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BUSINESS ECONOMICS

Problem Set

(1) Illegal downloading of music from the Internet triggered a huge legal crusade of music
record companies against Napster. The record companies counted their losses due to the
Napster activities by estimating the number of illegal copies downloaded and
multiplying this number by the price of a legal copy. Further they argued that because
the illegal copies were for free they could not withstand such unfair competition and
would soon go bankrupt. Do you agree with this line of argument? Would you have
other advice to the music record companies than fighting online piracy with legal
means?

(2) a. Only 6 hours of study-time remain before your final exams start. Your objective is to
get as high an average grade as possible in Accounting, Finance, and Economics.
According to your best estimate, your grade in each course will depend upon the time
allocated to it according to the following schedule:

Accounting Finance Economics


hours of study grade grade grade

0 80 20 40
1 90 45 52
2 95 65 62
3 97 75 71
4 98 83 78
5 99 90 83
6 99 92 86

How should you allocate your time? What principles guide your decision?

b. Corporations will often allocate financial resources to divisions in proportion to


those divisions' rates of return on investment. Is this decision rule consistent with
the principle you discovered in question (a)?

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(3) Indicate whether each of the following will shift the demand curve for Peugeot's 308 to
the right, left, or not at all:

a. Renault introduces a new line of smaller, fuel-efficient cars;


b. the Trade Ministry reduces the imports of Japanese subcompacts into France;
c. the prime interest rate charged by banks rises;
d. Peugeot offers a temporary discount on all 308 purchases;
e. automobile workers win a wage increase;
f. a trade journal does a cover story favorable to the 308;
g. 17 people are reported to be killed due to faulty 308 brakes.

(4) The disappearance of anchovies off the coast of Peru in 1972 caused a scramble for
protein-rich substitutes, notably soybeans. Because soybeans were used in animal feed,
higher soybean prices eventually were translated into higher cattle prices.

Use demand and supply diagrams to show what happened in the anchovy, soybean, and
cattle markets. Indicate which curves shifted in each instance and show the effects on the
equilibrium price and quantity in the relevant market.

(5) During World War II in Great Britain, a ceiling was imposed to stop a rise in the market
price of bread. Explain why there was upward pressure upon the price of bread. What
consequences of the upward pressure would you anticipate, given continuing
enforcement of the ceiling? To help reduce this upward pressure, the British government
took fresh bread off the market - all bread sold had to be at least one day old. Would you
expect this regulation to achieve the desired effect?

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(6) In 1914, Professor H.L. Moore did an empirical analysis of the demand for pig-iron. He
plotted time series data on pig-iron prices and sales quantities and drew the following
"demand" curve.

price of
pig-iron

pig-iron sales quantity

This, he said, demonstrated that the economist's theory of a downward sloping demand
curve was an outmoded concept (in 1914) which "stood in the way of successful
treatment" of economic problems.

Critique Professor Moore's method of trying to find a demand curve. What do you think
he actually discovered and why do you think so?

(7) Evaluate the following two statements. Do you agree? Why or why not?

a. ‘If the government taxes land, wealthy landlords will pass the tax on to their poorer
renters.’
b. ‘If the government taxes blocks of flats, wealthy landlords will pass the tax on to their
poorer renters.’

(8) There are three different ways of ensuring an adequate supply of labor for the army.

a. The army offers a wage rate sufficient to attract the quantity of labor that it feels
necessary. This is sometimes called a "volunteer army".
b. The army selects at random the number of people it needs and forces them to serve.
This is the "draft" principle.
c. The army drafts men and women to serve but it then allows those drafted to pay
others to take their places in the army.

How do these three alternatives differ in terms of efficiency and equity (fairness)?

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(9) Assume that the United States demand and domestic long run supply of motor gasoline
are given in the following table. Assume also that the industry is competitive.

Long Run Domestic


Price Quantity Demanded Quantity Supplied
($ per gal.) (billion gal. per month) (billion gal. per month)

1.50 5.5 6.5


1.25 6.0 6.0
1 00 6.5 5.7
.75 7.0 5.5
.50 7.5 5.0
.25 8.0 4.5

In addition to domestically produced supplies, a second source of supply exists. The U.S.
can import all the gasoline (actually the crude oil equivalent) it wants for $.75 per gallon.

a. Given the above information, what will be the equilibrium price and quantity
demanded? (Assume no government intervention in the industry).

Fear of an international embargo against the U.S., which would cut off its imports, has
prompted the government to study some policy alternatives. One is to allow the free
market to function with no government controls.

b. If there were an embargo, what would be the short run equilibrium price of gasoline
if, in the short run, domestic production is fixed at its pre-embargo quantity?

c. What would be the long run equilibrium price if the embargo were permanent?

The government is also considering a gasoline rationing scheme. Ration coupons, good
for one gallon each, would be printed and distributed free to the populace. To buy a
gallon of gasoline, one would pay the pump price of the gasoline and present a coupon.
The coupons themselves could be legally traded between people (called a "white market"
plan).

d. How many coupons per month would the government have to distribute to prevent
the pump price of gasoline from rising above its pre-embargo level?

e. What will it cost you to buy a gallon of gasoline?

f. What rules would you propose for deciding who gets how many ration coupons?

g. In addition to the free market and the ration coupons, the government could simply
pass legislation and then try to enforce a price ceiling equal to the pre-embargo
price. Which of these three alternatives do you think is best and why?

h. Compare a sales tax (excise tax) of $.75 to the alternatives discussed above. By what
criteria should such a comparison be made?

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(10) (From The Economist, June 7th, 2007)

At the end of last year the Thai government stunned the drugs industry when it said it
would overrule international patents for Efavirenz, an anti-retroviral drug made by Merck,
an American firm, and switch to a Thai-made generic copy at half the price. The country
had signed the Agreement on Trade-Related Aspects of Intellectual Property Rights
(TRIPS), which protects drugs patents. But that deal allows “compulsory licensing” only
under special conditions—conditions that some complained Thailand did not fulfill.

In the months since then, Thailand has said it would overrule the patents on two more
drugs, and it may soon add a further pair to the list. Moreover, other countries have
followed its lead. Brazil declared last month that Merck was charging too much for
Efavirenz. In recent weeks the health ministers of India, Malaysia and Kenya have also
muttered about pursuing compulsory licensing.

All this has sparked an almighty row. Many global-health advocates—including Bill
Clinton, whose foundation works on HIV—have applauded the trend, arguing that access
to cheap generic drugs will greatly help the poor. Last month the World Health
Organisation passed a resolution supporting compulsory licensing. America objected
vociferously, but other rich countries supported the motion.

Drug executives are furious. Jon Pender of GlaxoSmithKline, a British drugs giant, insists
that compulsory licensing was meant to be used only “as a last resort”. He argues that
although compulsory licensing is legal, TRIPS rules allow it only under limited
circumstances, such as national health emergencies, and only after lengthy efforts to
negotiate prices with firms.

If you want to truly serve the society, which side would you support: Thailand and other
developing nations, or the pharmaceutical industry?

(11) If the Ministry of Transport adopted a toll system on motorways, this would ensure that
only those individuals who valued the roads at the cost to society would use them and
hence would result in a potential efficiency improvement.

Evaluate.

(12) Around the world, support for free trade is weak at best; and the WTO is copping the
blame for the perceived evils of globalization. It is under attack from trade unions, greens
and even consumer groups, all of whom say its rules advance big companies’ global
ambitions at the expense of jobs and the environment.

Who gains and who loses from free trade among countries? What are the arguments that
people use to advocate trade restrictions? What would be your answer to these
arguments?

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(13) An urban rapid-transit line runs crowded trains (200 passengers per car) at rush hours,
but very empty trains (ten passengers per car) at off hours. A management consultant
makes the following argument: The cost of running a car for one trip on this line is about
$50 regardless of the number of passengers. So the per-passenger cost is about 25 cents
at rush hour but rises to $5 per passenger in off hours. Consequently, we had better
immediately discourage off-hour business.

Is there a fallacy in the consultant's argument? "Commutation tickets" sold by some


transit systems (reduced-price, multiple-ride tickets) are predominantly used in rush hours.
Are such tickets a good idea?

(14) "If economies of scale are truly significant in the petroleum refining industry, it is hard to
explain the apparent ability to survive of so many plants that are far below the minimum
efficient scale for refining. One factor that may explain it is that if the capital costs of an
older, small refinery have been substantially written off through depreciation, its operating
costs may well be below the combined capital and operating costs of a newer, more
efficient refinery." From W. S. Measday, "The Petroleum Industry", in Adams, The
Structure of American Industry.

Analyze this quotation carefully. Does it make sense? Is there an alternative explanation
that makes more sense?

(15) A taxicab cannot be operated in New York City without a medallion issued by the Taxi
and Limousine Commission which has for many years held the number of medallions
outstanding at 11,750. These medallions are commonly traded through New York
brokerage houses. In the early 1980's, the going price for a medallion was
approximately $65,000. In 2011, the number of medallions was not much higher, just
over 13,000, but the price reached a mind-boggling level; two of them were even sold
for $1 million apiece.

a. Explain using rigorous economic analysis the price at which medallions exchange. Note
that the demand for medallions is derived from the demand for taxi services, so you will
have to start with an analysis of the market for taxi services.

b. Taxi meter rates in the City are set by the Taxi and Limousine Commission (In part (a)
you should neglect this fact). Representatives of the medallion owners argue before the
Commission that meter rates must be kept high because medallions cost so much. Are
they correct?

c. Suppose you were appointed to chair the Commission. You control both the number of
medallion and meter prices. Presuming you are a sincere servant of the public welfare,
what would you do and why?

d. What other businesses can you think of in which there are analogies to taxi medallions?

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(16) On January 1, 1984, the Bell has been effectively broken up. AT&T’s local
operations were split into several independent regional operator companies known as
“Baby Bells”. AT&T continued to run its long-distance services being able to keep
approx. 70% of the market in the early 1990’s. One study estimates long-run demand
elasticity of AT&T in the period 1988-1991 to be around -10.

a. Does the telecommunications service industry fit the perfect competition


framework? Why or why not? Focus your discussion on underlying
assumptions of the model.

b. What does your answer under (a) imply in terms of profitability of the
AT&T’s operations?

c. Assuming the elasticity estimate is correct, what does it imply in terms of


AT&T’s market power (i.e. ability to raise the price over the marginal costs)?

(17) In May 1990, IBM announced the introduction of the LaserPrinter E, a lower-cost
alternative to its popular LaserPrinter. The E version was virtually identical to the original
LaserPrinter, except that it printed text at 5 ppm speed, as opposed to 10 ppm for the
LaserPrinter. Both versions used the same “engine” and virtually identical parts, with one
exception: the LaserPrinter E included firmware, which in effect inserts wait states to slow
print speed.

Can damaging one’s own product be profitable?

(18) Price discrimination tends to be more common in the sale of services (e.g.,
discrimination by student/non-student status for movie screenings, by motive for travel or
by age for air transportation services) than in the sale of manufactured goods. Why do
you think this is the case?

(19) Imagine your company is a mobile phone operator. One segment of your customers
are business customers, who all have very similar demand curves for monthly usage of a
mobile phone. Suppose that marginal cost of a phone call is constants and negligible.

a. Using demand diagram show what would be the profit-maximizing two-part tariff
(monthly subscription fee and per-minute charge) for your mobile telephone services?

b. Suppose your customers differ in terms of willingness to pay for the mobile phone.
For simplicity assume that each of them belongs to one of the two groups: heavy users
and light users. You cannot identify who belongs to which group, but you can set two
different tariffs designed for the two groups. Would it be profit maximizing to simply
multiply the tariff you designed under (a) by using two different demand curves (for
heavy and light users)? Explain.

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(20) On January 1, 1971, the U.S. Congress passed legislation prohibiting cigarette
producers from advertising on radio and television. Congress claimed it was acting in the
public interest, given recent scientific evidence of a link between cancer and smoking.
There were some people, however, who argued that the cigarette producers themselves
would be the principal beneficiaries of the ban on radio and TV advertising.

a. Why might the producers benefit from government legislation forbidding their
principal medium of advertising?

b. There is considerable evidence that the producers did not want the ban. (For example,
they appealed the law to the U.S. Supreme Court - and lost). Given your answer to
(a), why do you think the producers opposed the law?

(21) Consider a mile-long beach with two identical ice cream (homogenous product)
vendors, one at each extreme of the beach. If both vendors sell at the same price, a
consumer who is located close to one end of the beach naturally prefers the seller who is
located nearby. The reverse is true for a consumer located near the other end of the beach.
The vendors do not talk to each other.

Will price competition between them drive the prices down to the marginal costs, as a
simple pricing game would predict? Why or why not? Would it make any difference if the
beach were ten miles long?

(22) EasyJet is one of the European success stories of the 1990s. Following deregulation
of the European airline industry, easyJet started operating low-cost, no-frills air service
between different European cities, using London-Lutton as its main hub. Soon after
entering the London-Amsterdam segment, KLM, which held 40% of the market,
responded by matching easyJet’s low fares. For KLM, this amounted most certainly to
pricing below cost, and it implied serious losses for easyJet on that particular route.
Although easyJet has survived this first response by an incumbent firm, it seems plausible
that KLM’s tactics were directed at inducing easyJet to exit the market

Such tactics are known as predatory pricing. Are they likely to succeed? Which market
and firm-specific conditions make success of predatory pricing more probable?

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(23) Prior to the Iranian revolution, Iran and Saudi Arabia usually took predictable
positions in debates within OPEC over oil pricing strategy. Iran invariably wanted to
charge higher prices than did Saudi Arabia.

a. What circumstances would cause one OPEC member to prefer a lower price than
another? From what you know about Iran and Saudi Arabia, can you explain the logic
of their differing pricing preferences?

b. Is there a single OPEC price that would maximize the cartel's profit? If so, why do
different countries prefer different prices?

c. What characteristics of OPEC helped its members to maintain a stable cartel? What
characteristics undermined that stability?

(24) Consider the following sequential strategic situation. There are two armies, led by a
general called Napoléon and Nelson, respectively. Napoléon wants to invade a
neighboring country, while Nelson would like to prevent this from happening. Napoléon
has a first-mover advantage, i.e. he decides first whether he invades ("in") or not ("out").
Responding to Napoléon's move, Nelson has two options, to fight or not to fight. The
situation can be represented by the following decision tree.

(10,0)
"out"
(-5,-5)
"fight"

"in"

"not
fight" (-1,10)

Note : The first number is the payoff to Nelson and the second to Napoléon.

a. What are the Nash equilibria in this game? Explain. What is the likely outcome of
this game? Explain.

b. What can Nelson do to possibly change the outcome in his favor? Explain.

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(25) There are three industrial firms in Eurovia.

Firm Initial pollution level Cost of reducing pollution by 1 unit


A 70 units €20
B 80 units €25
C 50 units €10

The government wants to reduce pollution to 120 units, so it gives each firm 40 tradable
pollution permits.

a. Who sell permits and how many do they sell? Who buys permits and how many do
they buy? Briefly explain why the sellers and buyers are each willing to do so. What
is the total cost of pollution reduction in this situation?

b. How much higher would the cost of pollution reduction be if the permits could not
be traded?

(26) Suppose that the government decides to issue tradable permits for a certain form of
pollution.

a. Does it matter for economic efficiency whether the government distributes or


auctions the permits? Does it matter in any other way?

b. If the government chooses to distribute the permits, does the allocation of permits
among firms matter for efficiency? Does it matter in any other way?

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