IMBA Managerial Economics Homework1 (Due:9/30) 1.

In each of the following instances, discuss whether horizontal or vertical boundaries have been changed, and whether they were extended or shrunk. a. General Motors divested Delphi Automotive Systems, which manufactures automotive components, systems and modules. b. Online auction service eBay acquired Skype, a provider of Internet telephony services. c. Following the September 11, 2001 attacks, the U.S. government established the Department of Homeland Security. The new Department took over the Customs and Secret Services from the Department of the Treasury and the Immigration Service from the Department of Justice. Answer: (a) Vertical boundaries shrunk. (b) Vertical boundaries expanded (eBay customers can use Skype to communicate with each other). (c) Horizontal and vertical boundaries of the Department of Homeland Security expanded. 2.In fall 2005, an ABC News poll reported that 46% of lower-income Americans (earning less than $100,000 a year) were angry about gasoline prices, while just 32% of higher-income people (earning $100,000 a year or more) were angry. Despite higher gasoline bills, just 22% of survey respondents said that they had reduced driving. However, 63% said that they would cut back on driving if gasoline prices rose above $3 per gallon. a. Use a demand curve to explain why the proportion of people who would reduce driving is higher if the price of gasoline is higher. b. Explain how people can adjust to higher gasoline prices by replacing their cars rather than driving less. c. Why were relatively fewer higher-income people angry about high gasoline prices? Answer: (a) The demand curve for gasoline would slope downward. Hence, the

higher is the price gasoline, the more people would reduce driving. (b) Cars differ in gasoline consumption. People can adjust to higher gasoline prices by replacing gas guzzlers with more fuel-efficient cars. This is a long-term response. (c) People with higher income would be less sensitive to price changes. 3.The price of Chanel perfume is around $200 per fluid ounce, while the price of Arrowhead bottled water is $1 per gallon. Nancy buys 2 fluid ounces of Chanel and 10 gallons of bottled water a month. a.Using relevant demand curves, illustrate Nancy's choices. Illustrate how the following changes will affect Nancy's demand for Chanel perfume: (i) price increase to $220 per fluid ounce, and (ii) cut in price of another of Nancy's favorite perfumes. b.Nancy spends more money each month on perfume than bottled water. Does this necessarily mean that perfume gives her more total benefit than water? Use appropriate demand curves to address this question. Answer: (a) (i) This will decrease the quantity demanded of Chanel perfume -movement down along the demand curve; (ii) This will decrease the demand for Chanel perfume -- the demand curve shifts to the left. (b) No. Total benefit is the area under the demand curve (which is not the same as expenditure). The area under the demand curve for perfume could be much smaller than that for water. Implication: Nancy is getting much more buyer surplus from her purchases of water than from her purchases of perfume. 4.PCCW provides broadband Internet access in Hong Kong under the brand name, Netvigator. Table 1 lists several of the plans offered in April 2004. Table 1: Netvigator Broadband Internet Access Plans Plan Monthly Included Charge per Subscription Hours additional hour Basic HK$198 20 HK$2 3M Single User Plan HK$298 100 HK$2

Bandwidth Up to 1.5 Mbps Up to 3.0 Mbps

6M Single User Plan

HK$398

200

HK$2

Up to 6.0 Mbps

a.Wong subscribes to the 6M plan and uses 150 hours a month. Suppose that Wong's demand curve is a straight line such that if the price of access were HK$20 per hour or higher, she would buy nothing. Draw her demand curve, and calculate her buyer surplus. b.Suppose that Wong switches to the 3M plan. Referring to her demand curve, how many hours would she use each month? Calculate her buyer surplus. Answer: (a) Refer to the following diagram for Wongs demand curve. Her buyer surplus with the 6M plan is x 20 x 150 398 = $1,102.

20

2 0 135 150 0

(b) With the 3M plan, she would use 135 hours a month (35 hours in excess of the included time). Her buyer surplus would be x [20 + 2] x 135 298 -70= $1,117. 5.Electric power producers have a choice of several fuels including oil, natural gas, coal, and uranium. Once an electric power plant has been built, however, the scope to switch fuels may be very limited. Since power plants last for thirty years or more, producers must consider the relative prices of the alternative fuels well into the future when choosing generating plant.

a. Do you expect the cross-price elasticity between the demand for oil-fired power plants and the price of oil to be positive or negative? b. Will the cross-price elasticity between the demand for oil-fired power plants and the price of coal be positive or negative? c. Compare the short with the long-run ownprice elasticity of the demand for oil-fired power plants. Answer: (a) Negative, because an increase in the price of oil will decrease the demand for oil-fired power plants. (b) Positive, because an increase in the price of coal will increase the demand for oil-fired power plants. (c) The demand for oil-fired power plants will be more elastic in the long run because there is more time for power producers to adjust to input prices, and specifically, to switch between plants fueled by oil and other types of generating plant. 6.Automobile travel demand (measured in total number of miles driven) is estimated to have short and long-run elasticities with respect to the price of gasoline of 0.10 and 0.29, respectively. The demand for automobile travel also depends on total travel time: the short- and long-run elasticities are estimated to be 0.27 and 0.57, respectively (Source: Victoria Transport Policy Institute, www.vtpi.org/elasticities.pdf ). a.Explain why the long-run elasticities of the demand for automobile travel are more negative than the short-run elasticities. How does consumer choice of automobile affect the difference? b.Suppose that the gasoline price rises by 20% and construction of new roads reduces travel time by 10%. Calculate the percentage change in the total number of miles driven in the (i) short run, and (ii) long run. Answer: (a) In the long run, there is more time to adjust, and hence, a proportionately larger adjustment to demand is possible. In the short run, consumers choice of car cannot be changed. By contrast, in the

long run, consumers can adjust to changes in gasoline prices by changing their cars. Hence, the long-run demand is more elastic. (b) (i) In the short run, the change in demand = [-0.10 x 20%] + [-0.27 x (-10%)] = +0.7%. (ii) In long run, the change in demand = [-0.29 x 20%] + [-0.57 x (-10%)] = -0.1%. 7.An Australian telecommunications carrier wants to estimate the own-price elasticity of the demand for international calls to the United States. It has collected annual records of international calls and prices. In each of the following groups, choose the one factor that you would also consider in the regression equation. Explain your reasoning. a. Consumer characteristics: (i) average per capita income, (ii) average age. b. Complements: (i) number of telephone lines, (ii) number of mobile telephone subscribers. c. Prices of related items: (i) price of electricity, (ii) postage rate from Australia to the United States. Answer: (a) The average per capita income accounts for a larger part of the variation in the quantity demanded of international calls than the average age. (b) The number of fixed lines accounts for a larger part of the variation in the quantity demanded of international calls than the number of mobile subscribers. (c) The postage rate accounts for a larger part of the variation in the quantity demanded of international calls than the price of electricity.

8.Barrick Gold owns the Bulyanhulu mine in Tanzania and the Karlgoolie mine in Australia. Table 2 reports information on selling prices and costs for the two mines. Barricks selling price of gold differs from the spot price as some production is sold through long-term contract and also owing to the companys use of hedging. The average cash cost includes operating cost, royalties, and taxes, while the average cost includes the cash cost as well as amortization.

a. Suppose that the Bulyanhulu mine always produces at the scale where its marginal cost equals the selling price of gold. Its marginal cost curve, however, shifts with changes in electricity prices, wages, and other factors. Using the data from table 4.8, illustrate the shifts in Bulyanhulus marginal cost curve, the selling price, and profit-maximizing scale of production between 2002 and 2004. b. In 2003, Barrick continued to produce from the Bulyanhulu mine even though the selling price of gold, $366 per ounce, was less than its average production cost of $369 per ounce. Was this a mistake? c. Use Barricks 2004 data to compare the (i) short-run break even conditions for Bulyanhulu and Karlgoolie; and (ii) the long-run break even conditions for the two mines. Table 2: Barrick Gold

2002 Production (thousand ounces) 356 Selling price ($ per ounce) 339 Average cash cost ($ per ounce) 198 Average cost ($ per ounce) 300 Source: Barrick Gold Corporation, Annual
Answer: (a)
Price ($/ounce) 391 366 339 2003

Bulyanhulu 2003 2004 314 350 366 391 246 284 369 384 Reports

Karlgoolie 2004 444 391 234 278

2004 2002 2002

314

350

356

Production (000 ounces)

(b) Not necessarily. It makes sense to produce provided that the price, $366 per ounce, exceeds average variable cost. Assuming that cash cost represents variable cost, the average variable cost was $246 per ounce, which was less than the price. (c) Assuming that cash cost represents variable cost, both the short- and longrun breakeven prices were lower at Karlgoolie than Bulyanhulu: $234 compared with $284 per ounce, and $278 compared with $384 per ounce.

9.Dynamic random access memory (DRAM) chips are an essential component of personal computers, mobile telephones, and other electronic devices. Over the course of the 1990s, DRAM technology evolved through several generations from 4 Megabits to the present state-of-the-art 4 Gigabit chips. Until 1998, there were two major American manufacturers of DRAMs Texas Instruments (TI) and Micron Technology. Then, TI sold its factories in Avezzano (Italy), Richardson (Texas), and Singapore, and interests in two Asian joint ventures to Micron Technology. TI shut the remainder of its DRAM production facilities including one in Midland, Texas. a.Which probably had the higher average cost the Richardson or Midland plant? b.Compare the effects on the world wide long-run DRAM supply of TIs sale of the Richardson plant with its closure of the Midland factory. c.Explain Microns decision to buy TIs plants in terms of differences between the two companies in their expectations of long-run DRAM prices. Answer: (a) The Midland plant probably had the higher average cost, which explains why TI could not sell it and had to shut it. (b) TIs sale of the Richardson factory did not change the worldwide long-run supply of DRAMs. Its closure of the Midland factory did reduce the supply. (c) Microns forecast of long-run DRAM prices may have been higher than TIs. 10.In January 2005, the worlds total supply of oil tankers amounted to 304.1 million deadweight tons (dwt). During 2005, 28.0 million dwt of new tankers were delivered into service, while 5.1 million dwt were scrapped or otherwise removed from service. Hence, at the end of the year, the worlds total supply was 326.9 million dwt. Among tankers and chemical carriers in operation of

200,000 dwt or larger, 60% by tonnage was less than 10 years old, 37% was 1020 years old, and the remainder was more than 20 years old. (Source: Platou Report, 2006.) Typically, older tankers are more costly to operate. a.Identify the following as either a short- or long-run decision: (i) lay-up (idling the vessel); (ii) scrapping. b.Explain how the owner of a tanker should decide whether to continue to operate, lay-up, or scrap a vessel. c.The marginal cost of keeping a tanker in service (lay-up equivalent) is the tankers operating cost minus the cost of lay-up. When tanker rates fall, identify which tanker owners would first lay up. Answer: (a) (b) Lay-up is a short-run decision; scrapping is a long-run decision. Operate if short-run price > average variable cost; Lay up if short-run price < average variable cost and long-run price > average cost; Scrap if long-run price < average cost. [More sophisticated answer using concepts of net present value, operating cost (continuing), and lay-up cost (one-off): Operate if NPV(short-run price operating cost) > - lay-up cost; Lay up if NPV(short-run price operating cost) < - lay-up cost and NPV(long-run price operating cost repair/refitting cost) > - scrapping cost; scrap if NPV(longrun price operating cost repair/refitting cost) < - scrapping cost.] (c) Those with relatively highest operating cost or lowest cost of lay-up.