Economic Environment of Business: Assignment 1

Fall 2013
Question 1: Demand/Supply (Chapter 3)
(a) Explain whether the following events will lead to a change in the demand for wool or a
change in the quantity of wool demanded (in the case of a change in demand indicate
whether it is an increase in demand or a decrease in demand)

(i) The price of wool rises

Answer:
Since only the price of wool is increasing, according to law of demand other things remaining
same when price of good increases the quantity demanded decreases hence the quantity of wool
demanded will decrease. There is movement upward along the same demand curve.

(ii) A close substitute for wool is invented

Answer:
Substitutes are one of the factors (price of related good) for change in Demand which is other
than price change. The invention of substitute can have impact in two ways:
-If the price of substitute rises, then the Demand curve for wool will shift towards the right
indicating increase in demand for wool as customers will prefer buying more wool than the
substitute.
-If the price of substitute decreases, then the Demand curve for wool will shift towards the left
indicating decrease in demand for wool as customers will prefer buying the substitute than
wool.

(iii) Extremely cold weather forces more consumers to purchase woolen sweaters
Answer:
Weather changes are affecting Preferences of people which is one of the factors for change in
Demand which is other than price change .Since extremely cold weather is forcing customers to
purchase woolen sweaters which are made from wool then the Demand curve for wool will shift
towards the right indicating the increase in demand of wool.
 (b) When a lumber mill makes logs from trees it also produces sawdust, which is used to
make plywood.

(i) Are logs and sawdust complements in production or substitutes in production?

Explain.
Answer:
Logs and sawdust are complements as sawdust is produced as byproduct during production
process of logs from trees. Logs or sawdust cannot be used as replacement of each other.

(ii) Explain how a rise in the price of sawdust influences the supply of logs.
Answer:
Sawdust and logs are complements the increase in supply of logs will cause a supply curve shift
as the change is in price of a related goods which is a factor for change in supply when its own
price remain same. The suppliers will try to increase their sawdust production by making more
logs hence rise in price of saw dust will increase in supply of logs, and the supply curve will shift
towards right

(iii) Explain how a rise in the price of sawdust influences the supply of plywood
Answer:
Since sawdust is used as raw material to make plywood the increase in price of sawdust will
increase in production cost of plywood i.e. price factor of production is affected which is factor
for change in supply .Suppliers will not be able to produce more plywood at this increase cost of
production hence plywood supply will decrease and supply curve will shift towards the left .

Question 2: Demand/Supply (Chapter 3)

The demand and supply schedules for gun are provided below:
Price (cents per pack) Millions of packs a week
Quantity demanded Quantity supplied
20 180 60
40 140 100
60 100 140
80 60 180
(a) Suppose that the price of gum is 70 cents a pack. Describe the situation in the gum
market (i.e. excess demand, excess supply, or equilibrium) and explain how the price of
gum adjusts.
Answer:
When the price of gum is 70 cents the Quantity demanded will be 80 million and Quantity
supplied will be 160 million hence there would be a surplus of 80 million packs. The market
forces will lead to decrease in price to reach the market equilibrium of 50 cents Price and 120
million Quantity Demanded and Supplied.
(b) Suppose that the price of gum is 30 cents a pack. Describe the situation in the gum
market (i.e. excess demand, excess supply, or equilibrium) and explain how the price of
gum adjusts.

Answer:
When the price of gum is 30 cents the Quantity demanded will be 160 million and Quantity
supplied will be 80 million hence there would be a shortage of 80 million packs. The market
forces will lead to increase in price to reach the market equilibrium of 50 cents Price and 120
million Quantity Demanded and Supplied.
 (c) Now suppose that a fire destroys some factories that produce gum and the quantity of
gum supplied decreases by 40 million packs a week at each price. Explain what happens
in the market for gum and draw a graph to illustrate the changes.

Answer:

Due to the fire, working factory number will reduce which will decrease the production of gum
and hence supply of gum will decrease. In above graph consider S0 as original supply curve,
with the decrease in supply due to production factor (not price) the supply curve shifts towards
left to S1 as supply curve can shift only when the factor for increase or decrease is not price of
the product. The new equilibrium price has now increased from 50 cents to 60 cents with
decrease in Quantity supplied and demanded from 120 million to 100 million pack.

(d) At the same time as the fire in part (c), the teenage population increases, and the quantity
of gum demanded increases by 40 million packs a week at each price. What is the new
market equilibrium? Show the changes on your graph.

Answer:
Due to the increase in teenage population the demand for gum will increase. In above graph
consider D0 as original demand curve, with the increase in demand due to population factor (not
price) the demand curve shifts towards right to D1 as demand curve can shift only when the
factor for increase or decrease is not price of the product. The equilibrium price now will further
increase to 70 cents with Quantity supplied and demanded from moving back to 120 million
pack. The original equilibrium price of 50 cents now in shortage supply region. Also we can
observe that since the Demand Increases and Supply Decreases and this shift is in opposite
direction, the Quantity remains same as 120 million packs and the price has increased from 50 to
70 cents

Question 3: Elasticity (Chapter 4)

The table below shows the demand schedule for coffee:
Price (dollars per pound) Quantity demanded (millions
of pounds per year)
10 30
15 25
20 20
25 15

(a) Calculate the elasticity of demand for a rise in price from 10 dollars per pound to 15
dollars per pound and describe the elasticity of demand for coffee in this price range (i.e.
elastic, inelastic, or unit elastic).

Answer:
% Change in Quantity demanded: (30-25) * 100 = (5/27.5) *100 = 18.18
 (30+25)/2

% Change in Price: (15-10) *100 = (5/12.5) *100 = 40

(15+10)/2

Price Elasticity of Demand= % Change in Quantity demanded = 18.18/40 = 0.4545

% Change in Price

The Price Elasticity of Demand is Inelastic as the value is less than 1 (Unit Elasticity)

(b) Calculate the elasticity of demand for a rise in price from 20 dollars per pound to 25
dollars per pound and describe the elasticity of demand for coffee in this price range (i.e.,
elastic, inelastic or unit elastic).

Answer:
% Change in Quantity demanded: (20-15) *100= (5/17.5) *100 = 28.57

(20+15)/2

% Change in Price: (25-20) * 100= (5/22.5) *100 = 22.22

(25+20)/2

Price Elasticity of Demand= % Change in Quantity demanded = 28.57/22.22 = 1.285

% Change in Price

The Price Elasticity of Demand is Elastic as the value is greater than 1 (Unit Elasticity)

(c) Use the total revenue test to determine whether the elasticity of demand for coffee will be
elastic, inelastic or unit elastic for a coffee price increase from 15 cents per pound to 20
cents per pound.

Answer:
Revenue at original price of 15 cents: Price P1* Quantity Demanded Q1 = 15*25 = $375

Revenue at new price of 20 cents: Price P2* Quantity Demanded Q2= 20*20 = $400

Since the increase in Price resulted in the Increase in Revenue i.e. the direction of change in
price is same as the direction of change in Revenue then the Price Demand Elasticity is Inelastic.

This means the quantity demanded is not that responsive to the change in price of coffee.

This can be confirmed by calculating the elasticity:

% Change in Quantity demanded: (25-20) *100= (5/22.5) *100 = 22.22

 (25+20)/2

% Change in Price change: (20-15) * 100= (5/17.5) *100 = 28.57

(20+15)/2

Price Elasticity of Demand= %Change in Quantity demanded = 22.22/28.57 = 0.777

% Change in Price

Thus, the Price Elasticity of Demand is Inelastic as the value is less than 1 (Unit Elasticity)

(d) Explain the circumstances under which raising the price of coffee will be beneficial, in
total revenue terms, to the coffee sellers.

Answer:

When the Price Demand Elasticity is Inelastic, increase in price of Coffee will result in increase
in Revenue for Coffee. This increase in revenue will be reach maximum when the Price Demand
Elasticity reaches the value of 1 i.e. Unit elasticity post that the Price Demand elasticity will
become Elastic and the revenue will start decreasing with increase in price. Thus, raising the
price of coffee will be beneficial in total revenue terms when the price elasticity of demand is
Inelastic.

When the Price demand is Elastic the decrease in price will be beneficial for total revenue
increase. To know the maximum revenue, we should calculate the price when the elasticity
becomes Unit elasticity.

Let us calculate the Price elasticity of price increase from 15 to 25

% Change in Quantity demanded: (25-15) *100= (10/20) *100 = 50

(25+15)/2

% Change in Price: (25-15) * 100= (10/20) *100 = 50

(25+15)/2

Price Elasticity of Demand= % Change in Quantity demanded = 50/50 = 1

% Change in Price

The average price between 15 to 25 is (25+15)/2 = 20, the Quantity at this price is 20, hence
Total revenue will be a maximum of 20*20 = $400 for Unit Elasticity.

Question 4: Elasticity (Chapter 4)

As noted in class, a demand schedule is a table that relates the quantity demanded (Q) to the
price (P). Likewise, a demand curve is a graph that relates the quantity demanded to the price.
We will now work with a demand function which is a formula which relates the quantity
demanded and price.
Consider the following demand function: Q=10-2P
(a) Draw the demand curve
Answer:

Demand Curve
6
5
4
Price

3
2
1
0
0 2 4 6 8 10 12
Quantity Demanded

(b) Determine the elasticity of demand when (i)p=1 and (ii) p=3 and confirm that the
elasticity of demand increases when price is increased from p=1 to p=3 i.e. the price
elasticity of demand increases when you move up the demand. Hint: Elasticity of
demand=slope x (P/Q)
Answer:
Elasticity of Demand = Slope * (P/Q)
Slope = -2 and Q=10-2P
(i) When p=1
Substituting the value of p in above equation:
(-2) * 1/ (10-2*1) = (-2)/8 = (-1/4) = -0.25
Therefore, Elasticity of Demand at p=1 is 0.25

(ii) When p=3

Substituting the value of p in above equation:
(-2) * 3/ (10-2*3) = (-6)/4 = (-3/2) = -1.5
Therefore, Elasticity of Demand at p=3 is 1.5
Thus, this confirms that confirm that the elasticity of demand increases when price is increased
from p=1 to p=3 i.e. the price elasticity of demand increases when you move up the demand
 (c) What price will maximize total revenue? Hint: Elasticity of demand is equal to 1 at the
price that maximizes total revenue.

Answer:
Elasticity of Demand = Slope * (P/Q)
Slope = -2 and Q=10-2P

Substituting the above values: (-2) * P/(10-2P)

For maximizing total revenue, the Elasticity should be = 1
Note: the value will be negative when we substitute in the equation as Elasticity of demand is
negative value.
Therefore (-1) = (-2) * P/(10-2P)
-10+2P= -2P
4P=10
P=2.5
Hence the price that maximizes the total revenue would be 2.5 and the quantity at this price
would be 5 (from equation Q=10-2P)
Total Revenue = P*Q = 12.5
Question 5: Elasticity (Chapter 4)
(a) If a 10 percent fall in the price of beef increases the quantity of beef demanded by 20
percent and decreases the quantity of chicken demanded by 15 percent, calculate the
cross elasticity of demand between beef and chicken. Please be sure to indicate the sign
of the cross elasticity (i.e., positive, or negative).
Answer:
% Quantity demanded change (Chicken): (-15)

% Price change of substitute or complement (Beef): (-10)

Cross Elasticity of Demand= % Change in Quantity demanded = (-15)/ (-10) = +1.5

 % Price change of substitute or complement

Cross Elasticity value is Elastic and since the sign is positive chicken and beef are substitutes

(b) Judy’s income has increased from $10000 to $12000. Judy increased her demand for
concert tickets by 10 percent and decreased her demand for bus rides by 5 percent.
Calculate Judy’s income elasticity of demand of demand for (a) concert tickets and (b)
bus rides. Based on this information indicate whether concert tickets and bus rides are
normal goods or inferior goods.

Answer:
a) Judy’s income elasticity of demand of demand for concert tickets

% Change in Income: = (12000-10000) * 100= (2000/11000) *100 = 18.18

(12000+10000)/2

Income Elasticity of Demand= % Change in Quantity demanded = +(10)/ +(18.18) = + 0.55

% Change in Income

Income Elasticity value is Inelastic and since the sign is positive concert tickets are normal
good

b) Judy’s income elasticity of demand of demand for bus rides

% Change in Income: (12000-10000) * 100= (2000/11000) *100 = 18.18

(12000+10000)/2

Income Elasticity of Demand= % Change in Quantity demanded = -(5)/ +(18.18) = - 0.275

% Change in Income

Income Elasticity value is Inelastic and since the sign is negative bus rides are inferior good

Question 6: Organizing Production (Chapter 10)

Depending on the type of industry, a firm may face stiff competition or very little or even no
competition.
As you may have read from Chapter 10 of the textbook, two popular measures of competition in
an industry which have been proposed are the Four-Firm Concentration Ratio and the
Herfindahl-Hirshman index.
(a) Use the following data on the sales of the firms in the tattoo industry to calculate the
four-firm concentration ratio for the industry and use the ratio to describe the structure of
the tattoo industry (i.e., perfect competition, monopoly, monopolistic competition or
oligopoly).

Firm Sales (dollars per year)

Bright spots 450
Freckles 325
Love Galore 250
Native Birds 200
Other 15 much smaller firms each of which has sales 800
less than 200 dollars per year

Answer:
Value of Sales for 4 largest Firms: (450+325+250+200) = 1225
Value of Sales for entire Industry: 1225 + 800 = 2025
Four-firm concentration ratio = Value of Sales for 4 largest Firms * 100 = 1225/2020*100=60.49
Value of Sales for entire Industry
Ratio less than 60 % is considered highly competitive market
Since the value 60.49 % is slightly greater than 60 % the ratio indicates the tattoo market is
highly concentrated and dominated by few firms and hence is an Oligopoly

(b) Now use the following data on the market shares of the firms in the chocolate industry to
calculate the Herfindahl-Hirshman index for the industry and use the index to describe
the structure of the chocolate industry (i.e., perfect competition, monopoly, monopolistic
competition or oligopoly).

Firm Market share (percent)

Truffles, Inc. 25
Magic, Inc 20
Mayfair, Inc 15
All Natural, Inc. 15
Gold, Inc. 15
Bond, Inc. 10

Answer:
The Herfindahl-Hirschman Index (HHI): = Sum of square of the percentage Market share of all firms (as
here the number of firms <50)
= 25^2+ 20^2+15^2+15^2+15^2 +10^2 =625+400+225+225+225+100= 1800
Since the HHI less than 2500 is Monopolistic competition, the Chocolate market is a Monopolistic
competition.

Question 7: Output and Costs (Chapter 11)

It was also mentioned in class that in the long-run all the costs are variable, owing to the ability
to alter plant sizes in the long-run (in the short-run the plant size is fixed but it is still possible to
increase output in the short-run by changing the quantity of the variable inputs).

The figure below gives a sequence of short-run average total cost (ATC) curves numbered 1
through 7 corresponding to seven different plant sizes.

(a) Copy the figure and draw the long-run average cost curve on the copy.
Answer:

The LRAC curve is the blue line drawn in the copy diagram
(b) If the desired level of output is 100 units per day, what is the best plant size to produce
this output? Give the number of the associated ATC curve.
Answer:
For desired level of output of 100 units per day the best plant size to produce would be Plant 2 as
this is the most economical efficient plant for this output

(c) If the desired level of output is 200 units per day, what is the best plant size to produce
this output? Give the number of the associated ATC curve.
Answer:
For desired level of output of 200 units per day the best plant size to produce would be Plant 5 as
this is the most economical efficient plant for this output

(d) Explain the meaning of the term “minimum efficient scale”.

Answer:
A firm’s minimum efficient is the smallest output at which long run average scale cost reaches
its lowest level. This determines the market structure as, if minimum efficient scale is small
relative to market demand the market is competitive. Whereas in market where minimum
efficient scale is large relative to market demand then the market is either oligopoly or monopoly

(e) From looking at the graph do you think the “minimum efficient scale” is closer to 200
units per day or to 100 units per day?
Answer:
The minimum efficient scale for this graph would be closer to the 200 units per day which comes
under the Plant size 5.