Question

Use the following information in answering questions 14 - 19. Assume persons of type 1 value quality level z and the product itself such that the reservation price for one unit is 8 + 2z. Similarly, for a person of type 2 the reservation price is 10 + 4z. The cost of producing the product is 2 and the cost of each unit of z is 3. Assume that z can be either equal to 1 or 2. This same information is repeated on the next page.

Answer 1

Note that the cost of production would be 2+3z per unit.

16. The correct option would be

• d) 10

The low quality would be represented by z=1. The reservation price of type 1 is 8+2*1 or 10 and of type 2 is 10+4*1 or 14. The producer would aim to maximize profit. If price is set at 14, only type 2 will buy and revenue would be 14 while cost would be 2+3*1 or 5. The profit is 9.

If price is set at 10, both type 1 and type 2 will buy, and total revenue is 20. The cost per unit is 5, and the total cost would be 10. The profit in this case is 10. The profit is higher when price is set at 10, and the profit is 10.

17. The correct option would be

• d) 10

The low quality would be represented by z=2. The reservation price of type 1 is 8+2*2 or 12 and of type 2 is 10+4*2 or 18. The producer would aim to maximize profit. If price is set at 18, only type 2 will buy and revenue would be 18 while cost would be 2+3*2 or 8. The profit is 10.

If price is set at 12, both type 1 and type 2 will buy, and total revenue is 24. The cost per unit is 8, and the total cost would be 16. The profit in this case is 8. The profit is higher when price is set at 18, and the profit is 10.