Institute of Business and Management ASSIGNMENT 1 Submission Deadline: Saturday 2 November, 2013

___________________________________________________________________________ ____________ 1. Suppose the price of regular-octane petrol were 20 paisa per gallon higher in Gujranwala than in Lahore. Do you think there would be an opportunity for arbitrage (i.e., that firms could buy petrol in Lahore and then sell it at a profit in Gujranwala)? Why or why not?

Gujranwala and Lahore represent separate geographic markets for petrol because of high transportation costs. If transportation costs were zero, a price increase in Lahore would prompt arbitrageurs to buy petrol in Lahore and sell it in Gujranwala. It is unlikely in this case that the 20 cents per gallon difference in costs would be high enough to create a profitable opportunity for arbitrage, given both transactions costs and transportation costs. 4. In E 2. The price of long-distance telephone service fell from 40 cents per minute in 1996 to 22 cents per minute in 1999, a 45% (18 cents/40 cents) decrease. The Consumer Price Index increased by 10% over this period. What happened to the real price of telephone service?

Let the CPI for 1996 equal 1 and the CPI for 1999 equal 1.1, which reflects a 10% increase in the overall price level. To find the real price of telephone service in each period, divide the nominal price by the CPI for that year. For 1996, we have 40/1 or 40 cents, and for 1999, we have 22/1.1 or 20 cents. The real price therefore fell from 40 to 20 cents, a 50% decline.

3.

Suppose the demand curve for a product is given by Q =300 2P +4I, where I is average income measured in thousands of dollars. The supply curve is Q =3P 50. a. If I =25, find the market-clearing price and quantity for the product. b. If I =50, find the market-clearing price and quantity for the product. c. Draw a graph to illustrate your answers.

If I=25, find the market clearing price and quantity for the product. Given I=25, the demand curve becomes Q=300-2P+4*25, or Q=400-2P. Setting demand equal to supply we can solve for P and then Q: 400-2P=3P-50 P=90 Q=220. b. If I=50, find the market clearing price and quantity for the product. Given I=50, the demand curve becomes Q=300-2P+4*50, or Q=500-2P. Setting demand equal to supply we can solve for P and then Q: 500-2P=3P-50 P=110 Q=280. c. Draw a graph to illustrate your answers. Equilibrium price and quantity are found at the intersection of the demand and supply curves. When the income level increases in part b, the demand curve will shift up and to the right. The intersection of the new demand curve and the supply curve is the new equilibrium point.

4.

Suppose the government regulates the prices of beef and chicken and sets them below their market-clearing levels. Explain why shortages ofthese goods will develop and what factors will determine the sizes of the shortages. What will happen to the price of mutton? Explain briefly. Explain the difference between each of the following terms: a price consumption curve and a demand curve an individual demand curve and a market demand curve an Engel curve and a demand curve an income effect and a substitution effect

5. a. b. c. d.

a price consumption curve and a demand curve The price consumption curve (PCC) shows the quantities of two goods a consumer will purchase as the price of one of the goods changes, while a demand curve shows the quantity of one good a consumer will purchase as the price of that good changes. The graph of the PCC plots the quantity of one good on the horizontal axis and the quantity of the other good on the vertical axis. The demand curve plots the quantity of the good on the horizontal axis and its price on the vertical axis. b. an individual demand curve and a market demand curve

An individual demand curve plots the quantity demanded by one person at various prices. A market demand curve is the horizontal sum of all the individual demand curves. It plots the total quantity demanded by all consumers at various prices. c. an Engel curve and a demand curve An Engel curve shows the quantity of one good that will be purchased by a consumer at different income levels. The quantity of the good is plotted on the horizontal axis and the consumers income is on the vertical axis. A demand curve is like an Engel curve except that it shows the quantity purchased at different prices instead of different income levels. d. an income effect and a substitution effect Both the substitution effect and income effect occur because of a change in the price of a good. The substitution effect is the change in the quantity demanded of the good due to the price change, holding the consumers utility constant. The income effect is the change in the quantity demanded of the good due to the change in purchasing power brought about by the change in the goods price. 6. Suppose that Bridget and Erin spend their incomes on two goods, food (F) and clothing (C). Bridgets preferences are represented by the utility function U(F,C)= 10 FC , while Erins preferences are represented by the utility function U(F,C)= 0.50 . a. With food on the horizontal axis and clothing on the vertical axis, identify on a graph the set of points that give Bridget the same level of utility as the bundle (10,5). Do the same for Erin on a separate graph. b. Do you think Bridget and Erin have the same preferences or different preferences? Explain

With food on the horizontal axis and clothing on the vertical axis, identify on a graph the set of points that give Bridget the same level of utility as the bundle (10,5). Do the same for Erin on a separate graph. The bundle (10,5) contains 10 units of food and 5 of clothing. Bridget receives a utility of represented by the equation 10FC C F. Some bundles on this indifference curve are (5,10), (10,5), (25,2), from the bundle (10,5). Her indifference curve is represented by the equation 0.2F2C or C F. This is the same indifference curve as Bridget. Both indifference curves have the normal, convex shape. b. On the same two graphs, identify the set of bundles that give Bridget and Erin the same level of utility as the bundle (15,8). For each person, plug F C this gives her a utility of 1200, so her indifference curve is given by the equation 10FC 1200, or C F. Some bundles on this indifference curve are (12,10), (10,12), (3,40), and (40,3). The indifference curve will lie above and to the right of the curve diagrammed in part a. This bundle gives Erin a utility of 2880, so her indifference curve is given by the equation 0.2F2C C F. This is the same indifference curve as Bridget. c. Do you think Bridget and Erin have the same preferences or different preferences? Explain. They have the same preferences because their indifference curves are identical. This means they will rank all bundles in the same order. Note that it is not necessary that they receive the same level of utility for each bundle to have the same set of preferences. All that is necessary is that they rank the bundles in the same order.