BU 5210Ex1Economic Analysis Winter 2014-15Examination #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 wellas downsides of market economy through S and D. Your answer should clearlydemonstrate your understanding of market economy, not a simple regurgitation ofwhat you read.1. This problem is loosely based on homework problem #4 in chapter 3 on D and S butdelves much deeper into the implications behind S and D.The following relations describe demand and supply.Qd = 30,000 – 100PQs = -10,000 + 100PWhere P is the price in dollar and Q is quantity in unit.a. Find the market clearing (equilibrium) price and quantity algebraically and showthem graphically using S and D curves. A free hand graph instead of excel (be sureto be in PDF) will do as long as you identify clearly market clearing P and Q.b. What would be the quantity demanded and the quantity supplied when P = $110?Why is demand curve negatively sloped whereas is supply curve positivelysloped? What is the implication behind negatively sloped demand curve andpositively sloped supply curve respectively?c. What would happen to price in (b) and explain why the price of $110 could not besustained in view of the market clearing P and Q in (a)? Incorporate short runrationing function of price in your answer.d. Suppose this is prescription drug that a terminally ill patient desperately needs. IfP of $110 is the only price the patient can afford to pay, would the patient be ableto get it and why or why not? What is the downside of market economy in thisconnection?e. What would be the quantity demanded and supplied when P = $290.f. What would happen to price in (e) and explain why the price of $290 could not besustained in the same fashion as you did in (c). Incorporate short run rationingfunction of price in your answer as you did in (c).g. 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 ofmarket efficiency?h. At what price would the demand be zero and at what price would supply be zero? 1 i. What does the spread between two prices (the price where quantity demanded iszero and the price where quantity supplied is zero) imply in this market? Explainclearly.j. Calculate the price when the quantity demanded is 1,000 units and also the pricewhen the quantity supplied is 1,000 units.Following questions are designed to understand the rationale behind marketclearing quantity.k. Plot the price for 1,000 units of quantity demanded and the price for 1,000 units ofquantity supplied in (j) on the same diagram in (a). Would there be buyers for thequantity of 1,000 units and would be sellers for the quantity of 1,000 consideringthe market clearing P and Q you got in (a)? Provide the basis of your answer withnumerical support. How about 5,000 units? What is the difference in yournumerical support for the case of 1,000 units and 5,000 units?l. Using the rationale you used in explaining why there are buyers and sellers for1,000 and 5,000 units in (k), explain why eBay emerged. Ability to get the bestdeal 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 benefitsof 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 truestory. In free market economy, market is non-judgmental indeed.m. Using the price you got in (j) for the quantity demanded of 1,000, calculate thequantity supplied at the price. Explain why this quantity will not be sold in view ofmarket clearing and quantity obtained in (a). On the other hand, the quantity of1,000 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.n. Would there be “buyer’s remorse” at Q = 1,000? How about at Q = 19,000? Besure to understand what does “buyer’s remorse” means. This is why we have agenerous return policy in retail sale such as in Kohl.o. Explain why the market clearing price and quantity obtained in (a) is Pareto’soptimum 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 whymarket economy is truly efficient. In the past students regurgitate what they foundabout Pareto’s optimality on internet without really understanding it.p. Explain why market efficiency alone is not enough to improve welfare of asociety? Give a specific example. Hint: consider your answer in (d).q. Suppose the demand for the product in question increases, which leads to a newdemand equation given below (i.e. a shift in demand)Qd = = 35,000 – 100PFind new market clearing price and quantity using new demand equation given aboveand the old supply equation. Show the result in the same graph with the marketclearing price and quantity you obtained in question (a). 2 r. Compare the new market clearing price and quantity to the one in (a) and discusshow does market eliminate the resulting disequilibrium (surplus or shortage). Alsoexplain how sellers (or producers) would make a short run adjustment in quantity sothat new market clearing is achieved. Use short run rationing function of price again inits adjustment process.s. Below is the new (increased) supply equation (i.e. a shift in supply). Find newmarket clearing price and quantity using the new supply equation above and the newdemand equation in (q).QS = -5,000 + 100PCompare the new market clearing price and quantity above to that in (q) and discussdisequilibrium adjustment process in terms of long run adjustment by sellers (orproducers). Incorporate long run rationing function of price.t. Discuss the difference in the role of price in taking care of shortage/surplus in shortrun 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 itsfirst 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. Becauseof entry of foreign suppliers into the market, now supply curve shifted to: Thisquestion covers the issues associated with outsourcing.Qs = 8,000 + 100PThere is no change in the original demand equation. Find the new market clearing priceand quantity and compare them to (a) at the beginning of the question. What happens toprice and quantity demanded in this country and the quantity supplied by the domesticsuppliers in such an open economy? How much is imported?w. Who benefits and who loses as a result of this open economy in this countryfocusing on this economy and ignoring foreign countries. Is there any net gain as aresult of open economy in this country and why?x. Explain how the impact of outsourcing covered in (v) and (w) is Pareto’s optimal inspite of negative impact of outsourcing has on domestic suppliers above?y. Suppose the original demand and supply equation at the beginning describehypothetical demand and supply equations of market for human organ (kidney). Becauseof moral implication of such a human organ market, supply is limited in our society byvoluntary donation, which will be 1,000 kidneys in this case. Remember that Q of 1,000is considered to be Pareto’s inefficient earlier. What would be the benefits lost for kidneypatients relying upon donated kidneys, which creates perennial problem of kidneysshortage ignoring negative moral implication behind such a market for human organ. Usethe same numbers used in your answer in (k). 3 2. The following is a full-blown demand equation for Pizza. This problem is looselybased on problem #6 of Joy’s Frozen Yogurt of chapter 3 on D and S.QD = – 200P + 1.5Phd – 5Psd + 20A + 15PopP = Price of pizzaPhd = 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 70a. Interpret all the coefficients in the above demand equation and then find thereduced demand equation, Q in terms of P only assuming the above values ofnon-price determinants. What does the constant term in this reduced demandequation (Q in terms of P only) represent?b. At a price of $5, what is price elasticity? Based upon the price elasticity you got atP = $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 -1Because revenue is maximized at unit elasticity, and because we are at unit elasticity, the priceshould not be reduced nor raised as it is already at its maximum value. Thus, it is neither better toraise nor reduce the prices; the firm should just keep on doing what it is doing. c. How far further down from the current price of $5.00 could you reduce the pricewithout hurting revenue? (i.e., MR should not be negative). Find that price leveland 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 wecannot change the price without reducing marginal revenue. Thus, the price reduction that wecould do would be 0%, since any movement would reduce marginal revenue. d. Compute the cross elasticity between hot dog/pizza as well as soft drink/pizzausing Q you found in (b) and interpret the results. Please read my elasticitycomments on my answer file for homework problems of chapter 3.e. If price is reduced further from $5.00 by the percentage you got in (c), computethe impact of this further price reduction on soft drink and hot dog using the crosselasticity figures you got in (d) and interpret the results. You may consider softdrink may include alcoholic drink such as beer/wine.f. Is it a good idea to reduce price further based upon your answer (e)? Why or whynot?g. With the advertising budget of $40,000 (use 40), calculate the elasticity ofadvertising using Q you obtained in (b)? Interpret the result. What would happento a constant term in a new reduced demand equation as a result an increase inadvertising budget? 4 (dQ/dA) * (A/Q) = Advertising ElasticitydQ/dA = 20A/Q = 40/1000Advertising Elasticity = 600/1000 = .6Remember that elasticity is also represented by (dQ/Q)/(dA/A), or the change in quantity over thechange in advertising. Because the elasticity is less than one, that means the change inadvertisement must be greater than the change in quantity; thus, the advertising is not worth itbecause 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 everyprice the constant would be higher, yielding a higher quantity. The reduced demand curve wouldshift up by the exact change in the advertising budget. h. Due to the health consciousness on the part of the population concerned, there is10% drop (use 10) in the pizza population from 70%. What would be its impacton the demand?i. How much would the advertising expenditure have to be increased to compensatefor the drop in population?j. Do you think the above increase in the advertising expenditure is worthwhile ornot? Provide number for your argument. 5
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