Managerial Economics (COMM 172)

Professor Veikko Thiele

Midterm Exam Winter 2015 – Solutions

Question 1 (Production)
Firm A has the following (estimated) production function:
.
, 5∙ ∙
where is the labor input (measured in hours) and is the capital input. The wage per hour is $20
and the unit cost of capital is $100. The firm is currently using 10 units of capital (i.e., 10).
Note: For all your derivations carry 2 digits to the right of the decimal. Moreover, you don’t need to
round the optimal labor and capital inputs to whole numbers.

a) Derive the average product of labor, , when 10. Is increasing or decreasing in ?

Without doing any math, what can you infer about the marginal product of labor, (i.e., is
increasing or decreasing in )? Briefly explain. (5 points)

Average product of labor with :

.
, ∙ ∙
.

Average product of labor ( ) is decreasing labor input . This implies that the marginal
product of labor ( ) is decreasing (according to the average-marginal principle).

b) In the short run when capital is fixed at 10 units, how many hours of labor does Firm A need in
order to produce 200 units of output? What is then Firm A’s total cost of production? (6 points)

With and we can write the production function as

.
∙ ∙
Solving for : . ,
Total cost of production: $ ∙ , $ ∙ $ ,

c) In the long run when capital is variable, how many hours of labor and units of capital should
Firm A use to minimize the cost of producing 200 units of output? What is then Firm A’s total
cost of production? (12 points)

The cost minimizing combination of capital and labor satisfies

We first need to find and :

1
 , .
∙

, .
∙

With $ and $ we can write the optimality condition as

.
∙
∙ .

which can be simplified to

Using and the new expression for we can write the production function as
follows:
.
∙ ∙ ⇒ .
Thus, .
To minimize costs, Firm A should use 21.63 hours of labor and 21.63 units of capital to
produce 200 units of output.
Total cost of production: $ ∙ . $ ∙ . $ , .

Question 2 (Make-or-buy Decisions of Firms)

Firm A needs a specific input for its production, which Firm A has so far produced internally at a
cost of $70 per unit. To reduce its cost, Firm A decided to outsource the production of the input to
Firm B. Firm B’s cost of producing the input is $40 per unit.
Alternatively, Firm A could buy the input from Firm C at a price of $55 per unit. And instead of
selling to Firm A, Firm B could sell the input to Firm D at a price of $45 per unit.

a) Assuming Nash bargaining, what is the price per unit that Firm A and Firm B will agree on?
(4 points)
The maximum acceptable price for Firm A (buyer) is: $
The minimum acceptable price for Firm B (seller) is $
Applying the Nash bargaining solution we find

∗
$ $
$

b) Given your price from part (a), what is the share of surplus (per unit) for Firm A and Firm B,
respectively? (4 points)

Surplus Firm A = $70 – $50 = $20

Surplus Firm B = $50 – $40 = $10

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c) Given your price from part (a), what is the rent (per unit) for Firm A and Firm B, respectively?
(4 points)

Rent Firm A = $55 – $50 = $5

Rent Firm B = $50 – $45 = $5

d) Briefly explain the “holdup problem” (including its causes and consequences). (8 points)

The holdup problem can arise when two parties (e.g. two firms) engage in a trading
relationship, and (i) one party is required to make a relation-specific investment, which,
once made, is sunk, and (ii), contracts are missing or incomplete. The other party has then
an incentive to renegotiate the price, thereby taking advantage of the weaker bargaining
position of the trading partner (due to the investment now being sunk).
Holdup increases the cost of market transactions, and can lead to underinvestment.

Question 3 (Demand Estimation/Cost Estimation/Monopoly)

The owners of B&M Canada, a monopolist, hired you as a business consultant to help them making
B&M more profitable.
Using B&M’s monthly sales data you estimated the following log-linearized demand function for
B&M:
∙ ∙ ∙
where is the intercept, is the quantity sold, is B&M’s price per unit, and is B&M’s
advertising expenditures. Your regression results are as follows:
Coefficients Standard Error P‐value
Intercept 15.05 1.334 0.0045
ln(P(B)) ‐1.35 0.632 0.0123
ln(A) 0.25 0.107 0.0321
Time 0.002 0.001 0.0018

Using B&M’s monthly cost data you get the following regression results for the different cost
functions:
Estimated cost function: ∙ ∙ ∙
Coefficients Standard Error P‐value
Intercept 26567.5 1138.8 0.029
q 62.4 17.6 0.012
q^2 2.6 1.3 0.032
q^3 ‐0.8 0.2 0.072
Adjusted R Square 0.57

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 Estimated cost function: ∙ ∙
Coefficients Standard Error P‐value
Intercept 24768.2 1224.2 0.034
q 47.6 16.4 0.010
q^2 1.8 1.2 0.031
Adjusted R Square 0.76

Estimated cost function: ∙

Coefficients Standard Error P‐value
Intercept 25675.8 1738.7 0.031
q 53.2 18.3 0.008
Adjusted R Square 0.83

a) Using the regression results, write down the constant elasticity demand function for B&M.
Briefly explain the economic meaning of the estimated coefficients and . (Hint: In your
answer refer to the actual values of the estimated coefficients.) (8 points)

. . . . ∙
Constant elasticity demand function: ∙ ∙ ∙
The estimated coefficient . is the price elasticity of demand. When B&M
increases its price by 1%, then the quantity demanded will decrease by 1.35%.
The estimated coefficient . is the advertising elasticity of demand. When B&M
increases its advertising expenditures by 1%, then the quantity demanded will increase by
0.25%.

b) Using the regression results, write down the monthly total cost function for B&M. Briefly
explain how you identified B&M’s total cost function (6 points)

We first note that the coefficient for for the cubic cost function is not significant at the
5% level as P-value . . Thus, we can rule out the cubic cost function. Moreover, we
can see that all estimated coefficients for the quadratic and linear cost functions are
significant at the 5% level. We then need to compare the adjusted coefficients of
determination (Adjusted R Square). Note that the linear cost function has a higher
Adjusted R Square than the quadratic cost function. Thus, the linear cost function best
describes B&M’s actual costs of production.
Using the estimated coefficients we get the following estimated linear cost function for
B&M:
, . .

c) Use your results from parts (a) and (b) to derive the profit-maximizing price for B&M.
(3 points)

The marginal cost (MC) is . and the elasticity of demand ( ) is . .

Using the rule of thumb for pricing we get

4
 ∗
.
$ .
.

d) You know that B&M will spend $13,500 on advertising next month. Use your results from parts
(a) – (c) to derive the profit that B&M will then earn next month ( 25). (Hint: First use
your estimated demand function to derive the quantity that B&M will sell next month, given that
13,500 and 25. Then round the quantity demanded to the nearest whole number.)
(7 points)

We know from part (c) that ∗ $ . . With $ , and we can then

write B&M’s demand functions as
. . . . ∙
∙ . ∙ , ∙ ,
B&M’s profit is then given by
∗
∙ , . .
. ∙ , , . . ∙ , , , , .

Question 4 (Oligopoly)

Firm 1 and Firm 2 sell homogenous (i.e., identical) products. The market demand for their products
is given by 100 , where is the price per unit and is the total quantity, with
as Firm 1’s output and as Firm 2’s output.
Each firm has marginal cost of production equal to $10, and fixed costs equal to $500.

a) Suppose that both firms simultaneously choose their quantities in a non-cooperative game.
Identify
i) the equilibrium quantities,
ii) the equilibrium price, and
iii) the profits. (10 points)

Demand is given by .
Firm 1’s revenue: ∙ ∙

Firm 1’s marginal revenue:

Firm 1 maximizes profit by setting :

We solve this condition for to obtain Firm 1’s reaction curve:

Because of symmetry, Firm 2’s reaction curve is

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 This gives us two linear equations with two unknowns. Substituting Firm 2’s reaction
curve into Firm 1’s reaction curve, and solving for yields ∗ ∗
.
∗ ∗ ∗
The equilibrium price is then $ .
∗ ∗
Firm 1’s profit: ∙ $ $ ∙ $ $
Firm 2’s profit (because of symmetry): $

b) Now suppose that Firm 1 chooses its quantity before Firm 2. Identify
i) the equilibrium quantities,
ii) the equilibrium price, and
iii) the profits. (10 points)

Use Firm 2’s reaction curve from part (a) to write Firm 1’s revenue as a function of :

∙ ∙

Firm 1’s marginal revenue:

∗
Firm 1 maximizes profit by setting : ⇒

∗ ∗
Using Firm 2’s reaction curve we find its optimal quantity: .
∗ ∗ ∗
The equilibrium price is then $ . .
We can then calculate the profits of the two firms as follows:
∗ ∗
∙ $ . $ ∙ $ $ .
∗ ∗
∙ $ . $ ∙ . $ $ .

c) Now suppose that Firm 1 and Firm 2 form a cartel, i.e., they collude to restrict output. Identify
i) the quantity that each firm in the cartel will then produce,
ii) the cartel price,
iii) the profit of each firm in the cartel. (7 points)

Both firms choose the total quantity that maximizes their joint profit.
Revenue of the cartel: ∙ ∙

Marginal revenue of the cartel:

The cartel maximizes its total profit by setting :

∗
⇒
∗ ∗ ∗
Thus, each firm in the cartel produces / .
∗ ∗
The equilibrium price is then given by $

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 Firm 1’s profit:
∗ ∗
∙ $ $ ∙ . $ $ .
Symmetry then implies $ .

d) Use your results from part (a) to illustrate the reaction curves for both firms using a diagram
with the quantity of Firm 1 ( ) on the y-axis and the quantity of Firm 2 ( ) on the x-axis. Then
identify the quantities produced by the two firms that you derived in part (a), part (b), and
part (c). (6 points)

q1
Stackelberg
outcome
RC Firm 2 (part b)

Cournot
45 outcome
(part a)
30
22.5
RC Firm 1
Collusive
outcome
(part c) 22.5 30 q2