PRACTICE QUESTIONS

DEMAND AND SUPPLY

Midcontinent Plastics makes 80 fiberglass truck hoods per day for large truck
manufacturers. Each hood sells for $500.00. Midcontinent sells all of its product to the
large truck manufacturers. If the own price elasticity of demand for hoods is -0.4 and
the price elasticity of supply is 1.5. Assume that the demand and supply functions are
linear i.e.,
1

Qd =a0 a1 P ; Qs=b0 +b1 P

(i) Compute the supply and demand for truck hoods.
(ii)If the local county government imposed a per unit tax of $25.00 per hood
manufactured, what would be the new equilibrium price of hoods to the truck
manufacturer?
(iii)Would a per unit tax on hoods change the revenue received by Midcontinent?
2. Let the supply curve be QS=c+Dp. Prove that elasticity of supply is equal to 1 if
c=0. And that supply is inelastic if c<0

CONSUMER BEHAVIOR
3.

There are two goods, X and Y. Find the optimal bundles that you will consume for
the indifference curve U(X,Y)= Y +X.

(i)
(ii)

PX = 1 and PY= 1 and the income, M=100.

PX = 30 and PY= 1 and the income, M=100.

4. There are two goods, X and Y. PX = 2 and PY= 1 and the income, M=100. Find the
optimal bundle of consumption for
(i) U(X,Y)= X2+Y2 .
(ii) U(X,Y)= min{X,2Y}

Pizza Hut faces ONLY two consumers- Consumer A and B. Each consumer can
demand at most two units of pizza. They do NOT consume non integer values of
pizza.
The two consumers differ in their preferences in the following way.
5.

Consumer As maximum willingness to pay for the first pizza, VA 1 = 5

Consumer As maximum willingness to pay for the second pizza, VA 2 = 4
Consumer Bs maximum willingness to pay for the first pizza, VB 1 = 6
Consumer Bs maximum willingness to pay for the second pizza, VB 2 = 1
Assume Pizza Hut (PH) has no fixed cost but marginal cost of 1.
Answer the following questions assuming that if a consumer is indifferent between
consuming two units and one unit of Pizza, it would consume two units.
And that if it is indifferent between consuming one unit and nothing, it would consume
one unit.
(a) If Pizza Hut were to behave competitively, what would be the price that it would
charge? What would be its profit? (2 MARKS)
From here on assume that PH is the only pizza seller in the market

(b) How many units will Consumer A and B purchase if the price of the product was
5? (2 MARKS)
(c) What are the different prices that PH can charge? Assume it can charge only
integer value prices? (2 MARKS)
(d) What is the optimal uniform price that the monopolist PH should charge?
(4 MARKS)
(e) Assume that PH can separate the two consumers and hence (Third Degree) price
discriminate them. What is the optimal uniform price that it would charge to
Consumer A and what is the optimal uniform price that it would charge to
Consumer B? (6 MARKS)
(f) Assume that PH knows each consumer and their willingness to pay for each unit.
That is it can use First Degree Price Discrimination. Assume that PH uses two part
tariff to do so. That is it charges each consumer an entry fee and a per unit fee. What
will be the optimal entre fee and per unit fee that PH will charge to consumer A?
What will be the optimal entre fee and per unit fee that PH will charge to consumer
B? (4 MARKS)

6. Draw the indifference curves/map for the following cases. Indicate indifference
curves that give higher utility.
(a) Consumer considers amount of smoke(Product X) and amount of noise (Product Y)
as bads
(b) Utility function U(X,Y) = (X-1)2 + (Y-1)2. Please assume only for this case that
more is better and Law of Diminishing MRS holds true.
(c) Consumer considers amount of smoke (Product X) as neutral and amount of
Food (Product Y) as a bad
7. There are two goods, X and Y. The consumer has preferences represented by
U(X,Y)= X 0.4 Y 0.6
(i) Find the optimal bundle that you will consume for the indifference curve PX = 1
and PY= 2 and the income, M=100.
(ii) Write the consumers Price Consumption Curve when price of X changes, PY = 2
and M= 100
(iii)
Write the Demand Curve of Product X in terms of income M, price, PX . Keep
PY = 1
(iv)
Are the two products substitutes? Please Explain.

8. Consider the utility function U(x,y) = x 1/2y1/2. Px=1 and Py=2 and income M=150.
Find the following:
(i) What are the optimal bundle (x*,y*) that the consumer will consume?
(ii) Write the price consumption curve of X? Is X a giffin good?
(iii) Assume now that the price of X changes to Px= 2, what is the new amount of X
that is consumed?
(iv) What is the total change in Xs consumption due to this price change?
(v) What is the income needed so that consume at a point such that consumers are as
happy as before the price change but at the new prices? (Px=2, PY=2)

9. The following table presents Alfred's marginal utility for each good while
exhausting his income. Fill in the remaining column in the table. If the price of tuna is
twice the price of peanut butter, at what consumption bundle in the table is Alfred
maximizing his level of satisfaction? Which commodity bundle entails the largest
level of tuna fish consumption?

Bundle

MU of peanut
butter

MU of tuna

0.25

2.41

0.31

1.50

0.42

0.84

0.66

0.33

Marginal Rate
of Substitution

10. Draw a set of indifference curves for the following pairs of goods:
a) Fish and carrots for a vegetarian who neither likes nor dislikes meat.
(vegetarians do not eat meat)
b) Peanut butter and jelly for an individual that will not eat peanut butter
sandwiches or jelly sandwiches, but loves peanut butter and jelly
sandwiches made with two parts peanut butter and one part jelly.
c) Tickets for Knott's Berry Farm (KBF) and Universal Studios (US) for a
tourist that believes that KBF and US are perfect substitutes.
d) There are two goods; x, y. Their utility function is given by: U(x,y) = (
x1
y1
+(
2

2
11. Natasha derives utility from attending rock concerts (r) and from colas (c) as
follows:
U(c,r) = c.9r.1
The marginal utility of cola (MUc) and the marginal utility of rock
concerts (MUr) are given as follows:
MUc = .9c-.1r.1

MUr = .1c.9r-.9

a) If the price of cola (Pc) is $1 and the price of concert tickets (Pr) is $30 and
Natasha's income is $300, how many colas and tickets should Natasha buy to
maximize utility?
b) Suppose that the promoters of rock concerts require each fan to buy 4 tickets
or none at all. Under this constraint and given the prices and income in (a),
how many colas and tickets should Natasha buy to maximize utility?
c) Is Natasha better off under the conditions in (a) or (b)? Explain your answer

PRODUCTION AND COST

12. Marge's Hair Salon production function is

y K , L KL ,

where K is the number of

hair dryers and L is the number of labor hours she employs.

(i) Does this production function exhibit increasing, decreasing, or constant returns to
scale?
(ii) At the moment, Marge uses 16 labor hours and 16 hair dryers. Suppose that Marge
can use any amount of either input without affecting the market costs of the inputs.
If Marge increased her use of labor hours and hair dryers by 10%, how much
would her production increase?
(iii) Increasing the use of both inputs by 10% will result in Marge's costs increasing by
exactly 10%. If Marge increases her use of all inputs by 10%, what will increase
more her production or her costs?
(iv) Given that Marge earns $12.50 for each unit produced, do her profits go up or
down when she increases her input use by 10%?
13. Consider the production function F(K, L) = K2 L. Wage rate of labor, w= Rs 10
and rate of capital, r = Rs 5. Answer the following questions
a) What can you say about the rate of returns of production? (3 POINTS)
b) What is the optimal combination of capital and labor required when maximum
expenditure possible is Rs 150. ( 6 POINTS )
c) What is the optimal combination of capital and labor required to produce 2,000
units of output. (5POINTS)
d) If the capital is kept fixed at 20, find the short run average cost and short run
marginal cost functions. (6 POINTS) (HINT: Cost is a function of output)
e) At what output does the firm exhibit diminishing rate of returns, for the cost
function found in (d)? (3 POINTS)
f) Find the expansion path when capital is kept fixed at 20. (6 POINTS)
g) Find the Long Run Cost function. (8 POINTS)
h) What can you say about economies of scale at output 6? (3 POINTS)
14. Suppose that five of the alternative scales of plant that a firm can build in the long
run are given by the SAC curves in the following table.
Q
1
2
3
4
5

SAC 1
SAC
15.50
13.00
12.00
11.75
13.00
(i)

Q
2
3
4
5
6

SAC 2
SAC
15.50
12.00
10.00
9.50
11.00

Q
5
6
7
8
9

SAC 3
SAC
10.00
8.50
8.00
8.50
10.00

Q
8
9
10
11
12

SAC 4
SAC
10.00
9.50
10.00
12.00
15.00

Q
9
10
11
12
13

SAC 5
SAC
12.00
11.00
11.50
13.00
16.00

Define the firms LAC curve if these five plants are the only ones that are
feasible technologically (HINT: You dont have to find an equation. Use the
numbers to indicate LAC for different outputs) ( 10 POINTS)

(ii)
(iii)

Which plant will the firm use in the long run if it wanted to produce 3 units
of output? (5 POINTS)
What is Long Run Marginal Cost curve for this production function? (10
POINTS)

MONOPOLY
15. Suppose that a monopoly can produce any level of output it wishes at a constant
marginal and average cost of Rs 5 per unit. Assume that the monopoly sells its goods in
two different markets that are separated by some distance. The demand curve in the first
market is given by
X1 = 55-P1
And the demand curve in the second market is given by
X2 = 70-2P2
(i)

If the monopolist can maintain the separation between the two markets,
what level of output should be produced in each market and what price will
prevail in each market?
(ii)
What is the firms profit?
(iii)
How would your answer change if it only cost demanders Rs 5 to transport
goods between the two markets? What would be the new profit of the
monopolist?
(Hint: The monopolist maximizes the sum of two profits and chooses quantity sold in
First market (X1) and Second market (X2)
16. The Metro Electric Company produces and distributes electricity to residential
customers in the metropolitan area. This monopoly firm is regulated, as are other
investor owned electric companies. The company faces the following demand and
marginal revenue functions:
P = 0.04 - 0.01Q
MR = 0.04 - 0.02Q
Its marginal cost function is:
MC = 0.005 + 0.0075Q,
where Q is in millions of kilowatt hours and P is in dollars per kilowatt hour. Find the
deadweight loss that would result if this company were allowed to operate as a profit
maximizing firm, assuming that P = MC under regulation.

17. Suppose that a monopoly can produce any level of output it wishes at a constant
marginal and average cost of Rs 5 per unit. Assume that the monopoly sells its goods in
two different markets that are separated by some distance. The demand curve in the
first market is given by
X1 = 55-P1
And the demand curve in the second market is given by
X2 = 70-2P2
(i) If the monopolist can maintain the separation between the two markets,
what level of output should be produced in each market and what price will
prevail in each market?
(ii) What is the firms profit?
(iii) How would your answer change if it only cost demanders Rs 5 to transport
goods between the two markets? What would be the new profit of the
monopolist?
(Hint: The monopolist maximizes the sum of two profits and chooses quantity
sold in First market (X1) and Second market (X2)

PERFECT COMPETITION
18. Assume the market for tortillas is perfectly competitive. The market supply and
demand curves for tortillas are given as follows:
supply curve:
P = .000002Q
demand curve:
P = 11 - .00002Q
The short run marginal cost curve for a typical tortilla factory is:
MC = .1 + .0009Q
a. Determine the equilibrium price for tortillas. (2 points)
b. Determine the profit maximizing short run equilibrium level of output for a
tortilla factory. (2 Points)
c. Assuming that all of the tortilla factories are identical, how many tortilla
factories are producing tortillas? (3 Points)
d. What is the number of firms that would be in the long run if there are no fixed
costs. (3 Points)
19. The market demand for a type of carpet known as KS-12 has been estimated as
P = 75 - 1.5Q,
where P is price ($/yard), and Q is output per time period (thousands of yards per
month). The market supply is expressed as P = 25 + 0.50Q. A typical
competitive firm that markets this type of carpet has a marginal cost of
production of
MC = 2.5 + 10q.
a.
b.
c.
d.
e.

Determine the market equilibrium price for this type of carpet. Also determine
the production rate in the market.
Determine how much the typical firm will produce per week at the equilibrium
price.
If all firms had the same cost structure, how many firms would compete at the
equilibrium price computed in (a) above?
Determine the producer surplus the typical firm has under the conditions
described above. (Hint: Note that the marginal cost function is linear.)
What is the number of firms that would be in the long run if there are no fixed
costs.

PRICE DISCRIMINATION
20. The demand for action figures based on characters from children's movies is

extremely high around the time the movie is released. In this peak period, demand for
action figures is
The resulting marginal
QDpk 300, 000 10, 000 P P 30 0.0002QDpk .

revenue curve is

MR Q pk 30 0.0004Q pk .

Some time after the movie release, interest

in the action figure wanes. In this lull period, demand for the action figure becomes

QDl 100, 000 25, 000 P P 4 0.00008QDl .

curve is

MR Ql 4 0.00016Q l .

The resulting lull period marginal revenue

Suppose the marginal costs of producing the action

figures are constant at $1.50. What is the optimal pricing strategy in the two different
periods? (15 marks)
21. Assume the firm is a monopolist catering to two markets- Market A and Bs

demand and cost functions as given below.

Demand curve:
QA= 14 -2P
QB= 10 -P
Assume zero fixed cost. The short run marginal cost curve is:
MC = 3
a. If the monopolist can not price discriminate (i.e. charges the same price to both
markets) what is the deadweight loss to the society because of
monopoly? (3 MARKS)
b. If the monopolist can price discriminate (i.e. can charge different prices to
different markets) what is the total deadweight loss to the society
because of monopoly? (4 MARKS)
c. Under what kind of pricing does the society lose more? WHY? (3 MARKS)

GOVERNMENT AND POLICY

22. Assume that the demand curve for product X is QD = 100-2P and supply curve of
the product is QS = -20+ 4P
(a) If the price ceiling was imposed in this market at Rs 10, what would be the
deadweight loss? (6 points)
(b) What is the producer and consumer surplus after ceiling? (6 points)
(c) What should be the price ceiling if the government (who imposes the price ceiling)
wants to minimize deadweight loss. (HINT: Assume a generic price to be p*. Then find
QS(p*) and so on. Eventually, Deadweightloss in terms of p*) (10 points) ?
(d) Will this (one found in (c) ) be effective? (3 points)

23. The local community is considering two options to raise money to finance a new civic
center. The first option is to institute a per unit tax on restaurant meals of $2.46. The
market demand and supply functions for restaurant meals are:
and
QD 800, 000 6, 000 P

QS 14,500 P 225, 000.

(a) Calculate consumer and producer surplus with the per unit tax. (5 marks)
(b) What is the burden that consumer bear because of the tax? (5 marks)
The second option the community is considering implementing is an income tax. If an
income tax is implemented, the new demand for restaurant meals is:
QD 794,875 6, 000 P.

(c) Calculate the level of consumer and producer surplus in the restaurant market with
the income tax. (5 marks)
(d) What is the burden that producers bear in this case? (5 marks)
(e) Which of the two options will reduce the sum of consumer and producer surplus the
least?
24. 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 8,500 100 P P 85 0.01QDB .

The second type of customers of Laura's firm services are residential customers.
Residential demand is
QDR 12,500 500 P P 25

Laura's marginal cost function is

MC Q B Q R

QDR
.
500

20 Q B Q R

.
3
150

If Laura third degree price discriminates and charges business customers $35
while charging residential customers $15, is Laura maximizing profits?

25.

Midcontinent Plastics makes 80 fiberglass truck hoods per day for large truck
manufacturers. Each hood sells for $500.00. Midcontinent sells all of its product
to the large truck manufacturers. If the own price elasticity of demand for hoods is
-0.4 and the price elasticity of supply is 1.5. Assume that the demand and supply
functions are linear i.e.,
Qd =a0 a1 P ; Qs=b0 +b1 P
(a) Compute the supply and demand for truck hoods.
(b) If the local county government imposed a per unit tax of $25.00 per hood
manufactured, what would be the new equilibrium price of hoods to the truck
manufacturer?
(c) Would a per unit tax on hoods change the revenue received by Midcontinent?

26. The local community is considering two options to raise money to finance a new
civic center. The first option is to institute a per unit tax on restaurant meals of $2.46.
The market demand and supply functions for restaurant meals are:

QD 800, 000 6, 000 P

and

QS 14,500 P 225, 000.

(a) Calculate consumer and producer surplus with the per unit tax. (5 marks)
(b) What is the burden that consumer bear because of the tax? (5 marks)
The second option the community is considering implementing is an income tax. If an
income tax is implemented, the new demand for restaurant meals is:
QD 794,875 6, 000 P.

(c) Calculate the level of consumer and producer surplus in the restaurant market with
the income tax. (5 marks)
(d) What is the burden that producers bear in this case? (5 marks)
(e) Which of the two options will reduce the sum of consumer and producer surplus the
least?

GAME THEORY AND OLIGOPOLY

27. There are three firms. Each firm sets a quantity q i: The resulting price at which
they can sell their quantity is P(q1; q2; q3) = 10-(q1 +q2 + q3): Find the solution for
each of the following extended
Stackelberg games:
(i) Firm 1 moves first, firm 2 moves second, firm 3 moves last. Each firm observes the
choices made earlier. (10 marks)
(ii) Firm 1 moves first, firm 2, firm 3 moves next. Firm 2 and 3 see the choice of firm
1, but firm 3 does not see the choice of firm 2. (10 marks)

28. Two firms in a local market compete in the manufacture of cyberwidgets. Each
firm must decide if they will engage in product research to innovate
their version of the cyberwidget. The pay-offs of each firm's strategy is
a function of the strategy of their competitor as well. The pay-off
matrix is presented below.
Firm #2
F INNOVA
i
TE
r
m DO NOT
INNOVA
#
TE
1

INNOVATE

DO NOT
INNOVATE

$-10; $-10

$100; $-5

$-5; $100

$0; $0

(a) What are the Nash Equilibrium in pure strategy of this strategic form game? (5
marks)
(b) Firm #2 chooses to innovate with probability 20/21. If Firm #1 does the same,
what is the expected pay-off? (5 marks)
(c) Find the Mixed Strategy Nash Equilibrium of this game. (5 marks)
(d) Now consider the scenario where there are three firms, F1,F2, F3. Each firm
decides whether to innovate or not simultaneously. The following payoff matrix
describes the payoff of strategies when the Firm 3 decides to innovate (I3). The
payoffs are read as follows: for example, If Firm 1 and 3 decide to innovate and
F2 does not, then F1 and F3 get 10 each and F2 gets -5.
29.
I1
-1,-1,-1
-5,10,10

D1
I2
10,-5,10
D2
-2,-2,15
I3(Firm 3 Innovates)
The following payoff matrix describes the payoff of strategies when the Firm 3
decides to NOT innovate (D3)
I2
D2

I1
10,10,-5
-2,15,-2

D1
15,-2,-2
0,0,0

D3(Firm 3Does not Innovates)

(a) What are the strategies of the three players? (2 marks)
(b) What is the Nash Equilibrium, if we assume that firm 3 always plays I3?
(c) What is the Nash equilibrium of the entire game? (4 marks) (Hint: solve for
Nash equilibrium for both the boxes above and then proceed)

30. The market demand and supply functions for cotton are:

QD 10 0.4 P

and

QS 38P 20.

(i)

Calculate the consumer and producer surplus. (4 marks)

(ii)To assist cotton farmers, suppose a subsidy of $0.10 a unit is implemented.
Calculate the new level of consumer and producer surplus. (4 marks)
(iii)Did the increase in consumer and producer surplus exceed the increased
government spending necessary to finance the subsidy? (2 Marks)

31. Consider a Location Game. There are two managers-Manager 1 and Manager 2
employed by Pepsi Co. To sell the drink at a fixed price in City A. City A is divided
into 5 blocks. Each block has 20 consumers each. Each Consumer must consume one
unit of the drink. For each can that is sold the manager gets Rs 10. If a salesperson
serves all of the consumers in a single region he gets Rs 200.Consumers walk upto the
nearest booth to make their purchase.
Managers cannot decide on the price of the drink but decide simultaneously and
independently on which block to locate their booth out of the five regions. If the
consumers of any region are indifferent between the two booths then we assume that
half of them go to one and the other half go to the other.
(a) What is an example of the strategy of Manager 1? (2 points)
(b) Solve the above mentioned game. That is predict the Nash Equilibrium of the game
by clearly stating your arguments. Write the payoff matrix explicitly. (10 points)
(c) If instead each Manager is paid a fixed wage for their work. Imagine that selling a
can entails effort which they would not exert. That is the manager wants to minimize
the number of cans sold. In this game are there any dominated strategies of Manager
1? (5 points)
(d) Solve the game mentioned in (c). That is predict Nash Equilibria of the game by
clearly stating your agreements. (8 points)
32. Assume there are two firms, Firm 1 and Firm 2 in the market of running shoes
with same marginal cost, c and zero fixed costs. Assume that the demand for running
shoes is
P = a-b Q
if Q a/b ,
=0
if Q> a/b
(a) Assume both firms maximize individual profits (this is known to both firms) and
simultaneously decide on output to produce, i.e. they simultaneously decide on q1 and
q2. What is the Nash Equilibrium of this game ? (5 points)

(b) Assume now that Firm 1 chooses an output, q1 that maximizes his profit. But Firm
2 chooses an output that maximizes his market share (
) subject to not making a
q2
q 2 q1
loss. These two facts are common knowledge, that is everyone knows that Firm 1
maximizes his profits and Firm 2 maximizes his market share.
If both firms choose their output simultaneously, what is the Nash Equilibrium of this
game? (5 points)
(c) Assume now that Firm1 and Firm 2 both maximize their market share subject to not
making a loss. This is common knowledge. What is the Nash Equilibrium of this
game? (5 points)
33. Two firms at the St. Louis airport have franchises to carry passengers to and from
hotels in downtown St. Louis. These two firms, Metro Limo and Urban Limo,
operate nine passenger vans. These duopolists cannot compete with price, but
they can compete through advertising. Their payoff matrix is below:
United Limo
Increase
Dont Increase
Advertising
Advertising
Metro Limo

a.
b.
c.

Increase
Advertising
Dont Increase
Advertising

25, 15

30, 0

15, 20

40, 5

Does each firm have a dominant strategy? If so, explain and what that
strategy is.
Explain where the Nash equilibrium occurs in the payoff matrix.
Write the game in an extensive form and solve the game.