Managerial Economics

Indian School of Business

Term 1, 2012-13

HOMEWORK 1
Due: Friday, May 18 at 4pm

Problem 1
Madhu is a risk-averse decision maker whose utility function is given by U ( I )  I , where I
denotes Madhu‟s monetary payoff from an investment. Madhu is considering an investment in
machine tools factory with a payoff of Rs. 10,00,000 with probability 0.6, and Rs. 250,000 with
probability 0.4. If the cost of the investment is Rs. 6,00,000, should Madhu invest in this factory?

Problem 2
Consider two farmers and two pieces of land.1 We want to know what the effect is of each
farmer working his own piece of land versus the farmers cooperating and jointly working on the
two pieces of land. To simplify the exposition, we will denote these as „independent farmers‟ and
„cooperative farmers‟ respectively.

Assume that each farmer (whether independent or cooperative) can decide on his own how much
time to spend on farming. Let farmer i‟s weekly time spent on farming be denoted h i (in hours
per week; so h1 for farmer 1 and h2 for farmer 2). The farmer‟s productivity (expressed in
bushels of grain) is directly proportional to the time he spends on farming. In particular, an
independent farmer produces (80*hi) bushels of grain if he works hi hours per week. Farmers in a
cooperative are more productive since they can specialize: a cooperative farmer produces (90*
hi) bushels of grain if he works hi hours per week. Cooperative farmers share the output of their
farm equally. Let bi be the bushels of grain that farmer i can take home at the end of the year,
then bi = 80hi for an independent farmer, while bi = (90h1 + 90h2)/2 for a cooperative farmer.

Farmers dislike working and more so as they work more. In particular, farmer i‟s utility is

Ui = bi – (hi2/2)

We assume that a farmer i will choose hi to maximize his utility Ui.

(a) Write out the utility functions of an independent farmer and a cooperative farmer completely
in terms of h1 and h2.

(b) How many hours will an independent farmer work (assuming that farmers choose hi to
maximize their utility)? What is his utility?
1
This question is from Berndt, Chapman, Doyle and Stoker‟s course at MIT Sloan
(c) How many hours will a cooperative farmer work? What is his utility?

(d) What is the problem with a cooperative farm? What would happen (qualitatively) if 100
farmers worked jointly in a cooperative farm? How could the farmers solve that problem?

Problem 3
An annuity provides insurance against out-living one‟s financial resources. LEICO, a life
insurance company, takes a deposit from customers at age 60 years, and returns an annual
payment of Rs. 5000 till their death.

(a) Calculate the break-even deposit for LEICO if average population-wide life expectancy is 80
years. Assume a 5% interest rate.

(b) If potential customers have a sense of their life expectancy, based on factors such as the
longevity of their parents, who will purchase the annuity with the deposit you have calculated
above?

(c) If life expectancy is uniformly distributed in the population (up to a maximum of 100 years),
what is the deposit that that LEICO will ultimately end up charging? Who will finally buy
this annuity?

Problem 4
The business district of Bombay2, Hariman‟s Joint, sits on an island.3 Most of the people who
work in this district commute from the mainland. Specifically, 400,000 people make this
commute. Bombayites are in love with their cars, so each of the 400,000 people drives to and
from work in a private car; there is no carpooling.

There are two routes from the mainland into (and out of) the business district, the Borli Bridge
(B)4 and the Tycoon‟s Tunnel (T). The times it takes to commute across the bridge and through
the tunnel depend on the number of individuals nB and nT who take the bridge and the tunnel,
respectively. Specifically, if nB people come via the bridge, the commute time via the bridge is
30+ nB/20000 minutes, and if nT people come via the tunnel, the commute time via the tunnel is
40+ nT/5000 minutes.

(a) Suppose each of the 400,000 people who make this commute takes either the bridge or the
tunnel; that is, nB+nT =400,000. People choose whether to take the bridge or the tunnel
depending on which takes less time, so in equilibrium, the numbers nB and nT are chosen so
that the two commute times are equal. What are nB and nT?

2
Any resemblance to the actual city of Mumbai is purely coincidental.
3
This problem is adapted from Kreps‟ Microeconomics for Managers.
4
The local press grandly calls this a “sealink”.
(b) We define the total commute time as nB times the commute time via the bridge plus nT times
the commute time via the tunnel. In your answer to part a, what is the total commute time?

(c) Suppose Bombay‟s mayor could control the number of people who come via the bridge and
via the tunnel. She chooses these numbers to minimize the total commute time. How should
she allocate the 400,000 commuters between the bridge and the tunnel to minimize total
commute time?

(d) Except for the congestion on the bridge and tunnel, there is a 0 marginal cost of getting
commuters across the bridge and the tunnel. For this reason, transit across the bridge and
through the tunnel has been kept free. But the mayor is considering whether to impose a toll
on one or the other. If a toll of tB is imposed on the bridge and tT on the tunnel, consumers
will rearrange their commute so that (10tB+commute time through the bridge in minutes)
equals (10tT +commute time through the tunnel in minutes). In other words, 10 minutes of
commute time is worth Rs. 1 to commuters. Find values for tB and tT, where one is 0, so that,
facing these tolls, commuters arrange their commute in the manner that minimizes total
commute time.

Problem 5
Awbrey Butte is an exclusive neighborhood of big, modern houses surrounded by native pines in
the Oregon mountains (see attached article). Resident Susan Taylor likes to use a clothesline to
dry her laundry, and thus saves $80 on average in annual energy costs (apart from the obvious
environmental benefits). Neighborhood manager Carol Haworth is concerned that seeing laundry
outside might give potential home-buyers the idea that residents are too poor to afford dryers,
and that will drive down property values. Suppose the decline in property values is proportional
to the number of weeks a year Susan dries her laundry outside.

Number of weeks Total benefits to Susan Total annualized loss to

clothesline is used Taylor Carol Hayworth

0 0 0

10 $16 $10

20 $32 $25

30 $48 $45

40 $64 $70

50 $80 $100
(a) In the absence of bargaining, how many weeks would Susan dry her laundry if she has a right
to do so?

(b) In the absence of bargaining, how many weeks would Susan dry her laundry if Carol has a
right to protect her property value?

(c) What is the socially optimal number of weeks the clothesline should be used?

(d) With bargaining, how many weeks would Susan dry her laundry if she has a right to do so?
How much would Carol pay Susan?

(e) With bargaining, how many weeks would Susan dry her laundry if Carol has a right to
protect her property value? How much would Susan pay Carol?
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