Microeconomics-2

Problem Set-2
Solutions

1.
(a) The monopolist’s pricing rule as a function of the elasticity of demand is:
( P  MC ) 1

P Ed

or alternatively,
 1 
P 1    MC
 E d 

Plug in –2 for the elasticity and 40 for price, and then solve for MC = $20.
(b) (P – MC)/P = (40 – 20)/40 = 0.5, so the mark-up is 50 percent of the price.
(c) Total revenue is price times quantity, or $40(800) = $32,000. Total cost is equal to
average cost times quantity, or $15(800) = $12,000. Profit is therefore  = $32,000 –
12,000 = $20,000. Fixed cost is already included in average cost, so we do not use the
$2000 fixed cost figure separately.

2.
(a) Because demand (average revenue) is P = 11 – Q, the marginal revenue function is
MR = 11 – 2Q. Also, because average cost is constant, then marginal cost is constant and
equal to average cost, so MC = 6.
To find the profit-maximizing level of output, set marginal revenue equal to marginal
cost:
11 – 2Q = 6, or Q = 2.5.
That is, the profit-maximizing quantity equals 2500 units. Substitute the profit-
maximizing quantity into the demand equation to determine the price:
P = 11 – 2.5 = $8.50.
Profits are equal to total revenue minus total cost,
 = TR – TC = PQ – (AC)(Q), or
 = (8.50)(2.5) – (6)(2.5) = 6.25, or $6250.
The degree of monopoly power according to the Lerner Index is:
P  MC 8.5  6
  0.294.
P 8.5
(b) To determine the effect of the price ceiling on the quantity produced, substitute the
ceiling price into the demand equation.

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 7 = 11 – Q, or Q = 4.
Therefore, the firm will choose to produce 4000 units rather than the 2500 units without
the price ceiling. Also, the monopolist will choose to sell its product at the $7 price
ceiling because $7 is the highest price that it can charge, and this price is still greater
than the constant marginal cost of $6, resulting in positive monopoly profit.
Profits are equal to total revenue minus total cost:
 = 7(4000) – 6(4000) = $4000.
The degree of monopoly power falls to
P  MC 7  6
  0143
. .
P 7

(c) If the regulatory authority sets a price below $6, the monopolist would prefer to go
out of business because it cannot cover its average variable costs. At any price above $6,
the monopolist would produce less than the 5000 units that would be produced in a
competitive industry. Therefore, the regulatory agency should set a price ceiling of $6,
thus making the monopolist face a horizontal effective demand curve up to Q = 5 (i.e.,
5000 units). To ensure a positive output (so that the monopolist is not indifferent between
producing 5000 units and shutting down), the price ceiling should be set at $6 + , where
 is small.
Thus, 5000 is the maximum output that the regulatory agency can extract from the
monopolist by using a price ceiling.
The degree of monopoly power is
P  MC 6    6 
  0 as   0.
P 6 6

3.
(a) MMMT should offer enough t-shirts such that MR = MC. In the short run, marginal
cost is the change in SRTC as the result of the production of another t-shirt, i.e., SRMC =
5, the slope of the SRTC curve. Demand is:
10,000
Q ,
P2

or, in inverse form,

-1/2
P = 100Q .
1/2
Total revenue is TR = PQ = 100Q . Taking the derivative of TR with respect to Q,
-1/2
MR = 50Q . Equating MR and MC to determine the profit-maximizing quantity:
-1/2
5 = 50Q , or Q = 100.
Substituting Q = 100 into the demand function to determine price:
-1/2
P = (100)(100 ) = $10.
The profit at this price and quantity is equal to total revenue minus total cost:

2
  = 10(100) – [2000 + 5(100)] = –$1500.
Although profit is negative, price is above the average variable cost of 5, and therefore
the firm should not shut down in the short run. Since most of the firm’s costs are
fixed, the firm loses $2000 if nothing is produced. If the profit-maximizing (i.e.,
loss-minimizing) quantity is produced, the firm loses only $1500.
(b) In the long run, marginal cost is equal to the slope of the LRTC curve, which is 6.
Equating marginal revenue and long run marginal cost to determine the profit-
maximizing quantity:
-1/2
50Q = 6 or Q = 69.444
Substituting Q = 69.44 into the demand equation to determine price:
-1/2
P = (100)(69.444) = (100)(1/8.333) = 12
Total revenue is TR = 12(69.444) = $833.33 and total cost is LRTC = 6(69.444) =
$416.66. Profit is therefore $833.33 – 416.66 = $416.67. The firm should remain
in business in the long run.
(c) In the long run, MMMT must replace all fixed factors. Therefore, LRMC includes the
costs of all factors that are fixed in the short run but variable in the long run. These costs
do not appear in SRMC. As a result we can expect SRMC to be lower than LRMC.

4.
(a) The monopolist wants to choose the level of output to maximize its profits, and it does
this by setting marginal revenue equal to marginal cost. To find marginal revenue, first
rewrite the demand function as a function of Q so that you can then express total revenue
as a function of Q and calculate marginal revenue:

144 144 144 12

Q 2
 P2  P  , orP  12Q  0.5
P Q Q Q
12
R  PQ  Q  12 Q  12Q 0.5
Q

MR 
dR
dQ
 
 0.5 12Q  0.5  6Q  0.5 
6
Q
.

To find marginal cost, first find total cost, which is equal to fixed cost plus variable cost.
Fixed cost is 5, and variable cost is equal to average variable cost times Q. Therefore,
total cost and marginal cost are:
1 3
TC  5  (Q 2 )Q  5Q 2

1
dTC 3 2 3 Q
MC   Q  .
dQ 2 2

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To find the profit-maximizing level of output, we set marginal revenue equal to marginal
cost:
6 3 Q
  Q  4.
Q 2
Now find price and profit:
12 12
P   $6
Q 4
3
  PQ  TC  (6)( 4)  (5  4 2 )  $11.

(b) The price ceiling truncates the demand curve that the monopolist faces at P = 4 or
144
Q 9. Therefore, if the monopolist produces 9 units or less, the price must be $4.
16
Because of the regulation, the demand curve now has two parts:
 $4, if Q  9
P  
 12Q
1/ 2
, if Q  9.

Thus, total revenue and marginal revenue also have two parts:

 4Q, if Q  9
TR  
 12Q , if Q 9
1/2

 $4, if Q 9
MR 

1/ 2
6Q , if Q 9 .

To find the profit-maximizing level of output, set marginal revenue equal to

marginal cost, so that for P = 4,
3 8
4 Q , or Q , or Q = 7.11.
2 3

If the monopolist produces an integer number of units, the profit-maximizing production

level is 7 units, price is $4, revenue is $28, total cost is $23.52, and profit is $4.48. There
is a shortage of two units, since the quantity demanded at the price of $4 is 9 units.

(c) To maximize output, the regulated price should be set so that demand equals marginal
cost, which implies;
12 3 Q
  Q  8 and P  $4.24.
Q 2

The regulated price becomes the monopolist’s marginal revenue up to a quantity of 8. So

MR is a horizontal line with an intercept equal to the regulated price of $4.24. To

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maximize profit, the firm produces where marginal cost is equal to marginal revenue,
which results in a quantity of 8 units.
5.
(a) BMW should choose the levels of QE and QU so that MR E  MRU  MC .
To find the marginal revenue expressions, solve for the inverse demand functions:
PE  40,000  0.01Q E and PU  50,000  0.05QU .

Since demand is linear in both cases, the marginal revenue function for each
market has the same intercept as the inverse demand curve and twice the slope:
MR E  40,000  0.02Q E and MRU  50,000  0.1QU .

Marginal cost is constant and equal to $20,000. Setting each marginal revenue
equal to 20,000 and solving for quantity yields:
40,000  0.02Q E  20,000 , or Q E  1,000 ,000 cars in Europe, and

50,000  0.1QU  20,000 , or QU  300 ,000 cars in the U.S.

Substituting QE and QU into their respective inverse demand equations, we may

determine the price of cars in each market:
PE  40,000  0.01(1,000,000 )  $30,000 in Europe, and

PU  50,000  0.05(300 ,000 )  $35,000 in the U.S.

Profit is therefore:
  TR  TC  (30,000)(1,000,000)  (35,000)(300,000)  [10,000,000,000  20,000(1,300,000)]
  $4.5 billion.

(b) If BMW must charge the same price in both markets, they must find total
demand, Q = QE + QU, where each price is replaced by the common price P:
5,000,000 Q
Q = 5,000,000 – 120P, or in inverse form, P   .
120 120
Marginal revenue has the same intercept as the inverse demand curve and twice
the slope:
5,000,000 Q
MR   .
120 60
To find the profit-maximizing quantity, set marginal revenue equal to marginal
cost:
5,000,000 Q
  20,000 , or Q* = 1,300,000 cars.
120 60
Substituting Q* into the inverse demand equation to determine price:

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 5,000,000 1,300,000 
P   $30,833.33.
120  120 

Substitute into the demand equations for the European and American markets to
find the quantity sold in each market:
QE = 4,000,000 – (100)(30,833.3), or QE = 916,667 cars in Europe, and

QU = 1,000,000 – (20)(30,833.3), or QU = 383,333 cars in the U.S.

Profit is  = $30,833.33(1,300,000) – [10,000,000,000 + 20,000(1,300,000)], or
 = $4.083 billion.
U.S. consumers would gain and European consumers would lose if BMW were
forced to sell at the same price in both markets, because Americans would pay
$4,166.67 less and Europeans would pay $833.33 more for each BMW. Also,
BMW’s profits would drop by more than $400 million.

6.
(i) Choose quantity in each market such that marginal revenue is equal to
marginal cost. The marginal cost is equal to 3 (the slope of the total cost curve).
The profit-maximizing quantities in the two markets are:
15 – 2Q1 = 3, or Q1 = 6 on the East Coast, and
25 – 4Q2 = 3, or Q2 = 5.5 in the Midwest.
Substituting into the respective demand equations, prices for the two markets
are:
P1 = 15 – 6 = $9, and P2 = 25 – 2(5.5) = $14.

Noting that the total quantity produced is 11.5, then

 = 9(6) + 14(5.5) – [5 + 3(11.5)] = $91.50.
When MC is constant and demand is linear, the monopoly deadweight loss is
DWL = (0.5)(QC – QM)(PM – PC ),

where the subscripts C and M stand for the competitive and monopoly levels,
respectively. Here, PC = MC = 3 and QC in each market is the amount that is
demanded when P = $3. The deadweight losses in the two markets are

DWL1 = (0.5)(12 – 6)(9 – 3) = $18, and

DWL2 = (0.5)(11 – 5.5)(14 – 3) = $30.25.

Therefore, the total deadweight loss is $48.25.

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 (ii) Without price discrimination the monopolist must charge a single price for
the entire market. To maximize profit, we find quantity such that marginal
revenue is equal to marginal cost. Adding demand equations, we find that the
total demand curve has a kink at Q = 5:

 25  2Q, if Q  5
P 
 18.33  0.67Q, if Q  5 .
This implies marginal revenue equations of
 25  4Q, if Q  5
MR  
18.33  1.33Q, if Q  5 .
With marginal cost equal to 3, MR = 18.33 – 1.33Q is relevant here because the
marginal revenue curve “kinks” when P = $15. To determine the profit-
maximizing quantity, equate marginal revenue and marginal cost:
18.33 – 1.33Q = 3, or Q = 11.5.
Substituting the profit-maximizing quantity into the demand equation to
determine price:
P = 18.33 – (0.67)(11.5) = $10.67.
With this price, Q1 = 4.33 and Q2 = 7.17. (Note that at these quantities MR1 =
6.34 and MR2 = –3.68). Profit is
 = 10.67(11.5) – [5 + 3(11.5)] = $83.21.
Deadweight loss in the first market is
DWL1 = (0.5)(12 – 4.33)(10.67 – 3) = $29.41.
Deadweight loss in the second market is
DWL2 = (0.5)(11 – 7.17)(10.67 – 3) = $14.69.
Total deadweight loss is $44.10. Without price discrimination, profit is lower,
but deadweight loss is also lower, and total output is unchanged. The big
winners are consumers in market 2 who now pay $10.67 instead of $14. DWL
in market 2 drops from $30.25 to $14.69. Consumers in market 1 and the
monopolist are worse off when price discrimination is not allowed.

7.
(a) If price discrimination is impossible the firm will set MR  MC .
20  2Q  2Q
Q5

At this quantity, price will be P  15 , total revenue will be TR  75 , total cost will be
TC  49 , and profit will be   26 . Producer surplus is total revenue less non-sunk

7
cost, or, in this case, total revenue less variable cost. Thus producer surplus is
75  52  50 .

(b) With perfect first-degree price discrimination the firm sets P  MC to determine the
level of output.
20  Q  2Q
Q  6.67

The price charged each consumer, however, will vary. The price charged will be the
consumer’s maximum willingness to pay and will correspond with the demand curve.
Total revenue will be the area underneath the demand curve out to Q = 6.67 units, or
0.5(20 – 13.33)(6.67) + 13.33(6.67) = 111.16. Since the firm is producing a total of
6.67 units, total cost will be TC  68.49 . Profit is then   42.67 , while producer
surplus is revenue less variable cost, or 111.16  6.67 2  66.67 .

(c) By being able to employ perfect first-degree price discrimination the firm increases
profit and producer surplus by 16.67.

8.
(a) With demand P  20  Q , MR  20  2Q . A profit-maximizing firm charging a
uniform price will set MR  MC .
20  2Q  2Q
Q5

At this quantity, price will be P  15 . At this price and quantity profit will be

  15(5)  ( F  52 )
  50  F

Therefore, the firm will earn positive profit as long as F  50 .

(b) A firm engaging in first-degree price discrimination with this demand will produce
where demand intersects marginal cost: 20 – Q = 2Q or Q = 6.67 units. Its total revenue will
be the area underneath the demand curve out to Q = 6.67 units;
TR  .5(20  13.33)(6.67)  13.33(6.67)  111.16 . Profit will be
  111.16  ( F  6.67 2 )
  66.67  F

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Therefore, profit will be positive as long as F  66.67 . Comparing the solution to parts
(a) and (b), for values of F between 50 and 66.67 the firm would be unwilling to operate
unless it is able to practice first-degree price discrimination.

9.
(a) The firm would maximize profit by producing until MR = MC, or 40 – 6Q = 2Q.
Thus Q = 5 and the profit-maximizing price is P = 25. With MC = 2Q and no fixed costs, its
total costs are C = Q2, so  = 25(5) – 52 = 100.

(b) With perfect first degree price discrimination, the firm will charge a price on
the demand curve for all units up to the quantity at which the demand curve intersects
the marginal cost curve. The demand curve intersects the marginal cost curve when 40
– 3Q = 2Q, or when Q = 8. Total revenue will be the area under the demand curve, or
0.5(40 – 16)8 + 16(8) = 224. Total variable cost is the area of the triangle under its
marginal cost curve up to the quantity produced, that is, 0.5(16)(8) = 64. Economic
profit will be 224 – 64 = 160. So by price discriminating, the firm will be able to earn
an extra profit of (160 – 100) = 60.

10.
(a) When the firm sets a uniform price, it sets MR = MC: 100 – 2Q = 20. The quantity
that maximizes profit is therefore Q = 40. The profit maximizing uniform price is P = 100 –
Q = 100 – 40 = 60. Profit is PQ – F -20Q = (60)(40) – F – (20)(40) = 1600 – F. So the firm
could earn at least zero economic profit as long as F < 1600.

(b) With perfect first degree price discrimination, the firm will charge a price on
the demand curve for all units up to the quantity at which the demand curve intersects
the marginal cost curve. The demand curve intersects the marginal cost curve when 100
– Q = 20, or when Q = 80. Total revenue will be the area under the demand curve, or
0.5(100 – 20)80 + 20(80) = 4800. Total cost will be F + 20(80) = F + 1600. Economic
profit will be 4800 – F – 1600 = 3200 – F. So the firm will be able to earn at least zero
economic profit as long as F < 3200.