Business Economics 2023: Problem Set 1 with Solutions

October 14, 2024

1 Consumers and Demand

1. John’s preferences are Cobb-Douglas and given by the utility function
1 2
u(x1 , x2 ) = x13 x23

where x1 is John’s consumption of good 1 and x2 is John’s consumption of good 2.

The two goods are both priced at £1 each, and (alas!) John’s income is only £9.

(a) What condition pins down the optimal consumption bundle? What is the intu-
ition for this expression?
The tangency condition
u′1 (x∗1 , x∗2 ) p1
′ ∗ ∗ =
u2 (x1 , x2 ) p2
plus the budget constraint
p 1 y1 + p 2 y2 = y
are enough to pin down the optimal choice. The tangency condition implies
that the marginal utility of each good is proportional to its price; at any other
allocation, it would be possible to consume a little more of one good and a little
less of another to create a new bundle which is still affordable but yields higher
utility.
(b) How much does John spend on each good?
Two approaches are acceptable here. First, you could just note that in Lecture
1 we saw that with Cobb-Douglas utility the shares of income spent on each
good are just equal to the exponent on each good in the utility function. So in
this case John will spend one third of his income (£3) on good 1, and the rest
(£6) on good 2. Alternatively, you could do the math yourself. The marginal
utility of good 1 is
1 −2 2
u′1 (x1 , x2 ) = x1 3 x23 ,
3

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 and good 2 is
2 1 −1
u′1 (x1 , x2 ) = x13 x2 3 .
3
Now impose the tangency condition we stated in (a)
1 −1 p1
x x2 = .
2 1 p2
Rearrange this expression to write expenditure on good 1 in terms of good 2
1
p1 x1 = p2 x2
2
and then substitute into the budget constraint
3
p1 x1 + p2 x2 = (p2 x2 ) = y
2
This immediately tells us that John’s expenditure on good 2 is two thirds of his
income (£6), and since we know John spends all his income, his expenditure on
good 1 must be £3.
(c) What is John’s elasticity of demand for each good?
To get the elasticity of demand, we need to first get the demand function for
each good. In part (b) we obtained the expression
3
(p2 x2 ) = y.
2
We could write this as
2 y
x2 = D2 (p2 ) = ,
3 p2
which gives us the demand function for good 2. Now we know that John spends
the remaining one third of his income on good 1, so
1
p1 x1 = y,
3
or rearranging slightly,
1 y
x1 = D1 (p1 ) = ,
3 p1
which gives us the second demand function. Now let’s focus on good 1, and
recall the definition of the elasticity of demand
 
dD(p) p
ϵD (p) = − × .
dp D(p)

2
 The derivative of the demand function for good 1 is
dD1 (p1 ) 1 1
= y −2 .
dp1 3 p1

Notice that this follows from the rules of differentiation at the start of this
problem set. If you look at this derivative for a while, you may notice that
dD1 (p1 ) 1 1 D1 (p1 )
= − y −2 = − .
dp1 3 p1 p1

This is helpful because by moving all the terms on the right hand side to the
left, we obtain an expression for the elasticity of demand,
dD1 (p1 ) p1
− = 1.
dp1 D1 (p1 )
So the elasticity of demand for good 1 is exactly 1. By following the same steps
for good 2, we can also show that its demand elasticity is also 1.

2. The price of a good rises 10% and demand falls 25%. What is the elasticity of
demand?
Recall one definition of the elasticity of demand is
% change in quantity demanded
Elasticity = − .
% change in price
In this case, the change in quantity is 25% and the change in price is 10%. Taking
the ratio of these two numbers, we find that the elasticity of demand is 2.5

3. Suppose the demand curve for good 1 is given by

D1 (p1 ) = 100 − 5p1 .

Suppose also that demand for good 2 is given by

D2 (p2 ) = 200 − 3p2 .

(a) What is the elasticity of demand for good 1 at p = 2? At p = 10? At p = 30?

We’ll start by stating the definition of elasticity
 
dD(p) p
ϵD (p) = − × .
dp D(p)
In this case the derivative of the demand function is easy to calculate: it is just
-5. Then
p
ϵD (p) = 5
D(p)

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 Now we will evaluate this elasticity at different prices.
2 2 1
ϵD (2) = 5 =5 =
D(2) 100 − 10 9
10 10
ϵD (10) = 5 =5 =1
D(10) 100 − 50
Now, for the third price, demand according to the stated demand function will
actually be negative. The most reasonable assumption here would be that de-
mand will in fact be zero, and that the elasticity of demand will be undefined
or maybe zero. I must confess that this was an accident - when choosing the
prices I did not realise the result would be a negative value. My bad!
(b) Without knowing the price in each market, can you say demand for good 1 is
more or less elastic than for good 2?
No: for these demand functions, the elasticity of demand varies with price, so
without knowing the price of each good it is impossible to say that one is more
or less elastic. To give an example: suppose as in (a) that p1 = 10. Then we
know the elasticity of demand for good 1 is 1. Suppose the price of good 2 is
also 10. Then the elasticity of demand for good 2 is
10 10
ϵD (10) = 3 =3 ≃ 0.17,
D(10) 200 − 30

and demand for good 1 is clearly more elastic But now suppose that the price
of good 2 is 50. Then
50 50
ϵD (50) = 3 =3 ≃ 3,
D(50) 200 − 150

which would imply good 2 is more elastic. So clearly without knowing both
prices, we cannot say for sure which good is more elastic.

Suppose instead the two goods had demand functions

D1 (p1 ) = 100(p−5
1 ),

D2 (p2 ) = 200(p−3
2 ).

(c) How would your answers to (a) and (b) change?

To show the mechanics of getting demand elasticities in this case, let’s again
state the definition  
dD(p) p
ϵD (p) = − × .
dp D(p)

4
 Let’s focus on good 1 and take the derivative

dD1 (p1 )
= −100 × 5 × p−4
1 .
dp1
As with Cobb-Douglas demand in Q1, if you look at this for a while you will
notice it can be rewritten
dD1 (p1 ) D1 (p1 )
= −100 × 5 × p−4
1 = −5 ,
dp1 p1
and from this expression we can get the elasticity

ϵD1 (p1 ) = 5

As we have emphasised in the lectures, the elasticity of demand in this case is

constant and does not vary with price. Following the same steps, we find that
for good
ϵD2 (p2 ) = 3.
We can say that for every possible set of prices, demand for good 1 is more
elastic than demand for good 2.

4. You are interested in understanding the market for luxury watches. Your friend points
out that the average Rolex costs £10,000, while the average Omega costs £2,000. Yet
Rolexes are twice as popular as Omegas, so your friend tells you the demand curve
for luxury watches must slope upwards in price. Do you agree with your friend’s
reasoning? Why or why not?
Your friend is incorrect. The demand curve tells us how demand for a given good
— with given characteristics — varies with its price. In this case we are comparing
two different goods which may have very different demand curves. In particular a
reasonable theory here would be that Rolex watches are higher quality or better
known, and this means that demand for Rolexes is higher than for Omegas at every
price. The comparison between the two watches tells us nothing about the shape of
their demand curves.

2 Firms and Supply

1. Suppose you manage a restaurant. You have two kinds of cost: ingredients and rent.
You spend a certain amount on ingredients for each meal — let’s say c. You also pay
R in rent regardless of how many meals you serve.

(a) What are your fixed and variable costs?

Rent is a fixed cost and ingredients are a variable cost.

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 (b) Suppose you produce y meals: what is your average cost?
Let’s start by writing total costs

C(y) = R + cy

which accounts for the cost of rent plus the cost of ingredients in each meal, c,
times the number of meals, y. Average costs are just total costs divided by y,
so
C(y) R
= +c
y y

(c) Does your restaurant have increasing, decreasing, or constant returns to scale?
The restaurant has increasing returns to scale if average costs fall as output y
grows. By inspecting the expression for average costs in (b), we can see that
this is indeed the case. The restaurants has increasing returns to scale because
as output rises, the fixed cost of rent gets spread out over more meals.
(d) Suppose your rent doubles. In the short run should you change the number of
meals you produce?
No: rent is a fixed cost, which has no effect on short run production decisions.
(e) In the long run are you more or less likely to continue producing after your rent
doubles?
Yes: with higher rent my total profits will certainly be lower and may be nega-
tive. If they are negative, in the long run I would be better off shutting down.

2. Again suppose you manage the same restaurant as in Question 1, but suppose also
that you own the building that houses the restaurant and therefore pay no rent.
Of course, you always have the option of shutting your restaurant and renting out
the space at rate R. How would your answers to Question 1, (a) - (e) change?
The short answer is that none of (a) - (e) change. Remember that your decisions
should be based on opportunity cost, and the opportunity cost of using a resource
for a particular purpose is independent of who owns that resource. In particular,
in this case the restaurant should consider the foregone rent R an opportunity cost
and therefore a part of its total costs. When (potential) rent doubles in (e), the
opportunity cost of running the restaurant rises and you should be more likely to
shut down the restaurant and rent out the space.s

3. Before you started your restaurant, you worked as a consultant at McKinsey earning
some amount w each day. You always have the option of going back to McKinsey,
although they do not allow you to work part-time – so combining the restaurant and
the consulting job is impossible. You learn that McKinsey’s salaries have recently
risen 10%.

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 (a) How have the costs of running the restaurant changed?
You should consider your foregone wages at McKinsey as another part of the
cost of running the restaurant. In particular, given that you can only avoid this
cost by shutting down and going back to McKinsey, you should regard this as a
fixed cost. Total cost are now

C(y) = w + R + cy.

If McKinsey’s salaries rise, the cost of running the restaurant also rises.
(b) Should you change the number of meals you serve in the short run?
No: the foregone wages are a fixed cost, so they should not affect your short run
production decisions.

4. Now suppose that the cost of ingredients is not constant at c, but rather increases
with the number of meals you serve – perhaps because you have to spend longer
searching local markets to find the necessary quantity. In particular, your (variable)
costs are given by  
2
c(y) = y3.
3
(a) What is your marginal cost as a function of y?
In calculating marginal cost, we can focus only on variable costs since fixed costs
(in this case, rent and foregone wages) play no role. Variable costs are
 
2
c(y) = y3.
3

Marginal cost is defined as the derivative of variable cost, so

 
′ 2
Marginal cost = c (y) = × 3 × y 2 = 2y 2 .
3

(b) Suppose the going price for meals in your area is £18. How many meals would
you supply?
We know that for a firm which takes prices as given, the optimal choice of output
y sets marginal cost equal to price. Denoting the optimal choice by y ∗ , we have
r
2 18
p = c′ (y ∗ ) =⇒ 18 = 2 (y ∗ ) =⇒ y ∗ = = 3,
2
so you would serve three meals.

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(c) How many meals would you supply at each price p between zero and £50? Show
your answer graphically.
The optimal choice of quantity will always satisfy marginal cost equal to price.
So p1
′ 2 2
p = c (y) = 2y =⇒ y =
2
Notice that what we have obtained here is just the supply curve of the firm,
s(p). Graphically:
Quantity y

s(p)
5

0 18 50 Price p

You may notice that this looks a little different than most of the supply curves
drawn in the lecture slides. The exact shape of the curve is not important.
What is important is that it slopes upward, that the curve is labelled as the
supply curve s(p), and that the axes are also labelled.