Individual Assignment 1

Demand, Supply, Equilibrium and Price Formation

(Sessions 2–4)

1. There are 10,000 identical individuals in the market for commodity X, each with a
demand function Q = 12 – 2P, where Q is the quantity of X demanded and P is the price
of X, and 1,000 identical producers of commodity X, each with a supply function given
by Q = 20P, where Q is quantity of X supplied and P is the price of X.
a. Find the market demand and market supply function for commodity X.
b. Obtain the equilibrium price and equilibrium commodity of X.
c. Calculate the own-price elasticity function (in terms of price) for both the market
demand curve and the market supply curve. Using these functions, calculate the
own-price elasticity of demand and supply at the point of equilibrium.
d. Calculate the consumer surplus and the producer surplus at equilibrium.
e. What happens if, starting from the position of equilibrium, the government
imposes a price floor of Rs.4/- on commodity X?
f. What happens if, starting from the position of equilibrium, the government
imposes a price ceiling of Rs.2/- on commodity X?

a. To find the market demand and supply functions, we first sum up the individual
demands and supplies:

Market Demand: Qd=10,000×(12−2P)=120,000−20,000PQd

=10,000×(12−2P)=120,000−20,000P

Market Supply: Qs=1,000×(20P)=20,000PQs=1,000×(20P)=20,000P

So, the market demand function is Qd=120,000−20,000PQd=120,000−20,000P

and the market supply function is Qs=20,000PQs=20,000P.

b. Equilibrium occurs where demand equals supply, so:

120,000−20,000P=20,000P120,000−20,000P=20,000P

120,000=40,000P120,000=40,000P

P=3P=3

Plugging P=3P=3 back into either the demand or supply function gives us the
equilibrium quantity:

Q=120,000−20,000×3=60,000Q=120,000−20,000×3=60,000

So, the equilibrium price is Rs. 3 and the equilibrium quantity is 60,000 units.

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c. Own-price elasticity of demand is given by:

ϵd=dQd/dPQd/P=−20,000120,000−20,000×3×310,000ϵd=Qd/PdQd/dP
=120,000−20,000×3−20,000×10,0003

ϵd=−20,00060,000×310,000=−1ϵd=60,000−20,000×10,0003=−1

Own-price elasticity of supply is given by:

ϵs=dQs/dPQs/P=20,00020,000×3×310,000ϵs=Qs/PdQs/dP=20,000×320,000×10,0003

ϵs=13ϵs=31

d. Consumer surplus is the area between the demand curve and the equilibrium
price, up to the equilibrium quantity:

Consumer Surplus = 12×3×60,000=Rs.90,00021×3×60,000=Rs.90,000

Producer surplus is the area between the supply curve and the equilibrium price, up
to the equilibrium quantity:

Producer Surplus = 12×3×60,000=Rs.90,00021×3×60,000=Rs.90,000

e. If a price floor of Rs. 4 is imposed, it is above the equilibrium price, so it is not

binding and has no effect on the market.

f. If a price ceiling of Rs. 2 is imposed, it is below the equilibrium price, so it is

binding. This would lead to excess demand (shortage) because quantity demanded
exceeds quantity supplied at this price. Buyers will want to buy more than sellers are
willing to sell at Rs. 2, leading to a shortage in the market.

2. Should a producer, facing a negatively sloped demand curve for the commodity sold,
operate in the inelastic range of the demand curve?

Operating in the inelastic range of the demand curve can be beneficial for a producer
facing a negatively sloped demand curve. In this range, a change in price results in a
proportionally smaller change in quantity demanded. Therefore, if the producer
increases the price, total revenue may increase because the decrease in quantity
demanded is proportionally smaller than the increase in price, leading to a net gain
in revenue.

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However, it's essential to consider other factors such as the elasticity of supply,
production costs, and market conditions. If the producer operates in a highly
competitive market where consumers have many alternatives, increasing prices in the
inelastic range may lead to a significant loss of customers. Additionally, long-term
effects on brand image and customer loyalty should be considered when making
pricing decisions based on elasticity.

3. If the market demand for agricultural commodities is price inelastic, would a bad harvest
lead to an increase or a decrease in the incomes of farmers (as a group)?

If the market demand for agricultural commodities is price inelastic, a bad harvest
would likely lead to an increase in the incomes of farmers as a group.

Price inelasticity implies that the percentage change in quantity demanded is less
than the percentage change in price. In the context of a bad harvest, the decrease in
supply would lead to a relatively small decrease in quantity supplied, which, if
demand is inelastic, would result in a relatively large increase in price.

Since farmers are price-takers in most agricultural markets, they would benefit from
the higher prices for the reduced quantity of goods they are able to supply. This
would result in higher total revenue for farmers, potentially offsetting the losses from
the reduced harvest.

4. Find the price elasticity of demand for the demand curve Q = aP–b.

To find the price elasticity of demand for the demand curve Q=aP−bQ=aP−b, we first
need to express the demand curve in terms of price and quantity.

Given Q=aP−bQ=aP−b, we can rewrite it as P=Q+baP=aQ+b.

The inverse demand function is P=Qa+baP=aQ+ab.

Now, to calculate the price elasticity of demand, we use the formula:

ϵ=dQ/dPQ/Pϵ=Q/PdQ/dP.

Differentiating the inverse demand function with respect to QQ gives:

dPdQ=1adQdP=a1.

Plugging this into the elasticity formula and simplifying, we get:

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ϵ=1a×Q/PQϵ=a1×QQ/P.

Since P=Qa+baP=aQ+ab, we can rewrite this as:

P=Qa+baP=aQ+ab.

So, P=Qa+baP=aQ+ab.

Now, plugging this back into the elasticity formula, we get:

ϵ=1a×QQa+baϵ=a1×aQ+abQ.

Simplifying this further gives:

ϵ=1a×aQQ+bϵ=a1×Q+baQ.

Finally, the aa cancels out, and we are left with:

ϵ=QQ+bϵ=Q+bQ.

So, the price elasticity of demand for the demand curve Q=aP−bQ=aP−b is
ϵ=QQ+bϵ=Q+bQ

5. The price elasticity of demand for a demand curve is same for every level of price. Show
that the functional form of the demand curve would be Q = aP–b where a and b are
parameters of the curve.

To show that the functional form of the demand curve would be Q=aP−bQ=aP−b
if the price elasticity of demand is the same for every level of price, we start by
assuming a linear demand curve in the form of Q=aP−bQ=aP−b, where aa and bb
are parameters.

Given this demand curve, the price elasticity of demand can be calculated as:

ϵ=dQ/dPQ/Pϵ=Q/PdQ/dP

Taking the derivative of Q=aP−bQ=aP−b with respect to PP, we get:

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dQdP=adPdQ=a

Plugging this into the elasticity formula, we have:

ϵ=aQ/Pϵ=Q/Pa

Since Q=aP−bQ=aP−b, we can rewrite this as:

ϵ=a(aP−b)/Pϵ=(aP−b)/Pa

Simplifying the denominator, we get:

ϵ=aa−b/Pϵ=a−b/Pa

Given that the elasticity is the same for every level of price, we can say that this
expression is a constant, let's call it kk:

k=aa−b/Pk=a−b/Pa

Rearranging this equation gives us:

k(a−b/P)=ak(a−b/P)=a
ka−kb/P=aka−kb/P=a
kb/P=ka−akb/P=ka−a
b/P=a(k−1)b/P=a(k−1)
b=aP(k−1)b=aP(k−1)

Now, let's substitute bb back into the original demand curve equation
Q=aP−bQ=aP−b:

Q=aP−aP(k−1)Q=aP−aP(k−1)
Q=aP−aPk+aPQ=aP−aPk+aP
Q=aP−aPk+aPQ=aP−aPk+aP
Q=aP(1−k)+aPQ=aP(1−k)+aP
Q=aP(2−k)Q=aP(2−k)

Let's assume 2−k2−k is another constant, say cc:

Q=aP⋅cQ=aP⋅c
Q=aP−bQ=aP−b

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Therefore, if the price elasticity of demand is the same for every level of price, the
functional form of the demand curve would be Q=aP−bQ=aP−b, where aa and bb
are parameters of the curve.

6. You are the CEO of a taxi company in city A. A recent strike in your company by taxi
drivers has resulted in a high wage settlement in city A. You now have to pay taxi drivers
10.0 per cent more wage compared to the wage before the strike took place. Should you
increase taxi fares?

As the CEO of a taxi company facing a 10.0% increase in wage costs due to a recent
strike, the decision to increase taxi fares depends on several factors:

1. Price Elasticity of Demand: If demand for taxi services is price inelastic (i.e., a
change in price results in a proportionally smaller change in quantity
demanded), increasing fares could potentially offset the higher wage costs
without a significant loss in customers. On the other hand, if demand is elastic,
a fare increase could lead to a notable drop in ridership.
2. Competitive Landscape: Consider the competitive environment. If other taxi
companies in city A do not increase their fares, raising yours could lead to a
loss of market share.
3. Customer Perception: Increasing fares might lead to negative customer
perceptions, especially if the wage increase is seen as excessive or if service
quality does not justify the higher price.
4. Cost Control: Evaluate other areas where costs can be reduced or efficiencies
can be improved to offset the wage increase before resorting to fare hikes.
5. Regulatory Environment: Ensure that any fare increases comply with local
regulations and do not invite backlash from regulators or the public.

In conclusion, while increasing taxi fares could help offset the higher wage costs, it is
crucial to consider the impact on demand, competition, customer perception, and
regulatory compliance before making a decision.

7. You are the curator of a museum. The museum is running short of funds, so you decide to
increase revenue. Should you increase or decrease the price of admission?

As the curator of a museum facing a shortfall in funds, the decision to increase or

decrease the price of admission depends on several factors:

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 1. Price Elasticity of Demand: If demand for museum visits is price inelastic (i.e.,
a change in price results in a proportionally smaller change in quantity
demanded), increasing admission prices could lead to higher revenue without
a significant drop in visitors. Conversely, if demand is elastic, a price increase
could lead to a notable decline in attendance and overall revenue.
2. Competitive Environment: Consider the pricing strategies of other museums
or attractions in the area. Increasing prices might make your museum less
competitive if similar attractions offer lower prices.
3. Visitor Experience: Evaluate whether the current admission price reflects the
value visitors receive from the museum. If visitors perceive the museum
experience as highly valuable, they may be willing to pay more, but if they feel
the price is too high for the experience, a price increase could lead to
dissatisfaction.
4. Alternate Revenue Streams: Explore other ways to increase revenue, such as
offering guided tours, hosting events, or selling merchandise, before
considering a price increase.
5. Public Perception: Consider how a price increase might be perceived by the
public and whether it aligns with the museum's mission and values.

In conclusion, the decision to increase or decrease the price of admission should be

based on a careful analysis of the museum's specific circumstances, including
demand elasticity, competition, visitor experience, alternate revenue streams, and
public perception.