Upscale hotels in the United States recently cut their prices by 20% in an effor

Question

Upscale hotels in the United States recently cut their prices by 20% in an effort to bolster dwindling occupancy rates among business travelers. A survey performed by a major research organization indicated that businesses are wary of current economic conditions and are now resorting to electronic media, such as Internet video conferencing, to transact business. Assume a company’s budget permits it to spend $5,000 per month on either business travel or electronic media to transact business. Graphically illustrate how a 20% decline in the price of business travel would impact this company’s budget set if the price of business travel was initially $1,000 per trip and the price of electronic media was $500 per hour. Suppose that, after the price of business travel drops, the company issues a report indicating that its marginal rate of substitution between electronic media and business travel is -1. Explain whether the company is allocating its resources efficiently, and if not, explain how the company may improve its resource allocation by increasing its business travel or increasing its usage of electronic media.

Explanation / Answer

Let income: M

Price of business travel (B): PB

Price of elecronic media (E): PE

Then, initial budget line:

M = B x PB + E x PE

5000 = 1000B + 500 E

Dividing both sides by 500,

10 = 2B + E

MRS = - Price ratio = - PB / PE = - 1000 / 500 = - 2

Now, PB decreases by 20% to $800.

New Price ratio = - 800 / 500 = - 1.6

If equilibrium condition holds, the new MRS should have been equal to the new price ratio, equalling - 1.6.

But revised MRS = - 1. This clearly indicates inefficient resource utilization.

Therefore, the company should increase business travel (and/or decrease electronic media), to bring about equilibrium.

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