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DEADLINE 21/03/18

BED 1101: INTRODUCTION TO MICROECONOMICS

CAT 1 AND 2

1.) You are a leading consultant with a firm producing milk within Laikipia County. One of your
main roles is to advice the firm on price strategies that would lead to maximize profits. The firm
is a monopolist which sells in two distinct markets, one of which is completely sealed off from
the other.

In line of your assignment, you establish that the total demand for the firms output is given by
the following equation:

Q = 50 – 0.5P

The demand for the firms output in the two markets is:

Q1 = 32 – 0.4P1

Q2 = 18 – 0.1 P2

Where Q= total output

P= Price

Q1= Output sold in market 1

Q2= Output sold in market 2

P1= Price charged in market 1

P2= Price charged in market 2

The total cost of production is given by C= 50 + 40Q, where C= total cost of producing a unit of
milk.
Required:

a) The total output that the firm must produce in order to maximize profits ( 3 marks)

Profit is maximized where MC = MR


MC = dTC/ dQ = 40

IN THE ENTIRE MARKET


MR = dTR/ dQ
TR = P.Q
Q = 50 – 0.5P

0.5P = 50 – Q

P = 100 – 2Q
TR = P.Q = (100 – 2Q) Q
TR = 100Q – 2Q2
MR = dTR/ dQ = 100 – 4Q

BUT MR = MC

Thus 100 – 4Q = 40

Q = 15 (this is the total output that the firm must produce in order to maximize profits)

b) What price must be charged in each market in order to maximize profits ( 2 marks)

Profit is maximized where MC = MR


MC = dTC/ dQ = 40

IN THE MARKET 1
MR1 = dTR/ dQ
TR1 = P1.Q1
Q1 = 32– 0.4P1

0.4P1 = 32 – Q1

P1 = 80 – 2.5Q1
TR1 = P.Q1 = (80 – 2.5Q1) Q1
TR1 = 80Q1 – 2.5Q12
MR1 = dTR1/ dQ1 = 80 – 5Q1

BUT MR1 = MC1

Thus 80 – 5Q1= 40
Q 1= 8

Substitution for P1 in equation P1 = 80 – 2.5Q1

P1 = 80 – 2.5*8
P1 = 60 (price in market one)

IN THE MARKET 2
MR2 = dTR2/ dQ2
TR2 = P2.Q2
Q2 = 18– 0.1P2

0.1P2 = 18 – Q2

P2 = 180 – 10Q2
TR2 = P2.Q2= (180 – 10Q2) Q2
TR2= 180Q2 – 10Q22
MR2 = dTR2/ dQ2= 180 – 20Q2

BUT MR2 = MC2

Thus 180 – 20Q2= 40

Q 2= 7

Substitution for P2 in equation P2 = 180 – 10Q2

P2 = 180 – 10*7
P2 = 110 (price in market two)

c) How much profit would the firm earn if it sold the output as a single price, and if the firm
discriminates

Profit = TR – TC
In the entire market Profit the firm would if it sold the output as a single price

TR = 100Q – 2Q2
Where Q = 15
Thus TR = 100*15 – 2*152 = 1050
TC = 50 + 40Q = 50 + 40*15 = 650
BUT Profit = TR – TC = 1050 – 650 = 400 profit the firm would earn if it sold the output
as a single price
Profit the firm would if the firm price discriminates
Profit = (TR1+ TR2 )– TC

TR1 = 80Q1 – 2.5Q12 =*8 80*8 – 2.5*8 = 620

TR2= 180Q2 – 10Q22 = 180*7 – 10*7 = 1190

Profit = (620+ 1190) – 650 = 1,160

(4 marks)
d) i.) The price elasticity of demand for the two markets at the equilibrium price and
quantity. (4 marks)

Assumption: Starting price is the individual market price while the equilibrium price is
the entire market price which is the final price.

PED = Price elasticity of demand = % change in Quantity demanded / % change in Price

Market 1 PED = ((15 – 8)/ (70 - 60))* 60/8 = 5.25 Thus Elastic as PED greater than 1
Market 2 PED = ((15 – 7)/ (70 - 110))* 110/7 = 3.14 Thus Elastic as PED greater than 1

ii.) Give a comment on how the price elasticity of demand may be used in making economic
decisions (3 marks)

Determination of price

The primary objective of any firm is to earn profit or increase revenue. Therefore, increasing

price of its products to maximize profit is one of the primary concerns of producers.

However, during the course of increasing price, the producers must not forget that demand and

price share inverse relationship. They must be aware that demand falls with rise in price. And

thus, they must increase price of their commodity to that level where their desired or optimal

profit is still achievable.

Monopoly price determination


A monopolist while fixing the price of the market has to determine whether its product is of

elastic or inelastic nature.

If the product is inelastic (less or no effect on demand with change in price), the producer can

earn profit by setting high price. However, if the product is elastic (highly affected by even

slightest change in price), the producer must set low or at least reasonable price so that the

consumers are attracted to buy the goods.

Price determination under discriminating monopoly

The situation where single group or company charges different prices for the same commodity at
different market is known as discriminating monopoly.

Price determination of joint products

Joint products are various products generated by a single production procedure at a single time.

Sheep and wool, cotton and cotton seeds, wheat and hay, etc. are some examples of joint

products. We cannot separate the cost of producing wheat and hay, as producing wheat will

automatically produce the hay as well.

However, since they are two different products, we cannot sell them at the same price in the

market. Price elasticity of demand plays important role in determining the prices of these joint

products.

e.) Under what market conditions is price discrimination possible? (2 marks)

Price discrimination is possible under following conditions:


1. Nature of Commodity:

In the first place it is said that price discrimination is possible when the nature of the commodity

or service is such that there is no possibility of transference from one market to the other.

That is, the goods sold in the cheaper market cannot be resold in the dearer market; otherwise the

monopolist’s purpose will be defeated.

2. Distance of Two Markets:

Price discrimination is possible when the two markets or markets are separated by large

distance or tariff barriers, so that it is not possible to transfer goods from a cheaper market to

dearer markets.

3. Ignorance of the Consumers:

Price discrimination is possible when the consumers are ignorant about price discrimination, they

are not aware that in one part of the market prices are lower than in the other part.

4. Government Regulation:

Price discrimination occurs when the government rules and regulations permit. For instance,

according to rules, electricity rates are fixed at higher level for industrial purposes and lower for

domestic uses
5. Geographical Discrimination:

Price discrimination may be possible on account of geographical situations. The monopolist may

discriminate between home and foreign buyers by selling at lower price in the foreign market

than in the domestic market.

6. Difference in Elasticity of Demand:

A commodity may have different elasticity of demand in different markets. Thus, the market

of a commodity can be separated on the basis of its elasticity of demand.

7. Artificial Difference between Goods:

A monopolist may create artificial differences by presenting the same commodity under different

names and labels, one for the rich and snobbish buyers and the other for the ordinary customers.

2. a.) What is a factor of production? (1 mark)

Factors of production is an economic term that describes the inputs that are used in the

production of goods or services in order to make an economic profit. The factors of production

include land, labor, capital and entrepreneurship.

b.) Explain the meaning of mobility of factors of production. To what extent


are factors of production mobile? (5 marks)
Factor mobility refers to the ability to move factors of production - labor, capital or land -

out of one production process into another. Factor mobility may involve the movement of

factors between firms within an industry, as when one steel plant closes but sells its

production equipment to another steel firm. Mobility may involve the movement of

factors across industries within a country, as when a worker leaves employment at a


textile firm and begins work at a automobile factory. Finally mobility may involve the

movement of factors between countries either within industries or across industries, as

when a farm worker migrates to another country or when a factory is moved abroad.

Factors determining mobility of factors of production eg labour:

(1) Education and Training:

The mobility of labour depends on the extent to which Labour is educated and trained. Higher or

more a person is educated and skilled. The greater are his chances of moving from one

occupations or place to another. Geographical and vertical mobility is very much dependent on

education and training.

(2) Urge to Rise in Life:

The inner urge of the workers to rise in life determines the mobility. If workers are optimist and
broad minded, they will move to other jobs and places. Differences in language, habits, religion
caste etc. will not be hindrances in their mobility.

(3) Means of Transport and Communication:

Well-developed means of transport and communications encourage mobility of labour. The


worker knows that in case of emergency at home we can easily communicate with his family on
phone or travel back by train within the country or by aero-plane if he is abroad.

(4) Social Set-up:

The mobility of labour also depends upon the social set-up. A society dominated by caste system
and joint family system lacks in mobility of labour. But where the joint family and caste systems
do not exist or have disintegrated family, the mobility of labour increases.

(5) Agricultural Development:

In a developed agricultural area or where there is agricultural development labour moves from
high population to low population areas during busy seasons.
c.) What is the significance of the laws of diminishing marginal returns and
the laws of returns to scale in the management and economic policy
decision-making process?
( 6 marks)

1) This law is the basis of Malthusian Theory of Population.

2) It is also the basis for Ricardian Theory of Rent.

3) Several theories relating to wages, interest and profits are propounded on the basis of the Law

of Diminishing Returns. The theory of distribution of national income is also based on this law.

4) The Law of Diminishing Returns is highly useful for understanding the problems of

developing countries. Because agriculture is the main occupation and primary sector in these

countries. As agriculture is subjected to the application of the Law of Diminishing Returns, it is

used for increasing the productivity in agriculture.

5) The theory of pricing of factors of production is also based on the Law of Diminishing

Returns.

6) The least combination of factors is based on this law.

7) The Law of Diminishing Returns is also the basis for explaining the behaviors of cost of

production.
1. Microeconomics: Principles, Problems, & Policies by Campbell C, Stanley Brue, and
Sean Flynn

2. Principles of Microeconomics, 8th Edition by Gregory Mankiw

3. Microeconomics By: Paul Krugman and Robin Wells

4. Principles of Microeconomics 12th Edition by: Karl E. Case, Ray C. Fair and Sharon
E. Oster

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