Study guide 2 for Microeconomics

1- A. If a price of a product is sold $18 per unit for 600 units( point a), price is pictured in the vertical axes ($18) and quantity is pictured in the horizontal axis (600 units) and the manager wants to reduce the price of the product to $16 per unit and sells 800 units ( point b) to increase the total revenue, what is the effect of

a) A price effect and b) quantity effect?

c) The change in total revenue

Use the same graph as the one in question 1 of the assigned problem.

a) The effect of on total revenue of a price change, holding output constant is the price effect.

That is the price is reduced by $2, = $18 - $16 for each of the 600 units that can be sold at $18. The price reduction effect is -$2 times 600 units = -$1,200, which will reduce total revenue by $1, 200.

b) On the other hand, the effect on total revenue (TR) of changing output, holding the price constant is the quantity effect. From this example, the quantity is increased by 200 units, and each of these extra 200 units can be sold for $16 therefore, the quantity effect 200 times $16 = $3,200. It is clear that the increase in quantity causes total revenue to increase by $3,200

c) The change in total revenue TR after the price decrease ($16 times 800) – TR before the price decrease ($18 times 600), where TR = total revenue. That is $12,800 - $10,800 = $2,000 or the summation of price effect and quantity effect which yields the same result. That is the price effect = - $1,200, and the quantity effect equals an increase of $3,200. Therefore the summation of the two effects (-$1,200 +$3,200) = $2,000. In this case the price elasticity of demand is greater than one therefore the only way to increase revenue is to reduce the price because the quantity effect dominates the price effect and that will lead to an increase in total revenue. However if the manager tries to increase the price total revenue will be reduced.

1- B. Here is another example. If the price of a product is $5 per unit for 1,900 units but the managers wishes to reduce the price from $5 to $3, causing an increase for the quantity to be sold up to 2,100 units for the sake of raising total revenue, what is your suggestion for that action? In other words do you agree or disagree?

Use the same method that is mentioned above to solve this problem.

The change in total revenue from $5 times 1,900, which equals $9,500, to $3 times 2,100, which equals $6,300 is decrease of $3,200. That is $6,300 minus $9,500 = -$3,200.

a) The price effect = -$2 times 1,900 = -$3,800 since price is reduced by $2 for each of the 1,900 units that can be sold at $5.

b) The quantity effect = $3 times 200 = +600, because quantity is increased by 200 units, and each of these 200 additional units can be sold for $3.

c) The total effect of both price and quantity = -$3,800 + $600 = -$3,200. The result shows that it is unwise to reduce the price because the price elasticity is less than one so any reduce in price will lead to a total revenue decrease.

Now by understanding well this concept solve questions 1 and 2 that is due on the coming Tuesday.

The E in question 1) d is elasticity and the small e in the same question number e is also elasticity, however the solution in 1) e is in chapter elasticity handouts. Marginal revenue = the change in total revenue divide by the change in quantity.

For question number 5, you do not need to answer it.

For question 3 by using the information on the table calculate the price elasticity of demand, income elasticity of demand and cross price elasticity of demand. The last column of the table shows the price of related goods.

2- If income elasticity of demand for a good is –2.5 find the change in quantity demanded that will result from a 10 percent decline in income. Classify the good as income inferior or necessity or luxury good.

Ei = Percentage change in quantity demanded divided percentage change in income (that is %D Qd / %DI), where D I is the change in income and DQd is the change in quantity demanded. Ei is given in this example which is –2,5, and the %D I is given, 10 % decline in income,

therefore –2.5 = %DQd / -10 % and %DQd = -10% times –2.5% = 25 %.

This means that as income declines consumers would like to increase more of the lower quality product (an inferior good) and the result is 25% increase in the quantity demanded, so the good must be an inferior good.

3- The product manager for a particular company is planning a 20% increase in the price of the product. If the price elasticity of the product is 0.75 by how much should the manager increase or decrease production?

Since an increase in price will bring about a decrease in quantity demanded, the product manager should decrease production.

That is –0.75 = percentage change in Qd /20% , now solve for the percentage change in quantity demanded( %DQd) = -0.75 times 20% = -15%. Therefore the manager of the product should plan a 15% decrease in production to compensate for the decrease in quantity demanded that will result from the 20 percent increase in price.

4- Now consider this example. A manager of a particular Car dealer expects average household income in a particular are to increase from $25,000 to $28,000 annually when the current recession ends. The increase in income will cause sales to increase from 800 to 1,400 units per month when the average price per car is $15,000. Calculate the income elasticity for the new cars and mention whether they are a luxury commodity or necessity or an inferior.

5- Ei = percentage change in quantity demanded divided by the percentage change in income

Ei = (600/1,100) / (3, 000 / 26,500) = 54.55% / 11.32 = 4.82 it is greater than one so new cars are luxury goods.

6- The manager of a used car dealer in the same city as the above example, expects that the increase in household income will cause a decrease in the demand for used cars assuming that the price for the used cars is $5,500. The sales of used cars fell from 800 cars to 600 cars when income did increase from $25,000 to $28,000. Calculate the income elasticity and whether used cars in this case are inferior goods or luxury goods. Use the arc elasticity.

Ei = (-400/600) / (3,000/ 26,000) = -66.67% / 11.32 = - 5.89, so used cars are inferior goods.

7- Consider an example of cross price elasticity of demand, which are football and soccer (Efs) games. If the price is increased from $9 to $10 per soccer ticket and causes the sales of football tickets (Qf) increases from 48,000 to 50,000, knowing the average football price per ticket is $24.

Compute the cross price elasticity between football and soccer by using the average point formula.

Efs = % DQf / % DPs = (2,000/ 49,000) / (1 / 9.5) =4.08 % / 10.53% =0.39

The cross price elasticity between football and soccer is positive but small, therefore one can conclude that they are substitutes but a week substitute since the elasticity is very small.

Consider a case where the two goods are complementary goods. If the manager of a parking company decides to decrease the price of the parking tickets from $5 to $4 which causes the sales of football tickets from 50,000 to 55,000 as a result of the reduction in parking price. The price of football ticket is $24 on average.

Compute the cross price elasticity between the parking and football and mention whether they are complementary or substitute goods.

Efp = %DQf / %D Ps = (5/52.5) / (-1 / 4.5) = 9.52% /-22.22% = -0.43. The cross price elasticity between football and parking is negative indicating that they are complements but the number is very small meaning that the football fans are not responsive to changes in the price of parking.

8- What is total utility and marginal utility and explain the relationship between them (see the chapter handouts)

9- What is the law of diminishing marginal utility? Again look at the handouts.

10- What does rational behavior mean from the economic viewpoint?

Economists are assuming that individuals are rational in taking their decisions. That means people prefer more to less and will choose to consume goods that will give the highest satisfaction level possible.

The principle of rational choice is that consumers will spend their money only on goods that will give them the most marginal utility per dollar.

11- What is the utility maximizing rule in consumer theory?

When marginal utility per dollar of, say, good X = the marginal utility per dollar of the other good, say Y. At this point, consumers are receiving the maximum satisfaction level of consuming those goods, given their income level and the price of the goods they are consuming.

12- How the principle of diminishing marginal utility explains the law of demand?

The principle of diminishing marginal utility says that as individuals consume more of a product, the marginal utility received from extra unit of the good declines after some point. The law of demand says that as price goes up quantity demanded decreases and vice versa. That is the inverse relationship between the price and the quantity demanded of the product. Consider a case where an individual is enjoying utility maximizing rule. That is Marginal utility per dollar of good X = marginal utility per dollar of good Y, MU_{x /} P_{x =} MU_y / P_{y .}

Now consider a case where the equality does not hold for the above equation. For example suppose the price of good y increases and this will lower the ratio of MU_y / P_{y .} such that the equation will be as MU_{x /} P_x > MU_y / P_y

In order to restore the equilibrium in the equation, think this way: since the price of good y increases the consumer will buy less of good y because it is expensive but the marginal utility of good y increases, so this individual well consume less of good Y and consume more of good X since good X is cheap comparing to Y. When the consumer increases the consumption of good X , the marginal utility will increase decrease because of law of diminishing marginal utility.

This process will continue until the equality is restored. Think in the case where the price of good X increases, what will happen to the consumer equilibrium? Do that.

13- What is a consumer’s income constraint? It is a curve or line that shows the various combinations of goods a consumer can buy with his/her given income.

14- What is the indifference curve? It is a curve that shows combinations of goods that will yield the same satisfaction level. That is the consumer is indifferent consuming any point along the indifference curve.

15- How does marginal rate of substitution relate to marginal utility?

The marginal rate of substitution is the slope of the indifference cure, which is the ration of marginal utilities of the two goods.

16- What is the marginal rate of substitution (MRS between X and Y)?

The marginal rate of substitution is the rate at which an individual is trading off one good for another. Means you are giving up the consumption of some units of one good in order to increase the consumption another good.

17- What is the point of tangency between the indifference curve and the budget line?

The point of tangency between the two indicates consumer equilibrium. That is their tangency shows that the slope of the indifference curve = the slope of the budget line.

The indifference curve shows the willingness of the consumer to buy goods and the budget line shows the ability of the consumer to buy goods so their tangency will give the highest maximum satisfaction level of consuming goods.

18 - Suppose you want to maximize utility Big Macs at $2 a piece and three ice cream cones at $1 a piece. What happens to the number of Big Macs and ice cream cones consumed if the price of ice cream cones rises to 42 a piece? How does this change in consumption account for the law of demand?

If you were maximizing utility, then the initial consumer equilibrium must hold. That is MU of Big Macs / $2 = MU of ice cream cones /$1. If the price of ice cream cones increases then in that case you are no longer maximizing your utility. That is MU of Big Macs / $2 is greater than MU of ice cream cones / $2. In order to maximize your utility after the price increase of ice cream, you consume less of ice cream and that will raise marginal utility of ice cream and you consume more of Big Macs and the marginal utility will decline because of the law of diminishing marginal utility.

Therefore, the marginal utility of ice cream will keep increasing and that of Big Macs will keep declining until the equality is restored. To relate to the law of demand, the price of ice cream relative to Big Macs did increase and therefore the quantity demanded for ice cream did decrease; the price of Big Macs relative to ice cream did fall and as a result the quantity demanded did increase.

Consumer surplus is the difference between the maximum price that an individual is willing to purchase for a product and the actual amount that he/she is paying.

In other words, it is the area below the demand curve and above the price.

We did this staff in the class so I hope you are familiar with it.

The answers of homework II that we did in the class I will put them also in the website in case if you did not attend the class that day. Also I will put consumer choice theory chapter in the home page.

If you have some questions please feel free to email to me or call.

For Tuesday, the first part of the lecture will be production and costs on chapter 9, and some review session for the test.