Management Development Institute

PGPM 2013 (All sections)

Mid Term
Microeconomics
Maximum Mars! 30
Time! 2 "ours
Instructions! #losed $oo %xam& 'eig"tage! 30(
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Instructions: Closed Book exam
Question 1 is compulsory. Attempt any 2 from the remaining 3 uestions.
!ote: If a student attempts all the 3 uestions only the first ones attempted "ould #e checked serially. $he extra
attempted uestion "ould not #e e%aluated.
1* Please read t"e caselet and anal+,e it! 3 - .
$lac la/or in 0out"ern %urope (1e2! Paul 3rugman and 1o/in 'ells)
Most economists believe that minimum wage has relatively little effect on the job market in the
US. In 1964 the US minimum wage was !" of the average wage of blue #collar $ro%uction
workers& by '(1() %es$ite several recent increases) it ha% fallen to about 44".
*he situation is however %ifferent in many +uro$ean countries) where minimum wages have
been set much higher than in the Unite% States. Moreover +uro$ean countries often re,uire
em$loyers to $ay for health an% retirement benefits) which are more e-tensive an% so more
costly than com$arable .merican benefits. *hese man%ate% benefits make the actual cost of
em$loying a +uro$ean worker consi%erably more than the worker/s $ay0che,ue.
*he result is that in +uro$e $rice floor on labour is %efinitely bin%ing.
*he $ersistent sur$lus which results from this $rice floor a$$ears in the form of high
unem$loyment # million of workers) es$ecially young workers) seek jobs an% cannot fin% them.
In countries the enforcement of labour laws is either la-) or there is a wi%es$rea% evasion of
laws. In both Italy an% S$ain officials believe that there are hun%re%s of the thousan%s) if not
millions) of workers who are em$loye% by com$anies $ay them less than the legal minimum)
fail to $rovi%e the re,uire% health an% retirement benefits or both. In many cases the jobs are
sim$ly unre$orte%. S$anish economists estimate that about a thir% of country/s re$orte%
unem$loye% are in the 1black/ labour market # working at unre$orte% jobs. In fact) S$aniar%s
waiting to collect che,ues from the unem$loyment office have been known to com$lain about
the long lines that kee$ them from getting back to work2
+m$loyers in these countries have also foun% legal ways to eva%e the wage floor. 3or e-am$le
Italy/s labour regulations a$$ly only to com$anies with 1 or more workers. *his gives a big
cost a%vantage to small Italian firms) many of which remain small in or%er to avoi% higher
wages an% benefits. .n% sure enough) in some Italian in%ustries there is an astonishing
$roliferation of tiny com$anies. 3or e-am$le one of Italy/s most successful in%ustries is the
manufacture of woolen cloth) centre% in the 4arto region. *he average te-tile firm in that region
em$loys only four workers2
a* 5hat are bin%ing an% non0bin%ing minimum wages6 (0"o4n 4it" diagram /inding 4age
a/ove e5uili/rium 4"ere it is e22ective as price 2loor& non6/inding /elo4 e5uili/rium
4"ere it is not e22ective)
/* .naly7e the case how this situation ha% ha$$ene% in +uro$e an% suggest what is the way
out. 5hat is the relevance of this case in the In%ian labour market conte-t6 ($inding 4age
creates unemplo+ment and t"ere2ore a parallel /lac maret 4"ere due to excess
suppl+ e5uili/rium 4ages are t+picall+ lo4* 0olution! 1* More 7o/ creation /+ t"e govt&
2* more training given to unemplo+ed 4orers 2or /etter emplo+a/ilit+ and sel2
emplo+ment purpose* In India& unorgani,ed la/our maret t"at "as /een created due
to minimum 4age legislation o2 Industr+ Act& 4"ere 4ages 4ere t+picall+ lo4 earlier*
8o4ever M91%GA sc"eme "as improved t"e unorgani,ed la/our maret 4ages /+
a/sor/ing t"em at minimum 4ages 4"ic" 4as greter t"an e5uili/rium 4ages in
unorgani,ed la/our maret* T"is led to increase in e5uili/rium 4ages as suppl+ "ad
2allen* 9o4 minimum 4ages are slo4l+ /ecoming non6/inding in nature due to t"is
improved 4ages in t"e unorgani,ed sector and agriculture)

2* T"is 5uestion "as t4o parts 2 - 3 - 3 - 2
a* 5hat is the a%vantage of using $rice elasticity rather than the slo$e of the %eman% curve or
its inverse in or%er to measure the res$onsiveness in the ,uantity %eman%e% of a commo%ity
to a change in its $rice6 (slope is a/out a/solute c"ange and cannot capture t"e relative
c"ange in price and 5uantit+ as t"e+ "ave di22erent units and cannot /e compared* $ut
price elastcit+ can capture t"e responsiveness as it is /ased on ( c"anges in price and
5uantit+)
/* 3reshbake an% 8reambake both sell we%%ing cakes. .ssume current we%%ing cake sales to
be 9f : 16( an% 9% : 6'(. *he %eman% curves for the two com$etitors are;
:res"/ae! P2 ; .<0 = 0*3>2
Dream/ae! Pd ; .00 6 0*< >d
i) <alculate the $oint $rice elasticity for both 3reshbake an% 8reambake (6*<1<& 6
1*2<?)
ii) 3reshbake re%uce% the $rice of we%%ing cakes thereby increasing sales from 16( to
1=!4 units an% re%ucing 8reambake/s sales to 61( units. 5hat is the cross $rice
elasticity between 3reshbake an% 8reambake we%%ing cakes6 (0*1<@)
iii) 8o you think that 3reshbake/s strategy makes sense with regar% to revenue6 >9o as
t"e elasticit+ is less t"an one price reduction 4ill lead to loss in T1*)
3* . com$any $ro%ucing soft %rinks estimates its $ro%uction function to be 9:4((?
'
@) where 9 is
the ,uantity of soft %rinks $ro%uce% each week) ? is the hours of labour re,uire% $er week an%
@ is the number of machine hours re,uire% $er week. It is known that each machine o$erates
1'( hours every week. <ost of labour is As. '(Bhour an% cost of machine is As. 1((( $er week.
a. If firm has '( machines an% is currently $ro%ucing at its o$timal @B? ratio how many $eo$le
%oes the com$any em$loy6 .ssume each $erson works 4( hours a week. (MRTS = W/R
=> mpl/mpk =w/r => 2K/L = 120*20/1000. So if 20 machine opera!e"
!hen K i !he n#m$er of ho#r in !he week of opera!ion of all machine
an% i! i 20*120= 2&00 ho#r in a week. Replacin' K" we 'e! L=2000
la$o#r ho#r in a week" each worker can work &0 ho#r a week"
!herefore n#m$er of worker = (0.)
$. <onstant technological innovation has le% to a %ro$ in the $rice of machines. *he com$any
now has the o$tion to lease each machine for As. C(( a week. 5ill this have any im$act on
the o$timal @B? ratio6 +-$lain why. (*ni!ial K/L = +/( = 1.2" now !he new 2K/L =
120*20/,00 => K/L = -/2 = 1.(" . capi!al ha $ecome rela!i/el0
cheaper now" !he compan0 ho#l% re%#ce La$o#r ho#r an% increae
capi!al ho#r !o op!imall0 pro%#ce)
A* T"is 5uestion "as t4o parts! < - <
a. Ms* Aditi 0"arma) the owner0 manager of the :ine Duplicating 0ervice locate% near a
major University in South 8elhi) is contem$lating kee$ing her sho$ o$en after 4 $m until
mi%night. In or%er to %o so she woul% have to hire a%%itional workers. She estimates that
a%%itional workers woul% generate the following out$ut in a week >where each unit of
out$ut refers to 1(( $ages %u$licate%D.
5orkers hire% ( 1 ' ! 4 6
*otal $ro%uct ( 1' '' !( !6 4( 4'
If the $rice of each unit of out$ut is As 1(( an% each worker hire% must be $ai% As 4(( $er
week) how many workers shoul% Ms* Aditi 0"arma hire6 >M1PB;M1#B& 4"en <
4orers are "ired* T"ere2ore optimal emplo+ment is <)
b. 8escribe the effects of the following managerial %ecisions or economic influences on the
value of the firm;
i* *he firm is re,uire% to install new e,ui$ment to re%uce air $ollution (:ixed cost
increases and value o2 t"e 2irm reduces)
ii* *hrough heavy e-$en%itures on a%vertising) her firm/s marketing %e$artment
increases sales substantially. (#learl+ t"e cost and revenue /ot" increase& "o4ever
2rom t"e 5uestion it is clear t"at adv elasticit+ 4ould /e greater t"an one&
indication revenue increase is more t"an cots increase and value o2 t"e 2irm
4ould rise*)