İzmir University of Economics

Faculty of Economics and Administrative Sciences

Department of Business Administration

Surname, Name:
Student No:

BA 415 PROBLEM SET II KEY (January 20, 2011)

1) Suppose that a competitive firm’s marginal cost of producing output q is given by MC (q)= 3 + 2q .
Assume that the market price of the firm’s product is $9.
a) What level of output will the firm produce?
Solution:
q = 3.
b) What is the firm’s producer surplus?
Solution:
producer surplus = 9.
2) A number of stores offer film developing as a service to their customers. Suppose that each store
that offers this service has a cost function C (q) = 50 + 0.5q + 0.08q 2 . If the going rate for
developing a roll of film is $8.50, is the industry in long run equilibrium? If not find the price
associated with long run equilibrium.
Solution:
The industry is not in long run equilibrium because profit is greater than zero.
P=4.50.
3) A firm faces the following average revenue (demand) curve = P 120 − 0.02Q where Q is weekly
production and P is price, measured in cents per unit. The firm’s cost function is given by
= C 60Q + 25000 . Assume that the firm maximizes profits.
a) What is the level of production, price, and total profit per week?
Solution:
Q = 1500 P = 90 cents Profit = 200
b) If the government decides to levy a tax of 14 cents per unit on this product, what will be the
new level of production, price, and profit?
Solution:
Q = 1150 P* = 83 cents π= ( 83)(1,150 ) − ( ( 60 )(1,150 ) + 25,000=) 1450
4) Suppose that an industry is characterized as follows:
=C 100 + 2Q 2 Firm total cost function
P= 90 − 2Q Industry demand curve
a) If there is only one firm in the industry, find the monopoly price, quantity, and level of profit.
Solution:
Q=11.25 P=67.50 The level of profit =406.25
b) Find the price, quantity, and level of profit if the industry is competitive.
Solution:
Q=15 P=60 The level of profit =350.
5) The market for wheat consists of 50 identical firms, each with the total cost function shown as
TC= 90 + 0.01Q 2 where Q is measured in bushels per year. The market demand curve for wheat
is=
Q 9000 − 2000 P , where Q is again measured in bushels and P is the price per bushel.
a) Determine the short run equilibrium price and quantity that would exist in the market.
Solution:
Market supply Q = 50P
P = 2.00 Q= 5000
b) Calculate the profit maximizing quantity for the individual firm. Calculate the firm’s short run
profit (loss) at that quantity.

1
 Solution:
P = 2 = 0.02Q so Q = 100
Firm’s profit = TR – TC = 2000 - 190 = 1810
c) Analyze the individual firm’s position in terms of the shutdown condition. Should this
specific firm operate or shut down in the short run?
Solution:
AVC=1.9 at p=2 q=100 so The firm should operate since p larger than AVC

6) Answer the following questions using the above diagram. Justify your answers.
a) At P=$80, what is the profit-maximizing output in the short run?
Solution: 39
b) At P=$80, how much is profit in the short run?
Solution: 351
c) If the firm expects $80 to be the long run price, how many units of output will it plan to
produce in the long run?
Solution: 64
d) How much profit will the firm earn if price stays at $80?
Solution: 1024
e) As the competitive industry, not just the firm in question, moves toward long-run equilibrium,
the firm will be forced to operate at what level of output?
Solution: 50
f) As the competitive industry, not just the firm in question, moves toward long-run equilibrium,
what will the price be?
Solution: 60
7) A Mr. Varyemez is the city planner in a medium-sized city. The city is considering a proposal to
award an exclusive contract to Clear Vision, Inc., a cable television carrier. Mr. Varyemez has
discovered that an economic planner hired a year before has generated the demand and marginal
cost functions given below:
= 28 − 0.0008Q
P
MC = 0.0012Q
where Q = the number of cable subscribers and P = the price of basic monthly cable service.
Conditions change very slowly in the community so that Mr. Varyemez considers the cost and
demand functions to be reasonably valid for present conditions. Mr. Varyemez knows relatively
little economics and has hired you to answer the questions listed below.
a) What price and quantity would be expected if the firm is allowed to operate completely
unregulated?
Solution:
Without regulation we would expect the firm to behave as a monopolist, equating MR and MC.
P = 20 Q=10000
b) Mr. Varyemez has asked you to recommend a price and quantity that would be socially
efficient. Recommend a price and quantity to Mr. Varyemez using economic theory to justify
your answer.
Solution:

2
 Economic theory suggests that price should be equal to MC to achieve allocative efficiency.
Q=14000 P = 16.80
c) Compare the economic efficiency implications of (a) and (b) above. Your answer need not
include numerical calculations, but should include relevant diagrams to demonstrate
deadweight loss.
Solution:
In (a), the price is higher ($20 as opposed to $16.80), and quantity lower (10,000 as opposed to
14,000). The monopolist's higher price and smaller quantity result in a deadweight loss as shown
below.

8) Tad’ s bait shop has a monopoly on the bait market at Sanderson’s Lake. The demand curve for
bait is Q=
D 56 − 8 P . Tad has two employees he can use to search for bait. The marginal cost of
1
using Amanda to search for bait is MC A = QA . The marginal cost of using Andrew to search for
4
3
bait is MCB = QB . Determine how many units of bait each employee should gather. What is the
8
price Tad receives for selling the bait?
Solution:
We can think of Tad’s employees as two different plants that Tad owns. Tad’s aggregate supply
8
is: Q = QM + QN = 4MCM + MCN Tad’s marginal cost as a function of output at both plants is:
3
3
MC ( Q ) = Q .
20
3 1
MC ( Q ) = Q =MR ( Q ) =7 − Q ⇒ Q =17.5 .
20 4
At this output level, Tad’s marginal cost is $2.63. This means that Amanda is gathering 10.5 units
of bait while Andrew gathers 7 units of bait. Tad receives $4.81 per unit of bait.
9) The local zoo has hired you to assist them in setting admission prices. The zoo’s managers
recognize that there are two distinct demand curves for zoo admission. One demand curve applies
to those ages 12 to 64, while the other is for children and senior citizens. The two demand and
marginal revenue curves are:
P=
A 9.6 − 0.08QA
PS = 4 − 0.05QS
where PA = adult price, PS = children’s/senior citizen’s price, QA = daily quantity of adults, and QS
= daily quantity of children and senior citizens. Crowding is not a problem at the zoo, so that the
managers consider marginal cost to be zero. If the zoo decides to price discriminate, what should
the price and quantity be in each market? Calculate total revenue in each sub-market.
Solution:
Optimal price discrimination requires the zoo to set MRA = MRS = MC.
QA = 60 so PA = 4.8
QS = 40 so PS = 2
TRA = 288
TRS = 80
TR = 288 + 80 = 368

3
10) The industry demand curve for a particular market is= Q 1800 − 200 P . The industry exhibits
constant long run average cost at all levels of output, regardless of the market structure. Long run
average cost is a constant 1.50 TL per unit of output. Calculate market output, price (if
applicable), consumer surplus, and producer surplus (profit) for each of the scenarios below.
Compare the economic efficiency of each possibility.
a) Perfect Competition
Solution:
Under perfect competition P = LMC. Q=1500 P = 9 - 0.005(1500) = 1.50
P = LMC = LAC so that p (producer surplus) = 0
Consumer surplus is the area under the demand curve above market price, as indicated in the
figure.

b) Pure Monopoly
Solution:
Under monopoly MR = MC
P = 5.25

π = (P - LAC) x Q
π = (5.25 - 1.50) x 750
π = 2812.50
To find consumer surplus, find area of the triangle under the demand curve and above price.
CS = 9 – 5.25)(750)(0.5) = 1,406.25.
The sum of consumer surplus and producer surplus is 1406.25 + 2812.50 = 4218.75.
c) First Degree Price Discrimination
Solution:
Under first-degree price discrimination-output is at the point where the demand curve cuts the
LMC curve.

The firm charges the entire area under the demand curve. Output=1500

4
 PS = (9 – 1.5)(1,500)(0.5) = 5625.
Comparison of Efficiency
a. Competition
Consumer + Producer Surplus = 5625
b. Monopoly
Consumer + Producer Surplus = 4218.75
c. First degree
Consumer + Producer Surplus = 5625
Monopoly results in a deadweight loss. First-degree price discrimination results in a redistribution
of income, but does not result in a deadweight loss.
11) Internet service in the local market is supplied by Laura’s Internet Service. Laura has two types of
consumers. Local businesses are the first type of customers Laura’s firm services. Their demand
for internet service is =QDB 6500 − 100 P . The second type of customer of Laura’s firm services
=
are residential customers. Residential demand is QDR 12500 − 500 P . Laura’s marginal cost
20 Q B + Q R
function is MC (Q B + Q R ) = + . If Laura can third degree price discriminate, calculate
3 150
the profit maximizing price she charges business and residential customers.
Solution:
To maximize profits, Laura will choose the output levels where MR = R
MR= B
MC .
B R
Q =2187.5-0.25Q
QR=
We may then set MR R = MC and insert the information we derived above regarding business
20 2187.5 + 0.75Q R
output. This yields MR R =25 − 0.004Q R = + =MC ⇔ Q R =375 This, in turn,
3 150
implies that business output is 2093.75. The optimal price charged to business customers is
$44.06 while the optimal price charged to residential customers is $24.25.
12) A monopolist can produce at a constant average (and marginal) cost of AC = MC = 5. It faces a
market demand curve given by Q = 53 - P.
a) Calculate the profit-maximizing price and quantity for this monopolist. Also calculate its
profits.
Solution:
Q = 24, P = 29
Profits = 576.
b) Suppose a second firm enters the market. Let Q1 be the output of the first firm and Q2 be the
output of the second. Market demand is now given by Q1 + Q2 = 53 - P. Assuming that this
second firm has the same costs as the first, write the profits of each firm as functions of Q1
and Q2.
Solution:
When the second firm enters, price can be written as a function of the output of two firms:
P = 53 - Q1 - Q2. We may write the profit functions for the two firms:
π 1 = PQ1 − C (Q1 ) = (53 − Q1 − Q2 )Q1 − 5Q1 , or π 1 = 53Q1 − Q12 − Q1Q2 − 5Q1
π 2 = PQ2 − C(Q2 ) = (53 − Q1 − Q2 )Q2 − 5Q2 , or π 2 = 53Q2 − Q22 − Q1Q2 − 5Q2 .
c) Suppose (as in the Cournot model) that each firm chooses its profit-maximizing level of
output on the assumption that its competitor’s output is fixed. Find each firm’s “reaction
curve” (i.e., the rule that gives its desired output in terms of its competitor’s output).
Solution:
Under the Cournot assumption, Firm 1 treats the output of Firm 2 as a constant in its
maximization of profits.
∂π 1 Q
= 53 − 2Q1 − Q2 − 5 = 0, or Q1 = 24 − 2 .
∂Q 1 2
This equation is the reaction function for Firm 1

5
 Q1
the reaction function for Firm 2 is Q2 = 24 − .
2
d) Calculate the Cournot equilibrium (i.e., the values of Q1 and Q2 for which both firms are
doing as well as they can, given their competitors’ output). What are the resulting market
price and profits of each firm?
Solution:
To find the level of output for each firm that would result in a stationary equilibrium, we solve for
the values of Q1 and Q2 that satisfy both reaction functions by substituting the reaction function
for Firm 2 into the one for Firm 1:
 1  Q
Q1 = 24 −    24 − 1  , or Q1 = 16.
2 2
By symmetry, Q2 = 16.
P = 21.
Profits are given by Πi = PQi - C(Qi) = Πi = (21)(16) - (5)(16) = 256.
Total profits in the industry are Π1 + Π2 = 256 +256 = 512
e) We return to two firms with the same constant average and marginal cost, AC = MC = 5,
facing the market demand curve Q1 + Q2 = 53 - P. Suppose Firm 1 is the Stackelberg leader
(i.e., makes its output decisions before Firm 2). Find the reaction curves that tell each firm
how much to produce in terms of the output of its competitor. How much will each firm
produce, and what will its profit be?
Solution:
Firm 1, the Stackelberg leader, will choose its output, Q1, to maximize its profits, subject to the
reaction function of Firm 2:
Q2 = 24 −  1  .
Q
2
Substitute for Q2 in the demand function and, after solving for P, substitute for P in the profit
function:
max π 1 =  53 − Q1 −  24 −
Q1  
2   (Q1 ) − 5Q1 .
To determine the profit-maximizing quantity, we find the change in the profit function with
respect to a change in Q1:
dπ 1
= 53 − 2Q1 − 24 + Q1 − 5.
dQ1
Set this expression equal to 0 to determine the profit-maximizing quantity: Q1 = 24.
Substituting Q1 = 24 into Firm 2’s reaction function gives Q2:
24
Q2 = 24 − = 12.
2
Substitute Q1 and Q2 into the demand equation to find the price: P = 17.
Profits for each firm are equal to total revenue minus total costs, or
Π1 = (17)(24) - (5)(24) = 288 and Π2= (17)(12) - (5)(12) = 144.
Total industry profit= 288 + 144 = 432.