Opportunity costs

1. At the beginning of the year, Sundar quit his job and gave up a salary of
Rs.175,000 per year in order to start his own business. A partial income statement
for his company in 2004, is shown below:
In Rupees
Revenues
970,000
Operating costs and expenses
Cost of products sold
355,000
Selling expenses
155,000
Administrative expenses
45,000
Total operating costs and expenses
555,000
Income from operations
415,000
Interest expense (bank loan)
45,000
Legal expenses to start business
28,000
Income taxes
165,000
Net income
177,000
To get started, Sundar spent Rs.100,000 of his personal savings to pay for some of the
capital equipment used in the business. In 2004, he could have earned a 15 per cent
return by investing in stocks of other businesses with risk levels similar to the risk
level at his own business.
a.
b.
c.
d.

What are the total explicit, total implicit, and total economic costs in 2004?
What is accounting profit in 2004?
What is economic profit in 2004?
Given your answer in part c, evaluate Sundars decision to leave his job to start
his own business.

2. When Ramu graduated from the ABCD Academy with a second division, his
father presented him with a Rs.350,000 second-hand ambassador taxi. Recently
Ramu was boasting to some of his fellow cab drivers that his revenues were
typically Rs.25,000 per month, while his operating costs (petrol, maintenance and
depreciation) amounted to only Rs.18,000 per month. Taxis similar to the one
owned by Ramu rent for Rs.15,000 per month. If Ramu was driving a taxi for one
of the Taxi companies, he would earn Rs.5,000 per month.
a. How much are Ramus explicit costs per month? How much are his implicit costs
per month?
b. What is the opportunity cost of the resources used by Ramu per month?
c. Ramu is proud of the fact that he is generating a net cash flow of Rs.7,000 per
month, since he would be earning only Rs.5,000per month working for a Taxi
company. What advice would you give Ramu?

Costs
1. Complete the following table which shows the amounts of labor inputs applied (L) and the
corresponding outputs (Q) in the short run:
L
Q
APL
MPL
------------------------------------------------------------0
0
--------------------------------------------------------------------------1
15
-------------------------------------------------------------------------2
32
--------------------------------------------------------------------------3
51
--------------------------------------------------------------------------4
66
--------------------------------------------------------------------------5
75
--------------------------------------------------------------------------6
84
--------------------------------------------------------------------------7
91
--------------------------------------------------------------------------8
96
---------------------------------------------------------------------------9
99
-------------------------------------------------------------------------------------------At which output level do diminishing returns set in?
(b) Suppose that the price of labor is w = Rs. 400, the total fixed cost is Rs.10,000 and the total
product schedule is the same as in part (a) above. Complete the following table.
Q
TFC
TVC
TC
AFC
AVC
AC
MC
---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Etc.

4. Complete the following table:

Q

TFC

TVC

100

50

95

135

MC
-----

270

300

340

60

80

120

AFC
-----

AVC
-----

AC
-----

(Note that the MC figures are being shown against the second of the two numbers involved, rather
than in the middle. Thus, if total cost changes from 5 to 7, we write MC = 2 against 7 rather than
between 5 and 7)

6. In the short run, a firm faces the following input requirements:

Q

25

10

40

10

60

10

85

10

125

10

Also, w = Rs.2.00 and r = Rs.10.00. On the basis of these figures, complete the following table:
Again, enter the figures for MC against the second relevant figure.
Q

TFC

TVC

MC

AFC

AVC

AC

-----

2
3
4
5

Elasticity
1. Moving along a demand curve, quantity demanded decreases 8% when price
increases 10%.
a. The price-elasticity of demand is calculated to be _______________.
b. Given the price-elasticity calculated in part a, demand is
________(elastic/inelastic/unit elastic) along this portion of the demand curve.
2. The price-elasticity of demand for a firms product is equal to 1.5 over the range
of prices being considered by the firms manager. If the manager decreases the
price of the product by 6%, the manager predicts the quantity demanded will
____________ (increase/decrease) by ____________ per cent.
3.
a.
b.
c.
d.

Suppose the demand for good X is Q = 20P-1.

When P = 1, total revenue is _______________.
When P = 2, total revenue is _______________
When P = 4, total revenue is _______________
The price-elasticity of demand is equal to ______________.

Perfect Competition
1. (a) The market price facing a perfectly competitive firm in the short run is Rs.25.
Complete the following table (write down the MC figures against the second of the two
relevant figures):
Q

TR = PQ

P
---

STC

MC

25

---

49

69

86

100

114

128

144

163

185

10

212

11

246

12

300

(STC refers to short run total cost)

(b) Identify the profit-maximizing output level for the firm.

Profit

(c) Complete the following table based on the table in 1(a).

Q

TVC

AVC

0
1
2
3
4
5
6
7
8
9
10
11
12
(d) If the market price drops to Rs.16, what should be the firm's output and why?
2. The equation of the total cost curve facing a perfectly competitive firm in the short run is
TC = 50 + 2q2.
(a) For this firm, what are the equations of the ATC and AVC curves?
(b) Explain why this firm will never shut down its production in the short run.
(c) Prove that the ATC curve reaches its lowest point when q = 5.
(d) If the firm faces a market price of Rs.100 per unit, what will be its profit-maximizing
level of output?
3. The equation of the demand curve facing a competitive industry is Q = 5 - P/2 and the
equation of the long run supply curve is P = Rs.2. What will be the industry price and
output in the long run equilibrium?

Monopoly
1. If the equation of the (inverse) demand curve is P = 20 Q, fill up the blanks in the
following table:
Q

Total Revenue

0
1
2
3
4
5
6
7
8
9

20

Marginal
Revenue
-

(Note: The table here will always give you a MR figure that is slightly different from what
you obtain from the formula MR = 20 2Q, because you are considering discrete changes)
2. A monopolist's demand function is of the form P = 100 - Q, and she faces a total cost
function C = 4Q2. The monopolist charges a single price to all her customers and tries to
maximize profit.
How much will the monopolist produce and what price will she charge?
3. A monopolist has a cost function given by C(Q) = Q2 and faces a demand curve given by
P = 120 - Q.
(a) What is the profit-maximizing monopolist's output and price? monopoly profit ?
(c) Now suppose that the monopolist has to follow a marginal-cost pricing policy. What is
her output and price?
4. The equation of the total cost curve for a natural monopoly is LTC = 20Q - (1/8)Q 2 and
the demand function is P = 50 - Q.
(a) If regulators force the monopolist to follow the marginal-cost pricing rule, how much
will she produce and what price will she charge? What will be her profit/loss?
(b) If she is forced to follow the average-cost pricing rule, how much will she produce
and what price will she charge?
5. A monopolist selling in two markets faces the demand curves P1 = 164 - 2q1 and P2 = 108
- 5q2 in the two markets. Her marginal cost function is MC = 8. She has no fixed costs. If

the monopolist can charge different prices in the two markets, what prices will she charge
in the two markets ?
6. S. Tendulkar and B. Bhutia have the same sports agent to market their sponsoring
services. Disregard the agent's costs. Perfect price discrimination is not possible.
(a) Suppose that the agent faces a cricket-product firm and a football-product firm that are
willing to pay the following amounts for sponsorship by the two players:
S. Tendulkar
B. Bhutia
Together
Cricket-prod. firm
Rs.470,000
Rs.90,000
Rs.560,000
Football-prod. firm
Rs.500,000
Rs.50,000
Rs.550,000
Is it more profitable for the agent to sell the services of the two players as a "bundle" or
separately? What should be the prices charged for their services?
(b) Suppose, instead that the figures are as follows :
S. Tendulkar
B. Bhutia
Cricket-prod. firm
Rs.490,000
Rs.80,000
Football-prod. firm
Rs.470,000
Rs.30,000

Together
Rs.580,000
Rs.500,000

Is it more profitable for the agent to sell the services of the two athletes as a "bundle" or
separately? What should be the prices charged for their services?
7. A firm faces a single buyer with an inverse demand curve given by P = 1,000 - Q and its
marginal cost is MC = 200. If the firm uses a two-part tariff to achieve the same profit as
perfect price discrimination, what will be its access price and the per unit price?
Hints:
If the demand equation is of the form P = a bQ, where a and b are constants, then the
equation of the marginal revenue curve is MR = a 2bQ.
If total cost is TC = aQn, then MC = anQn-1.
Games
1. Karishma and Madhuri are roommates. Each of them prefers a clean room to a dirty
room, but neither likes to clean the room. Their payoffs from adopting the strategies of
"clean" and "not clean" are as follows:
Both clean: Each gets 5.
One cleans, the other doesnt: The player who cleans gets 0, the other gets 8,
Neither cleans: Each gets 1.
(a) Represent the payoffs in a payoff matrix.
(b) What will be the equilibrium of this game? What type of equilibrium is it? Explain.

2. Tarun and Aruna live in adjoining apartments. Tarun plays the dholak and this disturbs
Aruna at her studies. Aruna wants to install sound-proofing (the noise of installation will
irritate Tarun). Their payoffs are given below (the first payoff in each pair refers to
Aruna):
Tarun
Be Noisy
Be Quiet
Install Soundproofing
(2,2)
(-1,1)
Aruna
Not install
(1,3)
(4,4)
(i) What are the two Nash equilibria of this game?
(ii) If Tarun gets to move first, what will be the equilibrium reached by backward
induction??