ECO201e Managerial Economics Assignment 2 – January 2017 Group Work

This document presents a comprehensive solution to ECO201e Managerial Economics Assignment 2, a group-based assignment from January 2017. The solution addresses several key economic concepts, including cost-benefit analysis, income and price elasticity of demand, marginal utility, and profit maximization. The assignment analyzes decision-making on the margin to maximize grades, calculates income elasticity for instant noodles and movies, and discusses the impact of economic recession on demand. It also determines optimal consumption combinations using marginal utility analysis and applies price elasticity to a pharmaceutical company's pricing strategy. Furthermore, the solution evaluates a firm's profit or loss based on market price, average total cost, and average variable cost, and determines whether the firm should continue or shut down its operations in the short run. Finally, it explores the characteristics of different points on the cost curves.

ECO201e
Managerial Economics
Assignment 2 – Group-based
Assignment
January 2017 Presentation
Student Name: Student
Number:
Pamela Lee Jia Ling E1611460
Nur Azlin Binte Sabari Z1410637
Nor’ain Binte Mohammad
Yahya Attia
B0902806
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Question 1
Question 1(a)
Cost-benefit analysis (CBA) is a weighing-scale approach to making decisions.
The economic concept of decision making on the margin can be used in other scenarios –
in this case, to maximize the average grade of both Economics and Mathematics
examinations.
Cost: Hours of Study
Benefit: Highest grade
In order to achieve a total highest grade of 151, it was derived that the whole three hours
must be utilized. It is also necessary to allocate two hours of studying for Mathematics, and
an hour on Economics.
However, to ensure the marginal benefit is maximised for marginal cost for every additional
hour spent on studying, a chronological, step-by-step process for the revision schedule is
adopted as follow:
Total
Time
0 hours 1st hour 2nd hour 3rd hour
Greatest
Marginal
Benefit
- +8 marks +7 marks +6 marks
Total
Grade
130
 0 hours
Economics,
70 marks
 0 hours
Mathematics,
60 marks
138
 0 hours
Economics,
70 marks
 1-hour
Mathematics,
68 marks
145
 1-hour
Economics,
77 marks
 1-hour
Mathematics,
68 marks
151
 1 hours
Economics,
77 marks
 2 hours
Mathematics,
74 marks
Above table is with reference and extracted from Appendix A.
Therefore, sequencing is an important factor to consider so as to achieve the greatest
marginal benefit against marginal cost at every hour. The first hour should be spent on
Mathematics instead of on Economics, where it only reaped a marginal benefit of +7 marks.
The next hour should be spent on Economics than on Mathematics where there is only an
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addition of 6 marks. Finally, the last hour should be spent on Mathematics again, as choosing
otherwise for Economics will only increase the grade by 5 marks.
Question 1(a) continued
Progressively, the marginal cost of 1 hour is not only incurred but also kept constant
throughout every increment of hours spent in studying.
The assumption made in the CBA is that economic agents are rational and seeks to maximise
their own welfare. Therefore, an activity should be ideally pursued if the benefit outweighs its
cost.
In this case, although it is possible to study fewer hours than the maximum duration, it will
eventually be most beneficial by attaining the highest grade possible.
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Question 1 (b)(i)
Income elasticity of demand (instant noodles), where:
Qf: final quantities demanded = 0 pack
Qi: initial quantities demanded = 7 packs
If: final incomes = $60,000
Ii: initial incomes = $15,000
Em =
=
=
Income elasticity of demand (instant
= − 1.6667
Income elasticity of demand (movies), where:
Qf: final quantities demanded = 11 movies
Qi: initial quantities demanded = 1 movie
If: final incomes = $60,000
Ii: initial incomes = $15,000
Em =
=
=
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Qf − Qi
X (Ii + If) ÷ 2
(If − Ii) (Qi + Qf) ÷ 2
0 – 7 X (15,000 + 60,000) ÷ 2
(60,000 – 15,000) (7 + 0) ÷ 2
− 7 X 37,500
45,000 3.5
Qf − Qi
X (Ii + If) ÷ 2
(If − Ii) (Qi + Qf) ÷ 2
11 - 1
X
(15,000 + 60,000) ÷ 2
(60,000 –
15,000) (1 + 11) ÷ 2
10 X 37,500
45,000 6

Income elasticity of demand (instant
= 1.3889
Question 1 (b)(ii)
Income elasticity of demand Classification of goods
Instant noodles -1.6667 Inferior
Movies 1.3889 Normal
Since instant noodles have a negative income elasticity of demand, it will be categorized as
inferior goods. On the other hand, the positive income elasticity of demand for movies will
indicate that movies are superior goods.
A further analysis on the income elasticity of demand, 1.3889 > 1 would explain that movies
are luxury rather than necessity goods – where it tends to be very sensitive to changes in
consumers’ income.
In response to a rise in Steven’s income, quantity demanded of movies has increased; while
the quantity demanded for movies has decreased. This therefore explains the rationale behind
Steven’s consumption to rise from 11 to 1 per year as he buys proportionately more of
movies and purchased less of instant noodles from 7 to 0 packs a week.
("Income Elasticity of Demand,")
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Question 1 (b)(iii)
The income elasticity of demand is a measure of responsiveness of quantity demanded to
changes in consumers’ income, with all other factors remaining unchanged.
Goods or services that have negative income elasticities imply that they are inferior good,
where the quantity demanded drops when income increases. This may further lead to changes
in preference to more luxurious substitutes since consumers are able to increase spending and
afford for it.
There is thus a positive relationship between real income and the quantity demanded for
normal goods, whereas an inverse relationship for inferior goods.
("Income Elasticity of Demand,")
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Question 1 (b)(iv)
A recession is a significant decline in activity across the economy.
When the economy enters a recession, inferior goods can become higher in demand, sellers of
instant goods would thrive during these times, resulting the revenues to increase.
In periods of economic contraction, consumers have reduced income and less money to
spend. Normal and luxury goods thus become lower in demand, movie theatre operators will
experience decline in business, resulting revenues to decrease.
In summary, inferior goods will cause the demand curve to shift right during recession.
Contradictory, normal or luxury goods will shift the demand curve to the left.
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Question 2
Question 2(a)
Given prices of fish and bread are both $10.00 per unit,
Quantit
y
Total
Utility
of
Fish
Marginal
Utility
of Fish
(MUFish)
MUFish ÷
PriceFish
Total
Utility
of Bread
Marginal
Utility
of Bread
(MUBread)
MUBread ÷
PriceBread
0 0 0 0 0 0 0
1 200 200 – 0
= 200
200 ÷ 10
= 20
140 140 – 0
= 140
140 ÷ 10
= 14
2 360 360 – 200
= 160
160 ÷ 10
= 16
260 260 – 140
= 120
120 ÷ 10
= 12
3 500 500 – 360
= 140
140 ÷ 10
= 14
360 360 – 260
= 100
100 ÷ 10
= 10
4 620 620 – 500
= 120
120 ÷ 10
= 12
440 440 – 360
= 80
80 ÷ 10
= 8
Based on the above tabulations, the possible optimal combinations are:
 3 Fish and 1 Bread
= (3 X $10) + (1 X $10)
= $30 + $10
= $40
 4 Fish and 2 Bread
= (4 X $10) + (2 X $10)
= $40 + $20
= $60
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Question 2(a) continued
The rational spending rule defines that a consumer should allocate his / her expenditure
across the goods and services in their chosen bundle with consideration that the marginal
utility per unit of dollar is equal across all goods.
Based on the budget of $40.00, the optimal consumption combination is 3 Fish and 1 Bread
for full utility maximization – largest amount of utility with limited amount of funds
available.
Rational spending rule is a more appropriate decision making tools for optimizing
consumption as the marginal utility per dollar spent on Fish is equals to the marginal utility
per dollar spent on Bread. By doing so, a consumer will be cautious to not spend more than
what have been budgeted. Similarly, one should stop spending when the marginal utility per
dollar is the same.
("What is the rule on rational spending?,")
Total utility refers to the overall benefit derived from a customer from consuming various
units of a good or services.
By simply evaluating the total utility of different bundles of goods, no marginal utility per
dollar will be on amount spent on Fish or Bread. It will ultimately lead to overspending since
total utility will increase with every successive unit of commodity consumed.
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Question 2(b)(i)
Given that P = $40,
Demand function: P = 60 – 5Q
40 = 60 – 5Q
Q = 4
Price elasticity of demand (medicine), at specific point where:
Px: $40
Qx: 4
Slope: – 5
Ex =
=
Income elasticity of demand (instant
= 10 X – 0.2
= – 2
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Px
X 1
Qx Slope
40 X 1
4 – 5

Question 2(b)(ii)
It is not a good idea for the pharmaceutical company to raise its price to earn more revenue.
This is because the price elasticity of demand that is more than 1 in absolute value (2 > 1);
where the demand is elastic and consumers are price sensitive.
Following are a few main characteristics for goods which are price elastic:
 Presence of close substitutes / very competitive market – consumers can easily switch
from a product to another even if the price change is not significant;
 Proportion of the consumer’s budget spent on the item – goods that have relative high
cost will result the consumers to be cautious about the purchase and seek substitutes when
needed; and
 Degree of necessity / frequency of goods bought – The lesser the necessity of a good, the
higher the elasticity will be.
As such, as pharmaceutical goods tend to consume a large portion of the consumer’s budget,
any price increase will instead, cause the company to lose revenues and customers; especially
when the goods are highly available and can be easily found in the market. Moreover, when
consumers are price sensitive, they will only purchase what is needed and when it is needed.
If consumers did not find a need to buy a product, it will also result the business to incur
losses.
("Determinants of Price Elasticity of Demand,")
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Question 2(b)(iii)
Marginal revenue maximisation:
MR = 60 – 5Q
= 60 – 5(-2)
= 60 + 10
= 70
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Question 3
Question 3(a)
MR = MC,
Optimum output: 580
Profit / (Loss): (Market Price – ATC) X Output
= ($6.00 - $4.00) X 580
= $1,160.00
In addition to the positive economic profit of $1,160.00 that is earned due to ATC of $4.00 is
higher than the per unit market price of $6.00, the firm should also continue its operation in
the short run since:
 Market Price = $6.00 > AVC = $2.60
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Question 3(b)
MR = MC,
Optimum output: 340
Profit / (Loss): (Market Price – ATC) X Output
= ($3.00 - $3.60) X 340
= ($204.00)
The ATC of $3.60 is greater than the per unit market price of $3.00, which eventually result
the firm’s total revenue to be lower than the total cost; even though a negative economic
profit of $204.00 is incurred, the firm should continue its operation in the short run since:
 Market Price = $3.00 > AVC = $2.60
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Question 3(c)
The market price of $1.00 is lower than the AVC of $2.60; therefore, operating beyond the
firm’s lowest AVC at any output will cause the perfectly competitive firm to incur losses.
Instead of incurring a negative economic profit, the firm should shut down its operation in the
short run since:
 Market Price = $1.00 < AVC = $2.60
 There will be an absence of revenue that is able to cover both the AVC and ATC
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Question 3(d)
Characteristics of: -
Point A:
The marginal cost of the firm is lower than the average costs of the variable at any output.
At this point, the firm will be operating at a total loss because its overall profit is lower than
the total costs. Since the loss incurred due to operating of production will be greater than the
economic loss of not producing, the firm will be forced to close its operations in order to
minimize the amount of loss (Awad, 2014).
On the other hand, operating below Point A and onwards will cause the firm to incur more for
every unit produced.
Point B:
The marginal cost of the firm is equals to the average cost of the variable. This would imply
that even though the fixed cost cannot be covered, the output that the firm produce is just
enough to cover the variable cost of production.
At this point, the firm can also enhance profit and at the same time, reduce losses by
manufacturing outputs when marginal cost is on par with marginal price.
Any price reduction beyond Point B will indicate that the firm is no longer be able to fulfil
for its fixed cost as well as variable costs. However, the producing loss will still be less than
the loss of not producing.
Point C:
A perfectly competitive firm is most productively efficient when the marginal cost is equals
to the average total cost.
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At this point, the average total cost of the firm is reduced to the lowest, also known as the
break-even point. This therefore means that fixed costs are absorbed by the items that are
already produced, and only the direct costs have to be accounted for. The profit of the firm is
zero, and will increase with every adjustment / increment in price.
The decline in production on the other hand, will bring a loss for the organization. Apart of
this, any decline in price further below the average cost will arise in a situation of shut down.
Question 3(d) continued
Point C also reflect that the marginal cost is greater than average cost, where every additional
unit of output produced adds more to average cost than to total cost.
From Point C onwards, due to the law of diminishing returns, the marginal cost of production
will gradually be higher than the average total cost when the output is expanded.
With reference to the given diagram, Point C depicts the long run equilibrium of the firm;
where marginal cost always remains equal to the average total cost.
As a result of economies of scale, the long run marginal cost initially drops, but eventually
rises due to diseconomies of scale - thereby increasing demand and prices of inputs.
("Marginal Cost,")
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Question 4
Question 4(a)
Total revenue is maximized when MR = 0,
MR = a – 2bQ
MR = 24 – 2Q
0 = 24 – 2Q
Q = 24
2
Q = 12
Substitute Q = 12 into demand curve:
P = 24 – Q
P = 24 – 12
P = $12
Therefore, if the monopolist wishes to maximise his / her revenue, a quantity of 12 should be
produced and the price must be set to $12.
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Question 4(b)
When Q = 0, substitute into demand equation:
P = 24 – Q
P = 24 – 0
P = $24
When P = 0, substitute into demand equation:
P = 24 – Q
0 = 24 – Q
Q = 24
Marginal revenue curve:
MR = a – 2bQ
MR = 24 – 2Q
Since MR = 24 – 2Q, MC = $6
MR = MC
24 – 2Q = 6
Q = 9
Substitute Q = 9 into demand curve,
P = 24 – Q
P = 24 – 9
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P = $15
Therefore, if the monopolist wishes to maximise his / her profits, a quantity of 9 should be
produced and the price must be set to $15.
Question 4(b) continued
Graphically,
Demand curve is P= 24-Q
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Question 4(c)
When the government imposes a tax of T dollars on the monopolist, there will be an
additional cost added to the consumer in the form of higher prices. So, T dollars will be
added on to the marginal cost.
MC = $6 + $T
Since MR = 24 – 2Q, MC = $6 + $T
MR = MC
24 – 2Q = $6 + $T
18 – T = 2Q
Q = 9 – ½T
Substitute Q = 9 – ½T into demand curve,
P = 24 – Q
P = 24 – (9 – ½T)
P = $15 + ½T
Consumers will need to pay P = 15 + ½ T after shouldering the tax burden of ½ T dollars.
Monopolist will receive $15 + ½ T from consumers, but since the government had imposed T
dollars of tax, the net profit will be:
(15 + ½ T) – T
= 15 - ½ T
Monopolist will receive P = 15 - ½ T after shouldering the tax burden of ½ T dollars.
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Illustrating with example,
If T = $1
MC = 6 + 1
= $7
MR = MC
24 – 2Q = 7
17 = 2Q
Q = 8.5
Substitute Q = 8.5 into the demand function P = 24 - Q
P = 24 - Q
P = 24 - 8.5
P = $15.50
Consumers will need to pay an additional $0.50 to shoulder the tax burden of $1.
P = 15 - ½ T
= 15 - ½ (1)
= $14.50
Monopolist will only receive $14.50 after shouldering the tax burden of $0.50.
From the illustration given above, the price facing the consumer after the imposition of the
tax is will be $15.50, an increase from the initial price of $15; whereas the monopolist
receives $14.50, a decrease from the initial amount of $15.
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The tax imposed has not solely burdened the monopolist producer, both the consumer and
producer each share 50% of the tax imposed.
In conclusion, there will be lower quantity produced when tax is imposed on the monopolist.
Demand will increase, where the producer will charge a higher price of goods / services,
which ultimately results the consumers to indirectly shoulder part of a tax burden.
("Monopoly,")
Appendices
Appendix A
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References
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Determinants of Price Elasticity of Demand. Retrieved 26/2/2017, 2017, from
https://www.boundless.com/economics/textbooks/boundless-economics-textbook/
elasticity-and-its-implications-6/price-elasticity-of-demand-54/determinants-of-price-
elasticity-of-demand-211-12302/
Income Elasticity of Demand. Retrieved 26/2/2017, 2017, from
http://www.investopedia.com/terms/i/incomeelasticityofdemand.asp
Income Elasticity of Demand. Retrieved 26/2/2017, from
http://xplaind.com/614558/income-elasticity-of-demand
Marginal Cost. Retrieved 26/2/2017, 2017, from http://moneyterms.co.uk/marginal-cost/
Monopoly. Retrieved 28/2/2017, from http://www.uh.edu/~ghong/fina3334/sol_10.PDF
What is the rule on rational spending? Retrieved 26/2/2017, 2017, from
https://www.quora.com/What-is-the-rule-on-rational-spending
Awad, A. S., Fuller, J. D., El-Fouly, T. H., & Salama, M. M. (2014). Impact of energy
storage systems on electricity market equilibrium. IEEE Transactions on Sustainable
Energy, 5(3), 875-885.
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