Question

The A-Mark company budgets $4,000 per month for business travel or electronic media for attending conferences. Marriott Hotels recently cut their room rental fees by 25% in an effort to bolster dwindling occupancy rates among its business travelers caused by more widespread use of teleconferencing using the internet.

a. Graphically illustrate how the 25% reduction in the price of business travel would impact A-Marks’ opportunity set if the initial price of business travel was $1,000 and the price of electronic teleconferencing is $500.

b. After the decrease in price, A-Mark reports that its marginal rate of substitution between business travel and electronic teleconferencing is 1. Explain why A-Mark is not allocating its resources in the most efficient manner.

c. Qualitatively (no numbers or calculations), what should A-Mark do in terms of increasing or decreasing its use of both business travel and electronic teleconferencing?

Answer 1

Budget = 4000

a)

Initial the opportunity set of the consumer is given by OAB:

With the budget of 4000, the consumer can have 4000/1000 = 4 business travels or 4000/500 = 8 electronic teleconferencing.

With the price change, the horizontal intercept changes as with the budget of 4000, the consumer can now have 4000/750 = 5.33 of business travels. Hence the opportunity sets increases to OAC.

b)

MRS = 1

At the equilibrium, the MRS must be equal to the price ratio.

Price ratio after price change = 750/500 = 1.5

Hence the MRS is lesser than the price ratio. Thus A mark is not allocating resources efficiently.

c)

Since MRS between business travel and electronic teleconferencing is less than the price ratio, this implies that the Marginal Utility of Business travel/Marginal Utility of electronic teleconferencing < Price of Business travel / Price of electronic teleconferencing

Thus A mark should decrease business travel and increase electronic teleconferencing until the MRS is equal to the price ratio.

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