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Economics 101

Fall 2010
Homework #5
Due: 12/14/2010 in lecture
Directions: The homework will be collected in a box before the lecture. Please place your name,
TA name and section number on top of the homework (legibly). Make sure you write your name
as it appears on your ! so that you can recei"e the correct grade. Please remember the section
number for the section you are registere! because you will need that number when you submit
exams and homework. #ate homework will not be accepted so make plans ahead of time. "lease
s#ow your work$ $ood luck%
1$ "erfect com%etition
A local microbrewery has total costs of production gi"en by the e&uation T'()**+,*&+)&
-
. This
implies that the firm.s marginal cost is gi"en by the e&uation M'(,*+,*& (you do not need to be able
to show this). The market demand for beer is gi"en by the e&uation /!(,*) 0 (,1-)2P.
a) 3rite the e&uations showing the brewery.s a"erage total cost and a"erage "ariable cost and a"erage
fixed cost, each as a function of &. 4how the firm.s M', AT' and A5' on one graph.
AT' ( T'1& ( ()**+,*&+)&
-
)1& ( )**1&+,*+)&
A5' ( 5'1& ( (,*&+)&
-
)1& ( ,*+)&
A6' ( 6'1& ( )**1&
b) 3hat is the breake"en price and breake"en &uantity for this firm in the short run7
8ote that M' crosses AT' at its minimum. 9ence, M' ( AT' at that le"el of output that corresponds
to the intersection of the AT' and M' cur"es.
,
M' ( ,* +,*& ( )**1& + ,* + )& ( AT'
)/ ( )**1&
)&- ( )**
&- ( ,**
& ( ,*
Then P ( M' ( AT' ( ,* + ,*& ( ,,*
c) 3hat is the shutdown price and shutdown &uantity for this firm in the short run7
6rom the picture abo"e, it is clear that A5' is minimi:ed at & ( *.
P ( M' ( A5' ( ,*+)(*) ( ,*
4hort;run <&uilibrium
d) f the market price of the output is =)*, how many units will this firm produce7
The firm will set M'(P()*. Thus, ,* + ,*& ( )*, hence &2 ( >.
e) $i"en a market price of =)*, how many firms are in this market7
Plug P ( )* in the market demand cur"e. Thus, we get /! ( ,*) 0 (,1-))* ( ?*
Thus, the number of firms in the short run is e&ual to@ 8 ( ?*1> (-* firms.
#ong;run <&uilibrium
f) Assuming the beer industry is perfectly competiti"e, what output would be produced by the firm in
long;run e&uilibrium7 3hat would be the long;run e&uilibrium price7
n long run e&uilibrium, there must be :ero profits. Therefore, rewriting the profit function,
( TA 0 T' ( P2& 0 AT'2& ( (P 0 AT') 2&
3e can see that :ero profit re&uires that P ( AT'. 4ince in perfect competition it is always the case
that P ( M' for a profit maximi:ing firm, we need to find the price at which M' ( AT'. 8ote that this
is the breake"en price and breake"en &uantity for the firm found in part (b).
#ong run e&uilibrium &uantity for the firm@ & ( ,*
#ong run e&uilibrium price@ P ( ,,*
g) 9ow many firms will be in the industry in long;run e&uilibrium7
3e already know that the long run e&uilibrium price must be ,,*. 6rom this information and the
demand cur"e we can find the &uantity demanded in this market in the long run.
/!(,*);(,1>)2P ( ,*) 0 (,1-)2,,* ( )*
n e&uilibrium, the market demand must e&ual the market supply. Thus, the number of firms@
8 ( /!1& ( )*1,* ( ) firms
-
2$ &ono%oly
4uppose 'harter 'ommunications is a monopolist in pro"iding cable tele"ision ser"ices to local
consumers in Madison. The market demand cur"e faced by 'harter 'ommunications is P ( ;/ + B*,
and 'harterCs cost is gi"en by T'(/
-
1- + -*, and 'harter 'ommunicationCs marginal cost is gi"en by
M'(/.
a) 3hat is the e&uation for Marginal Ae"enue for this monopolist7
MA ( ;-/ + B*
b) !raw the !emand cur"e, Marginal Ae"enue cur"e, and Marginal 'ost cur"e for this monopolist in
a graph.
c) 3hat is the monopolistCs profit;maximi:ing production &uantity, /M7 3hat price, PM , will the
monopolist charge7
Dse MA(M', we ha"e ;-/ + B* ( / , and we can get /M ( ,*
Plug /M ( ,* into demand e&uation, we ha"e PM ( ;,* + B* ( =-*
d) 'ompute the 'onsumer surplus, producer surplus and profits for the monopolist
'4 ( ,*x,*1- ( =)*
P4 ( ,*x,* + ,*x,*1- ( =,)*
n order to get the profit,
6irst,
B* ,)
B*
/
=
MA !
M'
B
AT' ( /1- + -*1/
4econd,
Profits ( TA 0 T'
TA ( PM/M ( -*x,* ( =-**
T' ( AT' (at /M)x/M ( (,*1- + -*1,*)x,* ( =Ex,* ( =E*
Then,
Profits ( TA 0 T' ( =-** ; =E* ( =,B*
8ow, suppose there is a technological change for the monopolist and the result of this technological
change is that the firmCs cost cur"es change. 'harter 'ommunications total cost is now gi"en by T' (
,*/, and its marginal cost is gi"en by M' ( ,*.
e) 3hat is the monopolistCs profit;maximi:ing production &uantity /M7 3hat price, PM, will the
monopolist charge7
Dse MA(M', we ha"e ;-/ + B* ( ,*, and we can get /M ( ,*
Plug /M ( B* into demand e&uation, we ha"e PM ( ;,* + B* ( =-*
f) 4uppose this market was a perfectly competiti"e market (i.e., the monopolistCs demand cur"e is still
the market demand cur"e, but now there are many firms pro"iding cable tele"ision ser"ices for the
market). $i"en the market is perfectly competiti"e, what would be the e&uilibrium price (Ppc) and
&uantity (/pc) in this competiti"e market7 Assume that each firmCs M' cur"e is gi"en by M' ( ,* for
this &uestion.

The competiti"e market e&uilibrium price should satisfy P(M', so Ppc ( ,*
Plug Ppc ( ,* into demand, we get ,* ( ;/ + B*, /pc ( -*.
8ow, let us compare the monopoly and perfect competition outcomes. 'onsider the last technology
where the firm faces T' ( ,*/ and M'(,*.
g) 3hat is the difference between the consumer surplus in the monopoly case and the consumer
surplus in the perfect competition case7
'4(monopoly) ( ,*x,*1- ( =)*
'4(perfect competition) ( -*x-*1- ( =-**
4o the difference is =)* ; =-** ( ;=,)*
h) 3hat is the difference between the producer surplus in the monopoly case and the producer surplus
in the perfect competition case7
P4(monopoly) ( ,*x,* ( =,**
P4(perfect competition) ( =*
4o the difference is =,** ; =* ( =,**
i) 3hat is the dead weight loss caused by the monopolist7
!3# ( F'4(perfect comp.)+P4(perfect comp.)G ; F'4(monopoly)+P4(monopoly)G
!3# ( F-**+*G ; F)*+,**G ( =)*

'$ (atural mono%oly
>
a) 4uppose Madison $as and <lectric (M$<) is a natural monopoly in Madison for
electricity. This firm faces a demand function P (-* H-/ and has a total cost function T'
( ,-+?/. 3e can find this firmCs marginal cost function by taking the first deri"ati"e of
the total cost function with respect to /. f you do not know how to do this or your
calculus skills are rusty, then here is the firmCs M' cur"e@ M' ( ?. In a graph illustrate
the !emand cur"e, A"erage Total 'ost cur"e, Marginal 'ost 'ur"e, and Marginal
Ae"enue 'ur"e for this firm.
4ince there is only one firm &(/
b) The go"ernment decides to regulate this market using marginal cost pricing. That is,
the firm is told to produce that le"el of output where M' is e&ual to P for the last unit
produced. 'alculate the minimum amount of subsidy that will be necessary in order to
keep this monopolist in business.
-*
*
,* )
?
M'
MA !
AT'
)
*
-*
*
,* /
M'
(J
P
M'
(?
M'
MA !
AT'
)
* /
A'
P
A'
)
The minimum amount of subsidy is the amount that gi"es :ero profit to the monopolist.
P(M'(?
Plug P(? into demand, then we get /M'(J
Profit(TA;T'
TA(Px/M'
(?xJ ( =>?
T'(AT'(at/M')x/M'
AT'(at/M')(,*1/M' + ? ( =,*
Then
T'(=,*xJ ( =J*
Thus,
Profit ( ;=,-
Therefore, the minimum amount of total subsidy is =,- (or, =- per unit of the good
produced).
c) 4uppose the go"ernment decides to use a"erage cost pricing regulation. That is, the
go"ernment tells the monopoly to produce that le"el of output where the firm earns :ero
economic profit. dentify in your graph the e&uilibrium price and &uantity that
corresponds to this type of regulation (donCt compute the "alues, Kust mark what the Pac
and /ac are in your graph). s this price and output combination allocati"ely efficient7
n the picture, the e&uilibrium is when !emand(AT'.
Profit ( *.
8I, this price and output combination is not allocati"ely efficient.
4$ "rice iscrimination
A monopolist faces demand from two groups of consumers.
!emand from class , is gi"en by@ /,(-* 0 P
!emand from class - is gi"en by@ /-(-- 0 (,1-)P
A monopolist has costs gi"en by@
T'(,* + *.)/
-
M'(/
The firm is able to price discriminate between the two markets.
a) 3hich group of customers has the more elastic demand cur"e7
3e can see that the demand from class , is more sensiti"e to changes in price.
b) 3hich group do you expect will pay a higher price under Brd degree price discrimination7
!emand from class - is relati"ely inelastic compared to class ,. 3e would thus expect class - to pay a
higher price.
J
c) 3hat is the e&uation for Marginal Ae"enue for each class of consumers7
TA from class , ( P/, ( -*/, 0 /,
-

MA from class , ( -* 0 -/,
TA from class - ( P/- ( >>/, 0 -/-
-

MA from class - ( >> 0 >/-
d) 3hat &uantities will the monopolist sell in the two markets7
The monopolist will set marginal re"enue in each class e&ual to the (common) marginal cost. 9ence,
in e&uilibrium
MA, ( -* 0 -/,

( /,+/- ( / ( M'
MA- ( >> 0 >/-

( /,+/- ( / ( M'
This is an e&uation system with two e&uations and two unknowns. 6rom the first e&uation we obtain
/- ( -* 0 B/,
Aeplacing in the second e&uation
>> 0 /, ( )(-* 0 B/,)
,>/, ( )J
/, ( >
Aeplacing in /- ( -* 0 B/, ( ?
e) 3hat price will the monopolist charge in each market7 Are the optimal prices in each class
consistent with your prediction in part (b)7
The e&uilibrium prices are found simply by plugging the e&uilibrium &uantities into the demand
functions.
6or demand from class ,
P ( -* 0 /, ( -* 0 > ( ,J
6or demand from class -
P ( >> 0 -/- ( >> 0 ,J ( -?
3e found that class - pays a higher price, which is consistent with our prediction.
f) 3hich class generates the highest re"enue for the monopolist7
TA from class , ( P,/, ( ,Jx> ( J>
E
TA from class - ( P-/- ( -?x? ( ->>
5$ +ame t#eory
8ow consider Lulia and Peter. Peter likes Lulia, but Lulia doesn.t like Peter that much, only a little.
<ach knows this, and neither wants to call the other before deciding what to do this weekend@ stay at
their respecti"e homes or go to the econ party.
9ere is the payoff matrix pro"iding a measure of the benefits that Lulia and Peter recei"e depending
upon whether they stay home or go to the party. n each cell the first number refers to LuliaCs benefit
while the second number refers to PeterCs benefit.
Peter
9ome Party
Lulia
9ome (-,*) (-,,)
Party (B,*) (,,--)
a) s there any strictly dominant strategy for Lulia7 <xplain your answer.
8o
n this case, Lulia.s best strategy depends on what Peter does. f Peter stays at home, then the best
decision for her is to go to the party. Mut f Peter goes to the party, then the best decision for her is to
stay at home.
b) s there any strictly dominant strategy for Peter7 <xplain your answer.
Nes.
6or Peter, regardless the decision of Lulia, the best decision is to go to the party. 4o it is his dominant
strategy.
c) 3hat is the e&uilibrium you can predict from this game7
Lulia knows that Peter will always go to the party, so she will choose to stay at home, thus (9ome,
Party) ( (-, ,) is the e&uilibrium for this game.
,$ -#ort Essay: . can/t wait for Econ 101 to en0 12ny answer gets full creit$3 4ake a breat# an
write a s#ort essay about 13 w#at you foun interesting in econ 1015 23 w#at you foun
c#allenging in econ 101: or '3 w#at sur%rise you most about econ 101$ .f you write about
graes an/or e6ams make sure your essay is more t#an 7ust a com%laint t#at t#ere are graes
or t#at t#e e6ams are ifficult 1or! fail to measure w#at you know8t#is essay to%ic nees to fully
e6%licate w#at you know an w#y t#e e6ams faile to measure it3$ 9se stanar Englis#
1sentences nee a sub7ect! a :erb! %unctuation an ca%itali;ation3 an make sure you write an
essay an not 7ust talking %oints0 Ha:e a goo time wit# t#is one$ 1-uggeste lengt#8one goo
%aragra%#: oes not nee to be a long iscussion03
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