Managerial Economics Homework: Market Failure and Pricing

This homework assignment in Managerial Economics addresses key concepts such as market failure, pricing mechanisms, and the impact of government policies. The first question explores market failure, government interventions like fiscal policy, control of monopoly power, price mechanisms, and legislations. A case study examines a company's environmental impact and the application of price mechanisms to mitigate harm. The second question analyzes market demand and supply, calculating equilibrium price and quantity, consumer and producer surplus, and discussing factors affecting supply. The third question investigates substitute goods, using cigarettes as an example, examining how tax increases influence demand for substitutes and proposing policies to reduce tobacco consumption. The final question defines price discrimination and its effects on consumer surplus, providing examples and analysis of its impact.

Managerial Economics

Section A
Question 1.
Market failure describes an economical condition when a market fails to meet the
standards of a perfect condition, due to insufficient distribution of goods and services. This
would impact negatively on economy because of non-optimal resource allocation. These can be
solved by government interventions and private market solutions. Basically, there are various
kind of government tools in order to assess any kind of market failure. By help of these tools
issue regarding to inefficient distribution of resources can be resolve easily. Herein , below some
kind of tools are mentioned that are as follows such as :
 Fiscal policy – This can be defined as a kind of policy that is linked with process of
managing the spending level and rate of tax to control the inflation of economy. It can be
helpful in the aspect of overcoming from any kind of market failure. This becomes
possible because government can increase the rate of tax and can minimise the expenses.
If tax rate will be higher then prices will be higher of products and services which may
lead to decrease in quantity of demand. Hence , the market failure can be overcome by
help of this policy if government implements it effectively.
 Control of monopoly power – Another tool to overcome from the market failure is
making effective control over the monopoly and this can be done only by help of
government. It is so because government can create laws and legislations that may lead to
minimising unfair competition level , ineffective discrimination of prices. Thus in the
case of market failure government can play a significant role by making effective control
over monopoly power.
 Price mechanism – In addition , the price mechanism is also an another way to managing
the economical situation in case of market failure. Basically , the price mechanism can be
defined as a way of changing the behaviour of customers and producers. It can become
possible only if government apply higher amount of tax rate on those products which are
harmful for consumers as well as for environment. For example , the if government
charges higher amount of tax rate on tobacco products then automatically its demand will
decrease. In addition , in the case of market failure due to lower supply can also be
resolve by this tool.
1

 Use of legislations – Apart from it , if government can use various kind of legislations in
order to sort out from market failure. In this case , only government has the right to
modify or remove any legislation. Such as government can implement legislation on
those products whose demand is higher and supply is low. By doing this government can
make match between demand and supply of products because if tax rate will be higher
then price will automatically raise. As a result customers will avoid to purchase harmful
products and market condition will be improved.
Given situation – The given situation is about a company that produces steel products
and production of each unit creates one unit of sludge. For this , company dump the sludge in
river that is harming to environment as well as water of river. In this situation , implementation
of “Price mechanism” can be helpful to protect the environment and river. This is so because if
customers will aware to minimise the use of steel products then demand will lower and
production also. This may become possible when government starts to charge higher amount of
tax rate on that particular company because they are harming to environment. By doing so , the
amount of sludge can be reduced and river will be protected. As well as in this case if this policy
will not be implemented then it can be resulted to harm of environment and river. It is so because
in the absence of any kind of legislation and taxation that company will not stop the production
of steel products in greed of profit and it all can be resulted in loss of environment. Hence, this
tool can be beneficial in order to prevention of production of harmful products as well as in
decreasing demand also.
Question 2:
Solution: Given, Market Demand of Potatoes (QD) = 1000 – 250P
Market Supply of Potatoes (QS) = 150 P
here, P is the price per bag and Q is number of bags per month, while QD represents the quantity
demand of potatoes and QS.
a) To determine the Equilibrium Price, set demanded quantity equal to quantity supplied as -
QD = QS
1000 – 250 P = 150 P
Add 250 P from both sides of equation as -
1000 – 250P + 250 P = 150 P + 250 P
2

1000 = 400 P
divide both side by 400,
P = 2.50
Thus, equilibrium price of potatoes equal to 2.50 unit price per bag.
Now, Equilibrium Quantity can be determined at a price of 2.50 unit per bag by -
QS = 1000 – 250 x 2.50 = 375.
hereby, the given calculation can also be illustrated in graphical manner, where the point at
which both quantity and price intersect is called equilibrium price, as shown below -
b) Consumer Surplus, defines as the value that consumers derive from buying an item. This
would can be illustrated as the shaded part in given figure of price and quantity graph, as shown
below -
At Equilibrium quantity q, Consumer surplus can be calculated by using formula -
Consumer Surplus (CS) = ∫ D(q) dq − pe qe over 0 to qe
3

here, qe = 375 and pe = 2.50
P = (1000 – q)/250
therefore, CS = ∫ (1000 – q) / 250 dq – 375 x 2.50 over 0 to 375
= (375000 – 70312.5)/250 – 937.5
= 281.25
c) Producer supply, can be shown by given chart of supply and demand graph. Here, producer
supply is represented by .. colour in given graph, as shown below. From this figure, producer
surplus can be calculated by finding the area of shaded triangle as product of ½ x base x height,
in following manner -
Hereby, from graph, base (equilibrium quantity) = 375 unit
while, height ( equilibrium price) = 2.5 unit
therefore,
Producer surplus = ½ x base x height
4

= ½ x 375 x 2.5
= 468.75 unit
By using another formula i.e. integral method,
Producer Surplus = pe qe - ∫ S(q) dq over o to qe
= 375 x 2.5 – ∫ q/150 dq over o to qe
= 937.5 – 468.75
= 468.75 unit
d) Since, consumer surplus defines as an economic measurement of benefits gained by
consumers, therefore, consumer surplus in this regard, happens when price which people pay for
purchasing a commodity is less than they are willing. As curve which is shown in part a)
represents the demand and supply curve, including the relationship between price and quantity of
potatoes demanded at 2.50 price unit, so, it will always increase when price of same product will
wall. In this case, by assuming that demand curve is constant, price below 2.5 unit were sold at
consumer plus. When supply quantity increases then price of potatoes may be decreased, because
in this case, chances of rotten this product might get increases. Under this case, suppliers will
5

sold potatoes on less rates, which ultimately lead to increase demanded quantity as well. Under
occasional period, demand of potatoes might also increases, which will provide opportunity to
suppliers to sold it on producer surplus rate i.e. more than 2.50 price unit.
e) Supply of any product in the market place can be influenced by number of reasons like
fluctuations in economical conditions, decrease in price rates, increase in cost of production and
more. Under this case, supply of potatoes can be decreased when cost of production increases,
due to government interventions, loss of fertility of land resource, increase in wage rates of
labour, transport and tax rate etc. Another main reason behind decrease in supply quantity of
potatoes is climatic conditions, where both excessive rain and scarcity of water affect adversely
the crops. While, heavy excise duties on import and export of potatoes also reduces its supply.
Question 3
(a) The cigars and chewing tobacco can be the substitute of cigarettes. This is so because both of
these products are produced by help of tobacco and cigarettes are also filled with tobacco. So
these products can be substitute. Herein , this case it is important that these products can not be
substitute for all customers. This is why because the regular and loyal customers will not buy
substitute products whether prices are high or not of original product.
(b) In the case when tax rate on cigarettes increases then demand of its substitute product will
increase. This is so because due to higher amount of tax rate , the price of cigarettes will increase
and as a result lower income level people will stop to buy. As a result demand of substitute
products like cigars and chewing tobacco will raise. It can be understand by an example like in a
USA if government increase the rate of tax over cigarettes then its price will be higher because
companies will recover this additional taxation amount from customers. Due to this customers
will find alternative of cigarettes and that can be cigars or chewing tobacco. Thus, demand of
these substitute products will raise.
Tax rate (in
percentage)
50 75 100 125 150
Demand of
cigarettes
150 120 95 80 70
Demand of 100 150 170 195 250
6

substitute
products
1 2 3 4 5
0
50
100
150
200
250
300
350
50 75 100 125 150150
120 95 80 70
100
150
190
245
290
Tax rate (in percentage)
Demand of cigarettes
Demand of substitute products
Hence , as per the above diagram this can be find out that if tax rate is increasing then demand of
cigarettes is decreasing at regular step. On the other hand , demand of substitute products is
decreasing.
(c) If policymakers want to reduce the total consumption of tobacco then they will need to apply
various kind of policies in relation with cigarette tax. In this case , they may apply below
mentioned policies such as : Increasing rate of agriculture tax – Apart from the tax rate , the policymakers can raise
the agriculture tax over tobacco due to this production companies will require to pay
additional amount to acquire the tobacco. As a result production will be lower and supply
too. This may lead to less consumption of tobacco.
 Increasing the rate of export – In addition , another way to prevent the consumption of
tobacco is increasing the total charges of exports. Due to this , companies will be
responsible to pay additional amount to make export of their tobacco products. As a
result consumption of tobacco will decrease.
So these are some policies except the tax rate which can be helpful in order to minimising the
consumption of tobacco.
7

Question 4. The price discrimination can be defined as a kind of strategy in which companies
charge different level of price from various customers of a similar product. The reason of this
charging various price is getting higher amount of profit. Basically , the price discrimination can
impact to the consumer surplus. This is so because if customer wants to pay lower amount of
price of a particular product but pays more in actual. It can be understand by an example that
there are two customers A and B who goes to buy a LED in a shop wherein seller charges
different price from them. Customer A is willing to pay $ 500 but in actual paid $ 450, in this
condition A gains surplus. While customer B wants to pay $ 450 bur in actual paid $ 500, in this
case customer A 's surplus reduced. This is indicating that price discrimination can lead to
minimisation of consumer surplus. On the other hand , for some customers this can be beneficial
as increasing in their surplus. It is so because seller may charge lower price from some customers
below their willingness to pay. Thus , it can be stated that price discrimination can be the reason
of decreased or increased consumer surplus. It totally depends on different price charged by
seller from various buyers. Herein , below a table is prepared on assumption basis which is
stating about relation between price discrimination and consumer surplus.
Price of a particular product that customers willing to
pay (in $)
100 120 90 85
Price paid in actual by customers (in $) 120 130 80 90
Consumer surplus (in $) -20 -10 10 -5
As per the above chart , this can be stated that due to price discrimination consumer surplus is
effecting. In some situations , the prices are charged less then to expectation and by this
consumers are getting surplus. On the other hand , in some cases consumers are paying more
then to willingness to pay and due to this consumer surplus is decreasing.
Question 5. In this case the organization of petroleum exporting countries increased the price of
crud oil at global level. As a result the demand of oil increased by customers and people faced
various kind of issues. In this situation , the OPEC is responsible for long line at gas station. It is
8

so because due to higher prices of oil , companies are not importing large quantity of oil and this
is leading in lower supply. On the other hand , demand is constant and as a result people are
facing the issue.
In addition , some economists are considering that government is responsible for this
situation. This is so because their strict legislations are resulting in lack of freedom to oil
companies in setting the price of oil. Though, both opinions are right but mainly the issue of this
condition is change in price by OPEC. The situation can be improve only if OPEC minimise the
current price of crude oil because it is widely used in various operations. As well as government
of various nations should make legislation liable so that price of oil can be controlled and issue
of long line at the gas stations and pumps will be resolved. On the other hand , in absence of
government support this can be difficult to keep the prices of oil suitable to customers.
Basically , the main element is keeping the level of demand and supply equal. This is so because
if supply of oil is enough then demand of customers will be satisfied.
9
1 2 3 4
-40
-20
0
20
40
60
80
100
120
140
100
120
90 85
120 130
80 90
-20 -10 10 -5
Price of a particular product
that customers willing to pay
(in $)
Price paid in actual by
customers (in $)
Consumer surplus (in $)

SECTION B
1. Fixed cost of textbooks = $100 and remaining cost is shown in below table -
Quantity of
Books (per
hour)
Total
Cost
Average
Cost
Marginal
Cost
Price
(dollars
per book)
TR MR
9 247 27.44 57 513
10 256 25.6 9 56 560 47
11 267 24.27 11 55 605 45
12 280 23.34 13 54 648 43
13 295 22.69 15 53 689 41
14 312 22.28 17 52 728 39
15 331 22.06 19 51 765 37
16 352 22 21 50 800 35
17 375 22.05 23 49 833 33
18 400 22.22 25 48 864 31
19 427 22.47 27 47 893 29
20 456 22.8 29 46 920 27
21 487 23.19 31 45 945 25
Total 4485 9763
10