis, and
= a - bP.
The slope of this line is -b. The inverse demand curve would then be P a/b - (1/b)Q,
1b. Eitlher representation of the line is fine; you just have to be clear about which you which has slope -
are using and you
have to be consistent within a given problem.

a. The slopes of the demand curves written as Q = a - bP are -1.0, -0.5 and -0.5,
of the inverse demand curves are -1.0, -2.0, and -2.0, respectively. respectively. The slopes

b. The own-price elasticity is defined as (AQ/AP)(P/Q) = -b(P/Q) where b is the slope of the demand
curve (or l/slope of the inverse demand curve). At P= 20, the elasticities are:

(1) -1.0(20/180) = -0.1|

(2) -0.5 (20/ 90) =-0.||
(3) -0.5 (20/ 190) =-0.053
C. No. The elasticity is defined in percentage terms, not in absolute terms. The elasticity is equal to the
slope, adjusted by the base price and quantity (and also, 1/slope of the inverse demand curve, adjusted
by the base price and quantity). You cannot directly infer the elasticity of demand from the slope ofa
linear demand curve without knowing where you are on that demand curve. For example, demand
curves (1) and (2) have different slopes, but the same elasticity at P- $20, while demand curves (2)
and (3) have the same slope, but different elasticities at P= $20.
10. (a) Total revenue will rise if price is increased for inelastic demand. (The fact that TR is currently high
for a good may not be the best indicator of how revenue will respond to further price increases.)

11.

a. At P =$10, the quantity of tickets demanded is Q= 10 - 50 = 60, in thousands of seats. However.

since the stadium only holds 56,000 people, total revenues are TR =$560,000.
b. He has under-priced tickets. He could sell tickets at higher prices, as indicated by the fact that the
current price of $10 he faces excess demand (60,000- S6,000).

c. The revenue-maximizing price is the midpoint price (half the vertical interceptof the demand curve)
because we are assuming a linear demand curve. More generally, the revenue-maximizing price is the
price at which demand is mit elastic, which happens to be the midpoint for a linear demand curve.
Since thevertical intercept is 22, this means you should charge $ll per seat. At this price, you will
sell 55,000 seats, and generate total revenues of $605,000. Ifthe owner keeps his promise, you should
make 10% of ($605,000 - $S60,000) for each game, or $4500 per game this coming season.

d. The optimal number of empty seats - S6,000 - S5,000 - 1,000. If we allowed you to use more
sophisticated pricing schemes, say non-linear pricing, it might be that the optimal strategy would
involve filling the stadiu (though not necessarily).

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BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY
Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS:
Module 2

12.

a. First, find the current value of Quc, given the data in the problem: QHC = 26.01 + 245(2450) +
1.82(21.9S) - 3.6(24,95) - 36.16. (Note that your answers might be slightly different due to rounding)
Therefore,

Anc. Pc-s24.50 -|.66

APec 36.16

ENC.HS AP,HS 36.16

=|.10

The competitor's compact cars are stronger substitutes for Hertz compact cars than are Hertz's own
subcompacts.
b. Plug in current prices: QHC = 125.98 - 3.60PHC, or PHc = 34.99 -0.278QHC. The slope of the inverse
demand curve (the one with P on the left-hand side) is -0.278, and the slope of the demand curve (the
one with Qon the left-hand side) is -3.60. The elasticity of demand at the current price is [ =
3.6(24.9S/36.16) = -2.48. This indicates that the demand for Hertz compact cars is relatively elastic,
which we would expect. First, there are many other rental car companies that offer substitute compact
cars and second, there are other size cars that can be rented, even from Hertz.
c. With this kind of question, there is of course no one correct answer. Examples would include the price
of taxicab rides, the price of mid-sized rental cars, airfares, the day of the week, the time of year, the
price of gas, and so on. All of these variables (and more) might affect the demand for Hertz compact
car rentals per day.

d. all
Yousubstitutes
need to explain your reasoning in this answe. Taxicab rides, mid-sized rentals and air travel are
for compact car rentals. We would expect their prices, when they go up, to have a
positive effect on the demand for Hertz's compact car rentals. The day of the week and the tine of
year effects would capture high demand during heavily traveled business days (Mondays and Fridays
maybe), and lower activity on weckends, for example. Sinmilarty for seasons. Finally, gas is a
complement for car rentals, and so an increase in its price should reduce the demand for Hertz's
compact cars.

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 BA533: Economics for Managers THE PENNSYLVANIASTATE UNIVERSITY
Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS:
Module 3

13. Disagree. They should shut down because total revenues do not even cover all their variable costs (TR =
$1 10,000 < TVC= 120,000). Another way of saying the same thing is to note that losses are $90,000 if
they stay open and $80,000 if they shut down.
14. (b) In general, you want to set MR = MC. Because this is a competitive firm-which follows firom the fact
that sales would fall dramatically if the firm tried to raise the pricewe know that MR = P. At q = 100,
you are currently at a point where P = $8.50 > AVC = $7.00. Since P > AVC, you don't want to shut
down, Because P> MC = $8.00 and P <ATC= $9.00 (where ATC is AVC + AFC), you are functioning
at a point where you won't cover all your costs. You minimize your losses by increasing output to the
point where MC= P= $8.50. This means you should increase output from 100 to g*, as shown on the
graph below.

MC ATC

9
8.50
AVC

100 q*
15. All of these statements are true in long-run equilibrium. Production should continue increasing to the
point where price equals long-run marginal cost in order to maximize firm profits. Market forces (entry
and exit) will drive the market price to the point of minimum long-run average cost, at which point
economic profits are zero.
16. While economic profit is the difference between total revenue and total cost, producer surplus is the
difference between total revenue and total variable cost. The difference between economic profit and
producer surplus is the fixed cost of production.

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