MICROECONOMICS 1 MODULE

TEACHING ASSISTANTS OF MICROECONOMICS

AND MACROECONOMICS
ECONOMICS AND DEVELOPMENT STUDIES
FACULTY OF ECONOMICS AND BUSINESS
PADJADJARAN UNIVERSITY
2012
1

ACKNOWLEDGEMENT
In the name of Allah, The Most Gracious, The Most Merciful
Alhamdulillah, all praises to Allah SWT, The Almighty, for giving belief,
health, confidence and blessing for the writers to accomplish this Module of
Microeconomics I. Shalawat and Salam be upon our Prophet Muhammad SAW, who
has brought us from the darkness into the brightness and guided us into the right way
of life.
In this opportunity, we also like to express our deep thanks to Dr. Kodrat
Wibowo, S.E. as the Head Department of Economics, Dr. Mohamad Fahmi, SE., MT
as the Head of Undergraduate Program of Department of Economics, lecturers, and
those who contributed and helped in the process of making this module. All of your
\kindness and help means a lot to us. Thank you very much
We realise that the contents in this module is not that perfect. Therefore, we
are willing to receive and consider feedback, suggestions and constructive criticisms,
and eager to implement improvements.
Hopefully this module can be the short guide for the students in order to
deepen the understanding and the analysis of Microeconomics I theory. Thank you.
List of the Module Writers:
1.
2.
3.
4.
5.

Iqbal Dawam Wibisono

Nedia Nurani
Rahma
Citra Kumala
Fierera Devi Febiosa

120210100156
120210110041
120210110124
120210110155
120210120012
Acknowledge and Agree,
Head of Undergraduate Program of
Department of Economics

Dr. Mohamad Fahmi, SE., MT

NIP19731230200012100

TABLE OF CONTENTS
MICROECONOMICS 1 MODULE.................................................1
ACKNOWLEDGEMENT...............................................................2
TABLE OF CONTENTS...............................................................3
MODULE AND LABORATORY GUIDANCE....................................4
REVIEW OF DIFFERENTIAL CALCULUS AND CONSTRAINED
OPTIMIZATION..........................................................................5
PREFERENCE, UTILITY, AND UTILITY FUNCTION.........................9
UTILITY MAXIMIZATION AND CHOICE I & II..............................12
THE THEORY OF OPTIMUM CONSUMERS CHOICE I & II.............16
UNCERTAINTY AND INFORMATION...........................................19
PRODUCTION FUNCTION..........................................................24
COST MINIMIZATION................................................................28
PROFIT MAXIMIZATION AND PARTIAL EQUILIBRIUM COMPETITIVE
MODEL................................................................................... 33
PARTIAL EQUILIBRIUM COMPETITIVE MODEL...........................38

MODULE AND LABORATORY GUIDANCE

1.

This module was arranged as a media to help the students deepen their
understanding during the laboratory session of Microeconomics 1.
2. This module could only be used during the laboratory of Microeconomics 1.
3. The students are not allowed to bring and copy the module unless they get
permission from the Team of Teaching Assistant.
4. For any reasons, the students are not allowed to write anything in the module
unless they get permission from the Team of Teaching Assistant.
5. The answers are written on the answer sheet/other paper that has been
provided by the Team of Teaching Assistant.
6. The materials in each laboratory meeting is adjusted based on the material
that has been given by each of the lecturers in the class.
7. During the laboratory, all of the students should obey the rules that has been
made by each of the Teaching Assistant.
8. The maximum duration for Laboratory is 2.5 hours (180 minutes)
9. For any incorrect or unclear questions that you found difficult, please re-read
the appropriate question or ask directly to the Teaching Assistant to clear up
any confusion.
10. After successfully finishing the problems, the students can leave the
laboratory room with the permission from the Teaching Assistant.
11. Here below we kindly inform the general rule during the laboratory:
The laboratory has 10 (ten) meetings. The Teaching Assistant will take
only 7 (seven) best mark and one other mark that comes from the
Review in the 10th meeting.
The students are not allowed to change their laboratory schedule
without any permission from their Teaching Assistant.
The students are not allowed to cheat, work together, and open the
book/note while solving the problems in the laboratory.
Other rules that are agreed by the Teaching Assistant and the students in
each laboratory.

Team of Teaching Assistant of Microeconomics 1

CHAPTER 1
REVIEW OF DIFFERENTIAL CALCULUS AND CONSTRAINED
OPTIMIZATION
3

1.

Differentiate

y=( x +7 x1)(5 x+ 3) .

2.

Differentiate

y=x2 ( 4+ 3 x 3 ) .

3.

Differentiate

y=x ln x .

4.

Differentiate

f ( x )=6 x 2 /3 tan x .

5.

Differentiate

y=5 x 2+ sin x cos x .

6.

Differentiate

x
g ( x ) =e ( 7 x ) .

7.

Differentiate

y=7 x e z .

8.

Differentiate

f ( x )=(x+ 8) sec ( 3 x ) .

9.

Differentiate

y=23 x+1 ln ( 5 x11 ) .

10. Differentiate

y=x 2 sin3 ( 5 x ) .

11. Differentiate

y=( x3 7 x 2)4 (1+ 9 x )1/ 2 .

12. Differentiate

y=sec 2 ( x 4 ) tan 3 ( x 4 ) .

13. Differentiate

y=

2
.
x+ 1

14. Differentiate

y=

x2
.
3 x1

15. Differentiate

y=

4 x 37 x
.
2
5 x +2

16. Differentiate

y=

4 sin x
.
2 x +cos x

17. Differentiate

y=

7 x2
.
4 e x x

18. Differentiate

g (x )=

1+ ln x
.
x 2ln x

2x
(
)
g
x
=
.
19. Differentiate
2 x 3 x
(x 21)3
20. Differentiate f ( x )= (x 2+ 1) .
5 ex
(
)
f
x
=
.
21. Differentiate
x+ e2 x

22. Differentiate

x 3 ln x
y=
.
x +2
6

x 2(2 x1)3
f
(
x
)
=
.
23. Differentiate
( x 2 +3)4

24. Differentiate

25. Differentiate

26. Differentiate

g (x )=

f ( x )=

1
.
x x 2 +1

3 x +2
.
2 x1

y=3 x 4 + tan

x
( x1
).

27. Differentiate

y=x 2 e x+1 .

28. Find an equation of the line tangent to the graph of

y=

x3
x 22

at

graph

of

x=1.
29. Find

an

equation

sin (2 x )
y=
cos ( 3 x )+ sec x

of

the

line

tangent

to

the

x= .
at
6

x2
(
)
f
x
=
f ' ( x )=0 for
2 x . Solve
30. Consider the function
e
f ' ' ( x )=0 for x .

x . Solve

31. Find all points

(x , y )

on the graph of

8 x+ 2 y =1.

lines are perpendicular to the line

32. Differentiate

y=(3 x+1)2 .

33. Differentiate

y= 13 x 25 x +8.

34. Differentiate

y=(14 x+7 x 5 )30 .

35. Differentiate

y=(4 x + x5)1 /3 .
6

36. Differentiate

8 xx
3
x

y=

37. Differentiate

y=sin ( 5 x) .

38. Differentiate

y=e5 x +7 x13 .

39. Differentiate

y=2cos x .

40. Differentiate

y=3 tan x .

41. Differentiate

y=ln ( 17x ) .

f ( x )=

x1
2x where tangent

x
4
+cos
.
42. Differentiate
y=log
43. Differentiate

y=cos 2 ( x 3 ) .

44. Differentiate

y=

45. Differentiate

y=ln ( cos5 ( 3 x 4 ) ) .

46. Differentiate

y= sin ( 7 x+ ln ( 5 x ) ).

( 51 ) sec

( 4+ x 3 ) .

2(6+7 x 4 )

1+

47. Differentiate

y=10
x
ln

(
ln

(
sec )) .
48. Differentiate
y=4 ln
49. Differentiate

50. Assume that

y=tan

cos (7 x ).

h ( x )=f ( g ( x ) ) ,

differentiable functions. If
the value of

where both

f and

are

g (1 )=2, g' (1 )=3,f ' ( 2 )=3, what is

h' (1 ) ?
9

51. Assume that

f ( 0 )=
graph of

h ( x )=(f ( x ) )3 , where f

1 '
8
f ( 0 ) =
2
3

is a differentiable function. If

determine an equation of the line tangent to the

h at x=0 .

10

CHAPTER 2
PREFERENCE, UTILITY, AND UTILITY FUNCTION

When individual reports that A preferred to B its taken to mean that all things
considered, he or she feels better off under situation A than situation B. There are
three basic properties of preference relation assumption:
1
2
3

Completeness: if A and B are any two situation, the person can chose three
possibilities: A is preferred to B; B is preferred to A ; or A=B.
Transitivity: the individuals choice are internally consistent, A is preferred
to B ; B is preferred to C ; so A is preferred to C.
Continuity: If an individual reports A is preferred to B , then situation
suitably close to A must also be preferred to B. individuals preferences are
assumed to be represented by a utility function of the form: U (x1,x2,,xn).

Utility, when people are able to rank in order all possible situations from the least
desirable to the most. The situations offer more utility than the other.
Utility = U (W).

The cateris paribus assumption is holding constant the other things that effect
behavior (other things being equal).
Indifferent curve represents those combination of x and y from which the
individual derives the same utility. The slope of this curve represents the rate of
which individual is willing to trade x for y while remaining equally well off. The
negative of the slope of an indifferent curve at the same point is termed the
marginal rate of substitution.
MRS = -

dy
dx

U = U1

Cobb-Douglas Utility,

U ( x , y ) = x y

Perfect Substitution,

U ( x , y ) = x+ y

Perfect Complement,

U ( x , y ) = min (x, y)

CES Utility ,

U ( x , y )=ln x +ln y
11

CHAPTER 2
PREFERENCE, UTILITY, AND UTILITY FUNCTION
1

Graph a typical indifference curve for the following utility function and
determine whether they have convex indifference curve (that is, whether the
MRS declines as

x increses)!

U ( x , y )= x 2 y 2

U ( x , y )=

xy
x+ y

U ( x , y )=ln x +ln y has a diminishing MRS!

Show that

A consumer has a utility function

u ( x 1, x 2 )=max ( x 1, x 2 ) . What is the

consumer's demand function for good l? What is his indirect utility function?
What is his expenditure function?
4

Suppose that a person has initial amounts of the two goods that provide
utility to him or her. This initial amounts are given by
a
b

x and

Graph is initial amounts on this persons indifference curve map!

If this person can trade x for y (or vice versa) with other people,
what kind of trade would he or she voluntarily make? How do these
trades relate to this persons MRS at the point ( x ,

y .

y ) ?

A consumer has an indirect utility function of the form

v ( p1 , p2 , m )=

m
min ( p 1 , p2)

What is the form of the expenditure function for this consumer? What is the
form of a (quasiconcave) utility function for this consumer?

12

Consider the indirect utility function given by

v ( p1 , p2 , m )=

m
( p1 + p2 )

(a) What are the demand functions?

(b) What is the expenditure function?
(c) What is the direct utility function?
7

A consumer has a direct utility function of the form

U ( x 1, x 2 )=u ( x 1 ) + x 2
Good 1 is a discrete good; the only possible levels of consumption of good
1are

x 1=0 and x 1=1 . For convenience, assume that u ( 0 )=0

and

p2=1 .

(a) What kind of preferences does this consumer have?

(b) The consumer will definitely choose

x 1=1 if

p1 is strictly less

than what?
8

A consumer has an indirect utility function of the form

v ( p , m ) =A ( p ) m
(a) What kind of preferences does this consumer have?
(b) What is the form of this consumer's expenditure function
9

Show that the CES Function

x
y
+

is homotetic. How does the MRS depend on the rasio y/x?

10 Two goods have independent marginal utility if

13

e (p ,u) ?

2 U
2 U
=
=0
yx yx
Show that if we assume diminishing marginal utility for each good, then any
utility function with independent marginal utilities will have a diminishing
MRS. Provide an example to show that the converse of this statement is not
true.

CHAPTER 3
UTILITY MAXIMIZATION AND CHOICE I & II

To maximize utility, given a fixed amount of income to spend, an individual

will buy those quantities of goods that exhaust his or her total income and for
which the psychic rate of trade-off between any two goods (the MRS) is
equal to the rate at which the goods can be traded one for the other in the
marketplace.

To reach a constrained maximum, an individual should:

spend all available income
choose a commodity bundle such that the MRS between any two
goods is equal to the ratio of the goods prices

14

the individual will equate the ratios of the marginal utility to price
for every good that is actually consumed

The marginal rate of subsitution (MRS) of goods X and Y is the maximum

amount of goods X that a person is willing to give up to obtain 1 additional
unit of Y. The MRS diminishes as we move down along an indifference
curves. When there is a diminishing MRS, indifference curves are convex.

Consumers maximize satisfaction subject to budget constraint. When a

consumer maximizes satisfaction by consuming some of each of two goods,
the marginal rate of substitution is equal to the ratio of the prices of the two
goods being purchased.

Maximization is sometimes achieved at a corner solution in which one good

is not consumed. In such cases, the marginal rate of substitution need to equal
the ratio of the prices.

The individuals optimal choices implicitly depend on the parameters of his

budget constraint
choices observed will be implicit functions of prices and income
utility will also be an indirect function of prices and income

Demand functions show the dependence of the quantity of each goods

demanded on

p1 , p2 , .. , pnI

maximum utility=U ( x 1 , x 2 , , x n )
V ( p1 , p2 , , p n , I )

The dual problem to the constrained utility-maximization problem is to

minimize the expenditure required to reach a given utility target
yields the same optimal solution as the primary problem
leads to expenditure functions in which spending is a function
of the utility target and prices

Expenditure function is the individuals expenditure function shows the

minimal expenditures necessary to achieve a given utility level for a
particular set of prices.

minimal expenditure=E ( p 1 , p2 , , pn , U )
15

Properties of expenditure functions :

Homogeneity
Expenditure functions are nondecreasing in prices
Expenditure functions are concave in prices

CHAPTER 3
UTILITY MAXIMIZATION AND CHOICE I & II

What is utility maximization? Graph and show where is the optimal quantity
of x and y that maximize utility.

16

A consumer has a utility function

u ( x 1 , x 2) =max {x 1 , x 2 } . What is

the consumer's demand function for good l? What is his indirect utility
function? What is his expenditure function?
3

A consumer has an indirect utility function of the form

v ( p1 , p2 , p 3 )=

m
min { p1 , p 2 }

What is the form of the expenditure function for this consumer? What is the
form of a (quasiconcave) utility function for this consumer? What is the form
of the demand function for good l?

Explain mathematically first order condition for a maximum utility (for two
goods)

Consider the indirect utility function given by

v ( p1 , p2 , m )=

m
p 1+ p 2

(a) What are the demand functions?

(b) What is the expenditure function?
(c) What is the direct utility function?
6

A young connoisseur has $300 to spend to build a small wine cellar. She
enjoys two vintages in particular : a 1997 French Bordeux (W F) at $20 per
bottle and a less expensive 2002 California varietal wine (W C) priced at $4.
How much of each wine should she purchase with Langrangian expression if
her utility is:
U (WF, WC ) = WF 2/3 WC 1/3

A person has an income $100. His use his money to buy good x and y. Price
of good x is $10 and price of good y is $20.
a
b

Make the budget constraint equation

Suppose that income increase 50%. Make the new budget constraint

17

What happen if price x decrease until 20% (with the first income given).
Make a new budget constraint
Continuing from part c, now price y increase 25%. Make a new budget
constraint.
Graph them !

d
e
8

A consumer has a direct utility function of the form

U ( x 1 , x 2) =u ( x 1 )+ x2
Good 1 is a discrete good; the only possible levels of consumption of good 1
are

x 1=0

and

x 1=1 .

For

convenience,

assume

that

u ( 0 )=0 p2=1 .
(a) What kind of preferences does this consumer have?
(b) The consumer will definitely choose

x 1=1

if

p1 is strictly less

than what?
(c) What is the algebraic form of the indirect utility function associated with
this direct utilityfunction?

George has $300 to spend to buy book and novel. Price of book is $ 4 and
price of novel is $12.
How much the MRS between book and novel? How much of each book and
novel should he purchase with Langrangian expression if his utility is:
U ( b,n ) =

b1 /2 n1 /2

10 A person has utility function U (x,y) = x 0.4y0.8 for good x and y. Assume he
has an income $100. Price of good x is $ 4 and price of good y is $12.
a Show MRS between good x and good y
b Calculate optimum combination of good x and good y to maximize
utility

18

CHAPTER 4
THE THEORY OF OPTIMUM CONSUMERS CHOICE I & II

In this chapter we used the utility maximizing model of choice to examine

relationship among consumer goods. Although these relationship may be
complex, the analysis presented here provided a number of ways of categorizing
and simplyfying them.
When there are only two goods, the income and substitution effects from the
change in the price of one good (py) on the demand for another good (x) usually
work in opposite directions; the sign of

two goods are gross substitutes if

xi
pj

xi
pj

> 0 and gross complements if

<0

because these price effects include income effects, they may not be
symmetric; it is possible that

is ambiguous, the substitution

effect is positive, the income effect is negative.

In cases of more than two goods, demand relationships can be specified in two
ways

x
py

xi
pj

xj
pi

If a group of goods has prices that always move in unison, expenditures on these
goods can be treated as a composite commodity whose price is given by the
size of the proportional change in the composite goods prices.
An alternative way to develop the theory of choice among market goods is to
focus on the ways in which market goods are used in household production to
yield utility-providing attributes.
A composite comodity theorem applies to any group of commodities whose
relative price all move together. It is possible to have more than one such
commodity if there are several groupings that obey that theorem.
Slutsky-type Equation :

19

or, in elasticity term

CHAPTER 4
THE THEORY OF OPTIMUM CONSUMERS CHOICE I & II
1.

x=a+ bp . What are the

The demand function for a particular good is

associated direct and indirect utility functions?

2. Find the demanded bundle for a consumer whose utility function is

2
3

u ( x 1 , x 2) =x 1 , x 2 and her budget constraint is 3 x1 + 4 x 2=100.

3.

Calculate the substitution matrix for the Cobb-Douglas demand system with
two goods. Verify that the diagonal terms are negative and the crossprice
effects are symmetric.

4.

Ellsworth's utility function is

U (x , y )

min ( x , y ) . Ellsworth

has $150 and the price of x and the price of y are both 1. Ellsworth's boss is
thinking of sending him to another town where the price of x is 1 and the
price of y is 2. The boss offers no raise in pay. Ellsworth, who understands
compensating and equivalent variation perfectly, complains bitterly. He says
that although he doesn't mind moving for its own sake and the new town is
just as pleasant as the old, having to move is as bad as a cut in pay of $A. He
also says he wouldn't mind moving if when he moved he got a raise of $B.
What are A and B equal to?
5.

Suppose that utility is quasilinear. Show that the indirect utility function is a
convex function of prices!

20

6.

Consider a two-period model with Dave's utility given by

where

u(x 1 , x 2)

x 1 represents his consumption during the first period and

his second period's consumption. Dave is endowed with

x 2 is

( x 1 , x 2) which

he could consume in each period, but he could also trade present

consumption for future consumption and vice versa. Thus, his budget
constraint is

p1 x 1 + p 2 x 2= p1 x1 + p2 x2

where

p1 and

p2 are the first and second period prices respectively.

Derive the Slutsky equation in this model. (Note that now Dave's income
depends on the value of his endowment which, in turn, depends on prices:

m= p1 x 1 + p2 x 2 )

7.

Draw two different diagrams, one illustrating the Slutsky version of income
and substitution effects and the other illustrating the Hicks version of income
and substitution effects. How do these two notions differ?

8.

Two goods are available, x and y. The consumer's demand function for the xgood is given by

lnx=abp+ cm , where p is the price of the x-good

relative to the y-good, and m is money income divided by the price of the ygood. What equation would you solve to determine the indirect utility
function that would generate this demand behavior?
9.

A consumer has a utility function

prices of the three goods are given by

u(x , y , z)=min(x , y )+ z . The

( px , p y , p)

and the money the

consumer has to spend is given by m. What are the demand functions and the
indirect utility function for the three goods.
10. Let

(q , m)

be prices and income, and let

identity to derive the formula

21

p=q / m . Use Roy's

x i ( P )=

v( P)
pi
k

j=1

v ( P)
p
pj j

CHAPTER 5
UNCERTAINTY AND INFORMATION

The most common way to model behavior under uncertainty is to assume that
individuals seek to maximize the expected utility of their actions.
A fair game is a random game with a specified set of prizes and associated
probabilities that have an expected value of zero.
Individuals who exhibit a diminishing marginal utility of wealth are risk averse.
That is, they generally refuse fair bets. Risk-averse individuals will wish to insure

22

themselves completely against uncertain events if insurance premiums are

actuarially fair.
If the utility-of-wealth function is concave (i.e., exhibits a diminishing marginal
utility of wealth), then this person will refuse fair bets. A 5050 bet of winning or
losing h dollars, for example, yields less utility [U h(W*)] than does refusing the
bet. The reason for this is that winning h dollars means less to this individual than
does losing h dollars.
Risk aversion measure r(W), is defined as

U '' (W )
r(W) = U ' ( W )

The amount that a risk-averse individual is willing to pay to avoid a fair bet is
approximately proportional to Pratt s risk aversion measure.

Whether risk aversion increases or decreases with wealth depends on the precise
shape of the utility function. If utility is quadratic in wealth, risk aversion
increases as wealth increases. On the other hand, if utility is logarithmic in
wealth, risk aversion decreases as wealth increases.
Two utility functions have been extensively used in the study of behavior under
uncertainty: the constant absolute risk aversion (CARA) function and the constant
relative risk aversion (CRRA) function.
One of the most extensively studied issues in the economics of uncertainty is the
portfolio problem, which asks how an investor will split his or her wealth
between risky and risk-free assets. In some cases it is possible to obtain precise
solutions to this problem, depending on the nature of the risky assets that are
available.
A conceptual idea that can be developed concurrently with the notion of states of
the world is that of contingent commodities. Examining utility-maximizing
choices among contingent commodities proceeds formally in much the same way
we analyzed choices previously. The principal difference is that, after the fact, a
person will have obtained only one contingent good (depending on whether it
turns out to be good or bad times).
Information is valuable because it permits individuals to make better decisions in
uncertain situations. Information can be most valuable when individuals have
some flexibility in their decision-making.

23

CHAPTER 5
UNCERTAINTY AND INFORMATION
1

Show that the willingness-to-pay to avoid a small gamble with variance v is

approximately r(w)v/2.

24

What will the form of the expected utility function be if risk aversion is
constant? What if relative risk aversion is constant?

Consider the case of a quadratic expected utility function. Show that at some
level of wealth marginal utility is decreasing. More importantly, show that
absolute risk aversion is increasing at any level of wealth.

George is seen to place an even-money $100,000 bet on the Bulls to win the
NBA Finals. If George has a logarithmic utility-of-wealth function and if his
current wealth is $1,000,000, what must he believe is the minimum
probability that the Bulls will win?

An individual purchases a dozen eggs and must take them home. Although
making trips home is costless, there is a 50 percent chance that all of the eggs
carried on any one trip will be broken during the trip. The individual
considers two strategies: (1) take all 12 eggs in one trip; or (2) take two trips
with 6 eggs in each trip.
a List the possible outcomes of each strategy and the probabilities of
these outcomes. Show that, on average, 6 eggs will remain unbroken
after the trip home under either strategy.
b Develop a graph to show the utility obtainable under each strategy.
Which strategy will be preferable?
c Could utility be improved further by taking more than two trips?
How would this possibility be affected if additional trips were
costly?

Suppose the current wealth of Mr. Michael is $100,000. He faces the prospect
of a 25 percent of losing his $20000 automobile through theft during the next
year.
a Calculate the expected utility of him without insurance.
b Assuming that the insurance company only claims costs and
administrative costs are $0, how much a fair insurance premium will be?
Regardless of whether the car is stolen, calculate the expected utility of
him if he completely insures the car.
c How much the maximum premium that he will be willing to pay?

Ms. Fogg is planning an around-the-world trip on which she plans to spend

$10,000. The utility from the trip is a function of how much she actually
spends on it (Y), given by
U (Y) = ln Y
a If there is a 25 percent probability that Ms. Fogg will lose $1,000 of her

25

cash on the trip, what is the trips expected utility?

Suppose that Ms. Fogg can buy insurance against losing the $1,000 (say,
by purchasing travelers checks) at an actuarially fair premium of
$250. Show that her expected utility is higher if she purchases this
insurance than if she faces the chance of losing the $1,000 without
insurance.
What is the maximum amount that Ms. Fogg would be willing to pay to
insure her $1,000?

A coin has probability p of landing heads. You are offered a bet in which you
will be paid $21 if the first head occurs on the jth flip.
a What is the expected value of this bet when p = 1/2?
b Suppose that your expected utility function is u(x) = lnx. Express the utility
of this game to you as a sum.

b
c

A farmer believes there is a 5050 chance that the next growing season will
be abnormally rainy. His expected utility function has the form

where YNR and YR represent the farmers income in the states of normal
rain and rainy, respectively.
Suppose the farmer must choose between two crops that promise the
following income prospects:

Which of the crops will he plant?

Suppose the farmer can plant half his field with each crop. Would he choose
to do so? Explain your result.
What mix of wheat and corn would provide maximum expected utility to
this farmer?

10 Let R1 and R2 be the random returns on two assets. Assume that R1 and R2
are independently and identically distributed. Show that an expected utility
maximizer will divide her wealth between both assets provided she is risk
averse; and invest all her wealth in one of the assets if she's risk loving.

26

27

CHAPTER 6
PRODUCTION FUNCTION

The firms production function for a particular good, q,

q=f (k , l)

shows the maximum amount of the good that can be produced using alternatives
combinations of capital (k) and labor (l).
Marginal physical product of an input is the additional output that can be
produced by employing one more unit of that input while holding all other inputs
constant.

Marginal physical product of capital=MPk =

Marginal physical product of labor=MPl=

output
q f (k , l)
= =
labor input l
l

The marginal rate of technical substitution (RTS) shows the rate at which labor
can be substituted for capital while holding output constant along an isoquant.

RTS (l for k )=

q
l

Average product of labor (APl)

APl=

q
k

dk
dl

The return to scale exhibited by a production function record how output

responds to proportionate increases in all inputs. If output increases
proportionately with input use, there are constant return to scale. If there are
greater than proportionate increases in output, there are increasing returns to
scale, whereas if there are less than proportionate increases in output, there are
decreasing returns to scale.

28

The elasticity of substitution () provides a measure of how easy it is to

substitute one input for another in production.

( kl )

RTS

Technical progress shifts the entire production function an its related isoquant
map. Technical improvements may arise from the use of improved, moreproductive inputs or from better methods of economic organization.

29

CHAPTER 6
PRODUCTION FUNCTION
1

Suppose the production function is

Q = f (k, l) = 300 k2 l2 - k3 l3
Assume that k=10
Calculate:
a Average product of labor when it reaches the maximum value
b Optimum labor unit that should be hired

Please answer T if the statement is true, and answer F and correct the
statement if the statement is false.
a Marginal physical product of capital is the additional output that can be
produced by employing one more unit of labor.
b Marginal rate of technical substitution shows the rate which labor can be
substituted for capital while holding output constant along an isoquant.
c Isoquant curve shows the combinations of k and l that can produce
different level of output.
d The elasticity of substitution provides a measure of how easy it is to
substitute one input for another in production. High elasticity of
substitution implies that isoquants are nearly L-shaped.

Explain the term of marginal rate of technical substitution (RTS)! What does
RTS=3 mean?

Explain and draw the curve!

a Linear production function
b Fixed proportion production function
c Cobb-Douglas production function

Why labor cant be added indefinitely to a given amount of capital (when

keeping amount of machine, land, etc) ? What concept that explains it?

Suppose that the production function of Wayne Enterprises is Q = 12 K0,4 L0,8

a What is the type of return to scale (RTS) of this production function?
Prove it!
b Write the cost function if the price of L is 5 and the price of K is 2!

30

Draw the isocost if the cost of Wayne Enterprises is $2000!

Calculate the least cost combination of K and L with informations below!

Draw the curve!
C = 5L + 10 K
Q = 100 K0,5 + 100 L0,5 and Q=3000

Fill in the blank!

a The slope of isoquant is termed as ....
b A production function measures the relation between .... & ....
c When increasing inputs by leads to an increase in 1/3 output, it is
called .... return to scale

Oliver Queen is considering producing Queen Consolidated High-Tech

Computer. The production function is given by
Q = 0,1 k 0,2 l 0,8
Where q is the number of Queen Consolidated High-Tech Computer
produced in a week. K represent capital used and l represent the number s of
labor employed. Oliver Queen would like to produce 10 Queen Consolidated
High-Tech Computers and he allocated $1.000.000 for the production
process.
a Oliver Queen would like to buy and hire these two inputs in equal
amounts because capital and labor both cost the same amount
($5000). How much of each input will he hire and how much the
total cost?
b Oliver Queen is recently study microeconomics. He wants to
produce 10 Queen Consolidated High-Tech Computer by the least
possible cost. How much labor will he hire and how much capital
will he use? How much the total cost?
c Now Oliver Queen is considering maximizing all of his budget. If
he apply this method, how much labor will he hire and how much
capital will he use? How much Queen Consolidated High-Tech
Computer will he produce?

10 Based on the question number 9 above, what concept is the best used by
Oliver Queen (b, or c)? Give your argument!

31

32

CHAPTER 7
COST MINIMIZATION

We must differentiate between:

Accounting cost: the accountants view of cost stresses out-of-pocket
expenses, historical costs, depreciation, and other bookkeeping entries.
Economic cost: is that the cost of any input is given by the size of the
payment necessary to keep the resources in its present employment.
The Lagrangian expression for cost minimization of producing q0 (CobbDouglas) is
L = vk + wl + (q0 - k a l b)
A firm that wishes to minimize the economic costs of producing a particular
level of output should choose that input combination for which the rate of
technical substitution (RTS) is equal to the ratio of the inputs rental prices.
The firms average cost (AC = C/q) and marginal cost (MC = C/q) can be
derived directly from the total-cost function
if the total cost curve has a general cubic shape, the AC and MC curves
will be u-shaped

The firms expansion path is the locus of cost-minimizing tangencies.

Assuming fixed input prices, the curve shows how inputs increase as output
increases.
if the use of an input falls as output expands, that input is an inferior
input
In the short run, the firm may not be able to vary some inputs
it can then alter its level of production only by changing the employment
of its variable inputs
it may have to use nonoptimal, higher-cost input combinations than it

33

would choose if it were possible to vary all inputs

The long run average cost is the envelope of the firms short run average cost
curves, and it reflects the presence or absence of returns to scale.

CHAPTER 7
COST MINIMIZATION
34

For each cost function determine if it is homogeneous of degree one,

monotonic, concave, and/or continuous. If it is, derive the associated
production function.
a

C ( w , y ) = y 1/ 2(w1 w2 )3/ 4

w 1+ w 1 w2 +w 2
C ( w , y )= y

C ( w , y ) = y (w1 ew 1+ w2 )

C ( w , y ) = y (w1 w1 w2 +w 2)

C (w , y )= y +

( 1y ) w w
1

A firm producing hockey sticks has a production function given by

q=2 k . l
In the short run, the firms amount of capital equipment is fixed at k = 100.
The rental rate for k is y = $1, and, the wage rate for l is w = $4.
a

Calculate the firms short-run total cost curve. Calculate the shortrun average cost curve.
b What is the firms short-run marginal cost function? What are the
SC, SAC, and SMC for the firm if it produces 25 hockey sticks?
Fifty hockey sticks? One hundred hockey sticks? Two hundred
hockey sticks?
c Graph the SAC and the SMC curves for the firm. Indicate the points
found in part (b).
d Where does the SMC curve intersect the SAC curve? Explain why
the SMC curve will always intersect the SAC curve at its lowest
point.
Suppose now that capital used for producing hockey sticks is fixed at k in the
short run.
e

Calculate the firms total costs as a function of q, w, v, and

35

k .

f
g
h

Given q, w, and v, how should the capital stock be chosen to

minimize total cost?
Use your results from part (f) to calculate the long-run total cost of
hockey stick production.
For w = $4, v = $1, graph the long-run total cost curve for hockey
stick production. Show that this is an envelope for the short-run
curves computed in part (a) by examining values of

of 100,

200, and 400.

3

Suppose that a firms fixed proportion production function is given by

q = min (5k, 10l).
a Calculate the firms long-run total, average, and marginal cost
functions.
b Suppose that k is fixed at 10 in the short run. Calculate the firms
short-run total, average, and marginal cost functions.
c Suppose v = 1 and w = 3. Calculate this firms long-run and shortrun average and marginal cost curves.

A firms production process can be represented by the following production

function
Q = A Ka Lb
Where Q is the level of output produced, A>0 is technological parameter, K
is the level of capital used, L is the number of labor used, and a>0, b>0 are
parameters. The firm minimizes cost of production :
C = wL + rK
Where w is the wage rate, and r is the rental rate of capital.
a Calculate number of labor demand and capital demand .
b How to effect of technology change for input demand.

Calculate the number of labor (L1 & L2) and capital (K1 & K2) that solve the
minimization problem below :
(i) Minimize wL1 +rK1 subject to Q = min

K 1 L1
,
1/3 2/3 }

And
(ii) Minimize wL2 +rK2 subject to Q = min {4K2 , 5L2}
Where w = 25 is the wage rate, and r = 10 is the rental rate of capital. The
target level of output is Q= 100. Show the both of function with the relevant
graph!

36

A firm has production function Q = 4

K+ 2 L

, where Q is the level

of output produced, K is the level of capital used, L is the number of labor

used. The target level of output is Q= 120 with the wage rate is w= $5 and the
rent rate is r = $4.
a What kind of production function above?
b Calculate number of Labor and Capital if the firm want to minimize
cost.
c Calculate the firms minimum cost.
7

Calculate the number of labor (L) and capital (K) that solve the minimization
problem below :
minimize wL + rK subject to Q =

2
3
K+ L
5
5

where w = 25 is the wage rate and r = 10 is the rent rate. The target output is
Q = 100 units. Show with the relevant graph !
8

A firm has a production function given by f(x 1,x2) = min(2x1+x2 , x1+2x2).

What is the cost function for this technology? What is the conditional
demand function for factors 1 and 2 as a function of factor prices (w 1, w2) and
output y?

Suppose the total-cost function for a firm is given by

C = qw2/3 v1/3
a Use Shephards lemma to compute the constant output demand
functions for inputs l and k.
b Use your results from part (a) to calculate the underlying production
function for q.

10 A chair manufacturer hires its assembly-line labor for $22 an hour and
calculate that the rental cost of its machinery is $110 per hour. Suppose that a
chair can be produced using 4 hours of labor or machinery in any
combination . if the firm is currently using 3 hours of labor for each hour of
machine time, is it minimizing its cost of production? If so, why? If not, how
can it improve the situation?

37

CHAPTER 8
PROFIT MAXIMIZATION AND PARTIAL EQUILIBRIUM
COMPETITIVE MODEL

A profit-maximizing firm chooses both its inputs and its outputs with the sole
goal of achieving maximum economic profits is seeks to maximize the
difference between total revenue and total economic costs
Total revenue for a firm is given by: R(q) = p(q)q
In the production of q, certain economic costs are incurred [C(q)]
Economic profits () are the difference between total revenue and total costs
(q) = R(q) C(q) = p(q)q C(q)
To maximize economic profits, the firm should choose the output for which
marginal revenue is equal to marginal cost.
Profit Maximization

dR dC
= =MC
dq dq

marginal profit must be decreasing at the optimal level of q

Because MR = MC when the firm maximizes profit, we can see that

1
MC p 1

eq , p

MR=

p MC
1

p
eq , p

The gap between price and marginal cost will fall as the demand curve facing
the firm becomes more elastic
A firms economic profit can be expressed as a function of inputs:
= pq - C(q) = pf(k,l) - vk - wl
Only the variables k and l are under the firms control: the firm chooses
levels of these inputs in order to maximize profits. Treats p, v, and w as fixed
parameters in its decisions
We can apply the envelope theorem to see how profits respond to changes in
output and input prices

38

 ( p, v, w)
q ( p, v, w)
p
( p, v, w)
k ( p, v, w)
v

( p, v, w)
l ( p, v, w)
w

Differentiation with respect to w yields

l ( p, v, w) l c (v, w, q ) l c (v, w, q ) q

w
w
q
w

Short-run equilibrium prices are determined by the interaction of what

demanders are willing to pay (demand) and what existing firms are willing
to produce (supply). Both demanders and suppliers act as price takers in
making their respective decisions.
In the long run, the number of firms may vary in response to profit
opportunities. If free entry is assumed then firms will earn zero economic
profits over the long run. Because firms also maximize profits, the long-run
equilibrium condition is therefore P MC AC.
The shape of the long-run supply curve depends on how the entry of new
firms affects input prices. If entry has no impact on input prices, the longrun supply curve will be horizontal (infinitely elastic). If entry raises input
prices, the long-run supply curve will have a positive slope.
If shifts in long-run equilibrium affect input prices, this will also affect the
welfare of input suppliers. Such welfare changes can be measured by
changes in long-run producer surplus.

39

CHAPTER 8
PROFIT MAXIMIZATION AND PARTIAL EQUILIBRIUM
COMPETITIVE MODEL.

Let

f ( x 1 , x 2 ) be a production function with two factors and let

and

wz

be their respective prices. Show that the elasticity of the factor

(w 2 x 2 /w1 x1 ) with respect to ( x 1 /x 2 ) is given by

share

w1

Show that the elasticity of the factor share with respect to

1
1 .

w
( 2/w 1) is

1a
3

Let

( pt , y t )

for

t=1, .. , T

be a set of observed choices that

satisfy WAPM, and let YI and YO be the inner and outer bounds to the true

40

production set Y. Let

and

( p)

the

profit

+( p)

, be the profit function associated with YO

be the profit function associated with YI , and

function

associated

with

Y.

Show

( p) be

that

for

all

( p)
+( p) ( p) .
p ,
4

The production function is

f ( x )=20 xx 2 and the price of output is

x0 .

normalized to 1. Let w be the price of the x-input. We must have

(a) What is the first-order condition for profit maximization if
(b) For what values of w will the optimal

x be zero?

(c) For what values of w will the optimal

x be 10?

x> 0 ?

(d) What is the factor demand function?

(e) What is the profit function?
(f) What is the derivative of the profit function with respect to w?
5

Johns Lawn Moving Service is a small business that acts as a price taker
(i.e., MR = P). The prevailing market price of lawn mowing is $20 per acre.
Johns costs are given by

total cost =0.1 q2 +10 q+50

where q the number of acres John chooses to cut a day.
a. How many acres should John choose to cut in order to maximize profit?
b. Calculate Johns maximum daily profit.
c. Graph these results and label Johns supply curve.
6

La Belle Boutique is a small business that acts as a price taker. The prevailing
market price of La Belle Boutique is $30 per dress. La Belles costs are given
by:
a

C ( Q )=0,1Q2 +10 Q+60

How many quantity produced when the firm maximizing profit?

41

How much its profit?

Explain and show which is the Short-run Supply Curve? Give the detail label
on the graph!
8

Suppose a perfectly competitive market has 2000 firms. In the very shor run,
each of the firms has fixed supply of 200 units. The market demand is given
by: Q=320.000 20.000P
a Calculate the equilibrium price in the very short run!
b Calculate the demand schedule facing any one firm in the industry!

Suppose there are 100 identical firms in a perfectly competitive industry.

Each firm has a short-run total cost function of the form

C ( q )=

1 3
q + 0,2q 2 +4 q+10
300

a. Calculate the firms short-run supply curve with q as a function of market

price (P).
b. On the assumption that there are no interaction effects among costs of the
firms in the industry,
calculate the short-run industry supply curve.
c. Suppose market demand is given by Q = -200P + 8,000. What will be the
short-run equilibrium
price-quantity combination?
10 A perfectly competitive market has 1,000 firms. In the very short run, each of
the firms has a fixed supply of 100 units. The market demand is given by

Q=160,00010,000 P
42

a. Calculate the equilibrium price in the very short run.

b. Calculate the demand schedule facing any one firm in this industry
c. Calculate what the equilibrium price would be if one of the sellers decided
to sell nothing or if one seller decided to sell 200 units.
d. At the original equilibrium point, calculate the elasticity of the industry
demand curve and the
elasticity of the demand curve facing any one seller.

43

CHAPTER 9
PARTIAL EQUILIBRIUM COMPETITIVE MODEL

Market demands curve is the horizontal sum of each individuals demand

curve at a price the quantity demanded in the market is the sum of the amount
each individual demand for example at p* the demand in the market is

2= x
x
x1 + .

Timing of the Demand Response

In the analysis of competitive pricing, the time period under consideration is
important
very short run
no supply response (quantity supplied is fixed)
short run
existing firms can alter their quantity supplied, but no new firms can
enter the industry
long run
new firms may enter an industry

44

Short-Run Market Supply Curve

To derive the market supply curve, we sum the quantities supplied at every
price .
q1A + q1B = Q1

Long-Run Competitive Equilibrium

A perfectly competitive industry is in long-run equilibrium if there are
no incentives for profit-maximizing firms to enter or to leave the
industry
o this will occur when the number of firms is such that P =
MC = AC and each firm operates at minimum AC
We will assume that all firms in an industry have identical cost curves
o no firm controls any special resources or technology
The equilibrium long-run position requires that each firm earn zero
economic profit

45

The shape of the long-run supply curve depends on how entry and exit affect
firms input costs
a in the constant-cost case, input prices do not change and the longrun supply curve is horizontal
b if entry raises input costs, the long-run supply curve will have a
positive slope
c if entry reduces input costs, the long-run supply curve will have
negative slope

46

CHAPTER 9
PARTIAL EQUILIBRIUM COMPETITIVE MODEL
1

Suppose the market for widgets can be described by the following equations :
Demand : P = 10 - Q
Supply : P = Q - 4
Where P is the price in dollars per unit and Q is the quantity in thousands of
units. Then,
a
b

What is the equilibrium price and quantity

Suppose the government imposes a tax 0f $1 per unit to reduce
widget consumption and raise government revenues. What will the
new equilibrium quantity be? What price will the buyer pay? What
amount per unit will the seller receive?
Suppose the government has a change of heart about the importance
of widgets to the happiness of the American public. The tax is
removed and a subsidy of $1 per unit granted to widget producers.
What will the equilibrium quantity be? What price will the buyer
pay? What amount per unit (including the subsidy) will the seller
receive? What will be the total cost to the government ?

A vegetable fiber traded in a competitive world market and imported into the
United States at a world price of $9 per pound U.S. domestic supply and
demand for various price levels are shown in the following table :
PRICE
U.S. SUPPLY
U.S. DEMAND
(MILLION POUNDS)
(MILLION POUN
3
2
34
6
4
28
9
6
22
12
8
16
15
10
10
18
12
4
Answer the following about the U.S. market :
a Confirm that the demand curve is given by Qd = 40 2P, and that
supply curve is given by Qs = 2/3 P.
b Confirm that if there no restriction on trade, the United States would
import 16 million pounds.

47

Suppose that total cost of producing pizzas for the typical firm in a local
town is given by C(q) = 2q + 2q2. In turn, marginal cost is given by MC = 2 +
4q. (if you know calculus, you should be able to derive this expression for
marginal cost.)
a Show that the competitive supply behavior of the typical pizza firm
is described by q =
b

P 1

4 2

If there are 100 firms in the industry each acting as a perfect

competitor , show that the market supply curve is, in inverse form,
given by P=2 + Q/25.

We mentioned PT.TAMIMA and its control of plastic hanger market in the

chapter. Suppose that the inverse demand for hanger is given by P= 6 -

Q
8000 . Suppose further that the marginal cost of producing hangers is

constant at $2.
a What is the equilibrium price and quantity of hangers if the market
is competitive?
b What is the equilibrium price and quantity of hangers if the market
is monopolized? What is deadweight loss of monopoly in this
market ? Show with graph!
5

Suppose there are 100 identical firms in a perfectly competitive industry.

Each firm has a short-run total cost function of the form

C ( q )=

a
b
c

1 3
q + 0.2 q2 + 4 q + 10
300

Calculate the firms short-run supply curve with q as a function of

market price (P) !
On the assumption that there are no interaction effects among costs
of the firms in the industry, calculate the short-run industry supply
curve !
Suppose market demand is given by Q = -200 P + 8000 . What will
be the short-run equilibrium price-quantity combination?

Below is the inverse market demand curve :

48

P=

Where P is price, Q is quantity of market demand

> 0,

> 0 are

demand parameter. A firm has the following cost function :

C=

q2

Where C is cost of production , q is output supplied by the firm , and

>

0 is parameter.
a Write down the profit function if the firm produce under a
competitive market
b Show the first order condition for its profit maximization
c What is the level of profit maximizing level of output.
7

Based on the above data (number 6)

a Write down the profit function if the firm is a monopolist !
b Show the first order condition for its profit maximization !
c What is the level of profit maximizing level of output !
Assume that the manufacturing of cellular phones is a perfectly competitive
industry.
The market demand for cellular phones is described by a linear demand
function

Qd =

600050 P
9

The inverse demand can easily be worked out, therefore, to be

P = 120

9
Qd .
50

There are fifty manufactures of cellular phones. Each manufacture has the
same production costs. These are described by the long-run total and
marginal cost functions TC(q) = 100 + q 2 + 10q, and MC (q) = 2q + 10,
respectively.
a Show that firm in this industry maximizes profit by producing q=

P10
2

Derive the industry supply curve and show that it is Qs = 25P

250 !

49

c
d

Find the market price and aggregate quantity traded in equilibrium !

How much output does each firm produce ? show that each firm
earns zero profit in equilibrium !

The perfectly competitive videotape copying industry is composed of many

firms that can copy five tapes per day at an average cost of $10 per tape.
Each firm must also pay a royalty to film studios, and the per-firm royalty
rate (r) is an increasing function of total industry output (Q ):
r = 0.002Q

Demand is given by
Q = 1050 50P
a
b

Assuming the industry is in long-run equilibrium, what will be the

equilibrium price and quantity of copied tapes? How many tape
firms will there be? What will the per-film royalty rate be?
Suppose that demand for copied tapes increases to
Q = 1600 50P
In this case, what is the long-run equilibrium price and quantity for
copied tapes? How many tape firms are there? What is the per-film
royalty rate?

10 You know that if a tax is imposed on a particular products , the burden of the
tax is shared by producers and consumers. You also know that the demand for
automobiles is characterized by a stock adjustment process. Suppose a
special 20-percent sales tax is suddenly imposed on automobiles . will the
share of the tax paid by consumers rise, fall or stay the same over time?
Explain briefly ! Repeat for a 50-cents-per-gallon gasoline tax.

50