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# CHAPTER8

PROFITMAXIMIZATIONANDCOMPETITIVESUPPLY

EXERCISES

forwhichafirmcansellaunitofoutputandthetotalcostofproduction.

a. Fillintheblanksinthetable.

b. Showwhathappenstothefirmsoutputchoiceandprofitifthepriceof
theproductfallsfrom\$60to\$50.

Q P TR TC MC MR TR MR
P= P= P=60 P=50 P= P=50
60 60 50

0 60 100
1 60 150
2 60 178
3 60 198
4 60 212
5 60 230
6 60 250
7 60 272
8 60 310
9 60 355
10 60 410
11 60 475

Thetablebelowshowsthefirmsrevenueandcostforthetwoprices.

Q P TR TC MC MR TR MR
P= P= P=60 P=50 P= P=50
60 60 50

## 0 60 0 100 100 ___ ___ 0 ___ 100

1 60 60 150 90 50 60 50 50 100
2 60 120 178 58 28 60 100 50 78
3 60 180 198 18 20 60 150 50 48
4 60 240 212 28 14 60 200 50 12
5 60 300 230 70 18 60 250 50 20
6 60 360 250 110 20 60 300 50 50
7 60 420 272 148 22 60 350 50 78
8 60 480 310 170 38 60 400 50 90
9 60 540 355 185 45 60 450 50 95
10 60 600 410 190 55 60 500 50 90
11 60 660 475 185 65 60 550 50 75
Atapriceof\$60,thefirmshouldproducetenunitsofoutputtomaximize
profitbecausethisisthepointclosesttowherepriceequalsmarginalcost
without having marginal cost exceed price. At a price of \$50, the firm
shouldproducenineunitstomaximizeprofit.Whenpricefallsfrom\$60to
\$50,profitfallsfrom\$190to\$95.

2.Usingthedatainthetable,showwhathappenstothefirmsoutputchoice
andprofitifthefixedcostofproductionincreasesfrom\$100to\$150,andthen
to\$200. Assumethatthepriceoftheoutputremainsat\$60perunit. What
outputchoice?

Thetablebelowshowsthefirmsrevenueandcostinformationforfixedcost,
FCof100,150,and200.

Inallofthegivencases,withfixedcostequalto100,then150,and
then200,thefirmwillproduce10unitsofoutputbecausethisisthe
point closest to where price equals marginal cost without having
marginalcostexceedprice.Fixedcostsdonotinfluencetheoptimal
quantity,becausetheydonotinfluencemarginalcost. Higherfixed
costsalsoresultinlowerprofits.

Q P TR TC MC TC TC
FC= FC= FC=150 FC=150 FC=200 FC=200
100 100

## 0 60 0 100 100 ___ 150 150 200 200

1 60 60 150 90 50 200 140 250 190
2 60 120 178 58 28 228 108 278 158
3 60 180 198 18 20 248 68 298 118
4 60 240 212 28 14 262 22 312 72
5 60 300 230 70 18 280 20 330 30
6 60 360 250 110 20 300 60 350 10
7 60 420 272 148 22 322 98 372 48
8 60 480 310 170 38 360 120 410 70
9 60 540 355 185 45 405 135 455 85
10 60 600 410 190 55 460 140 510 90
11 60 660 475 185 65 525 135 575 85

3.UsethesameinformationasinExercise1.

a. Derivethefirmsshortrunsupplycurve.(Hint:youmaywanttoplotthe
appropriatecostcurves.)

Thefirmsshortrunsupplycurveisitsmarginalcostcurveaboveaverage
variablecost.Thetablebelowlistsmarginalcost,totalcost,variablecost,
fixedcost,andaveragevariablecost.Thefirmwillproduce8ormoreunits
depending on the market price and will notproduce in the 07 units of
outputrangebecauseinthisrangeAVCisgreaterthanMC.WhenAVCis
greaterthanMC,thefirmminimizeslossesbyproducingnothing.
Q TC MC TVC TFC AVC

## 0 100 ___ 0 100 ___

1 150 50 50 100 50.0
2 178 28 78 100 39.0
3 198 20 98 100 32.7
4 212 14 112 100 28.0
5 230 18 130 100 26.0
6 250 20 150 100 25.0
7 272 22 172 100 24.6
8 310 38 210 100 26.3
9 355 45 255 100 28.3
10 410 55 310 100 31.0
11 475 65 375 100 34.1

b. If100identicalfirmsareinthemarket,whatistheindustrysupply
curve?

For100firmswithidenticalcoststructures,themarketsupplycurveisthe
horizontalsummationofeachfirmsoutputateachprice.

60

Q
800
4. Suppose you are the manager of a watchmaking firm operating in a
competitivemarket.YourcostofproductionisgivenbyC=200+2q 2,whereq
isthelevelofoutputandCistotalcost.(Themarginalcostofproductionis4q.
Thefixedcostofproductionis\$200.)

a. Ifthepriceofwatchesis\$100,howmanywatchesshouldyouproduceto
maximizeprofit?

Profitsaremaximizedwheremarginalcostisequaltomarginalrevenue.
Here,marginalrevenueisequalto\$100;recallthatpriceequalsmarginal
revenueinacompetitivemarket:

100=4q,orq=25.

b. Whatwilltheprofitlevelbe?

Profitisequaltototalrevenueminustotalcost:

=(100)(25)(200+2*252)=\$1050.

c. Atwhatminimumpricewillthefirmproduceapositiveoutput?

thanitsvariablecosts.Rememberthatthefirmsshortrunsupplycurveis
itsmarginalcostcurveabovetheminimumofaveragevariablecost.Here,
VC 2q 2
averagevariablecostis 2q .Also,MCisequalto4q.So,MC
q q
isgreaterthanAVCforanyquantitygreaterthan0.Thismeansthatthe
firmproducesintheshortrunaslongaspriceispositive.

## 5. Suppose that acompetitivefirmsmarginalcost ofproducingoutput qis

givenbyMC(q)=3+2q.Assumethatthemarketpriceofthefirmsproductis
\$9.

a. Whatlevelofoutputwillthefirmproduce?

## To maximize profits, the firm should set marginal revenue equal to

marginalcost. Giventhefactthatthisfirmisoperatinginacompetitive
market,themarketpriceitfacesisequaltomarginalrevenue. Thus,the
firmshouldsetthemarketpriceequaltomarginalcosttomaximizeits
profits:

9=3+2q,orq=3.
b. Whatisthefirmsproducersurplus?

Producersurplusisequaltotheareabelowthemarketprice,i.e.,\$9.00,and
abovethemarginalcostcurve,i.e.,3+2 q.BecauseMCislinear,producer
surplusisatrianglewithabaseequalto\$6(93=6).Theheightofthe
triangleis3,whereP=MC.Therefore,producersurplusis
(0.5)(6)(3)=\$9.

Price
MC(q)=3+2q
10
9 P =\$9.00
8
Producer
Producers
7 Surplus
Surplus
6
5
4
3
2
1

Quantity
1 2 3 4

c. SupposethattheaveragevariablecostofthefirmisgivenbyAVC(q)=3+
q.Supposethatthefirmsfixedcostsareknowntobe\$3.Willthefirmbe
earningapositive,negative,orzeroprofitintheshortrun?

Profitisequaltototalrevenueminustotalcost.Totalcostisequaltototal
variable cost plus fixed cost. Total variable cost is equal to ( AVC)(q).
Therefore,atq=3,

TVC=(3+3)(3)=\$18.

Fixedcostisequalto\$3.Therefore,totalcostequalsTVCplusTFC,or

TC=18+3=\$21.

Totalrevenueispricetimesquantity:

TR=(\$9)(3)=\$27.

Profitistotalrevenueminustotalcost:

=\$27\$21=\$6.
Therefore,thefirmisearningpositiveeconomicprofits. Moreeasily,you
mightrecallthatprofitequalsproducersurplusminusfixedcost.Sincewe
foundthatproducersurpluswas\$9inpartb,profitequals93or\$6.

6. Afirmproducesaproductinacompetitiveindustryandhasatotalcost
function TC 50 4q 2q 2 andamarginalcostfunction MC 4 4q . Atthe
givenmarketpriceof\$20,thefirmisproducing5unitsofoutput.Isthefirm
maximizing profit? What quantityof output should thefirm produce in the
longrun?

Ifthefirmismaximizingprofit,thenpricewillbeequaltomarginalcost.
P=MCSettingpriceequaltomarginalcostresultsinP=20=4+4q=MC,or
q=4.Thefirmisnotmaximizingprofit,sinceitisastheyareproducing
toomuchoutput.Thecurrentlevelofprofitis

profit=20*5(50+4*5+2*5*5)=20,

andtheprofitmaximizinglevelis

profit=20*4(50+4*4+2*4*4)=18.

Givennochangeinthepriceoftheproductorthecoststructureofthe
firm,thefirmshouldproduceq=0unitsofoutputinthelongrunsinceat
the quantity where price is equal to marginal cost, economic profit is
negative.Thefirmshouldexittheindustry.

7.SupposethecostfunctionisC(q)=4q2+16.

a. Findvariablecost,fixedcost,averagecost,averagevariablecost,and
averagefixedcost.Hint:MarginalcostisMC=8q.
2
Variablecostisthatpartoftotalcostthatdependsonq( 4q )andfixed
costisthatpartoftotalcostthatdoesnotdependonq(16).

VC 4q 2
FC 16
C(q) 16
AC 4q
q q
VC
AVC 4q
q
FC 16
AFC
q q
b. Showtheaveragecost,marginalcost,andaveragevariablecostcurves
onagraph.
Averagecostisushaped.Averagecostisrelativelylargeatfirstbecause
the firm is not able to spread the fixed cost over very many units of
output. As output increases, average fixed costs will fall relatively
rapidly. Averagecostwill increaseatsomepointbecausethe average
fixedcostwillbecomeverysmallandaveragevariablecostisincreasing
asqincreases.Averagevariablecostwillincreasebecauseofdiminishing
returnstothevariablefactorlabor. MCandAVCarelinear,andboth
pass through the origin. Average variable cost is everywhere below
averagecost.Marginalcostiseverywhereaboveaveragevariablecost.If
the average is rising, then the marginal must be above the average.
Marginalcostwillhitaveragecostatitsminimumpoint.

c. Findtheoutputthatminimizesaveragecost.

TheminimumaveragecostquantityiswhereMCisequaltoAC:

16
AC 4q 8q MC
q

16
4q
q
16 4q2
4 q2
2 q.
d. Atwhatrangeofpriceswillthefirmproduceapositiveoutput?

ThefirmwillsupplypositivelevelsofoutputaslongasP=MC>AVC,oras
longasthefirmiscoveringitsvariablecostsofproduction.Inthiscase,
marginalcostiseverywhereaboveaveragevariablecostsothefirmwill
supplypositiveoutputatanypositiveprice.

e. Atwhatrangeofpriceswillthefirmearnanegativeprofit?

ThefirmwillearnnegativeprofitwhenP=MC<AC,oratanypricebelow
minimum average cost. In part c above we found that the minimum
averagecostquantitywasq=2.Plugq=2intotheaveragecostfunctionto
findAC=16.Thefirmwillthereforeearnnegativeprofitifpriceisbelow
16.

f. Atwhatrangeofpriceswillthefirmearnapositiveprofit?
Inpartewefoundthatthefirmwouldearnnegativeprofitatanyprice
below 16. The firm therefore earns positive profit as long as price is
above16.

8.Acompetitivefirmhasthefollowingshortruncostfunction:

## C(q) q3 8q2 30q 5 .

FindMC,AC,andAVCandsketchthemonagraph.

Thefunctionscanbecalculatedasfollows:

C
MC 3q2 16q 30
q
C 5
AC q 2 8q 30
q q
VC
AVC q 2 8q 30
q

Graphically, all three cost functions are ushaped in that cost declines
initiallyasqincreases,andthencostincreasesasqincreases. Average
variablecostisbelowaveragecost.Marginalcostwillbeinitiallybelow
AVCandwillthenincreasetohitAVCatitsminimumpoint.MCwillbe
initiallybelowACandwillalsohitACatitsminimumpoint.

Atwhatrangeofpriceswillthefirmsupplyzerooutput?

Thefirmwillfinditprofitabletoproduceintheshortrunaslongasprice
isgreaterthanorequaltoaveragevariablecost. Ifpriceislessthan
averagevariablecostthenthefirmwillbebetteroffshuttingdowninthe
shortrun,asitwillonlyloseitsfixedcostandnotfixedplussomeof
variablecost. Hereweneedtofindtheminimumaveragevariablecost,
whichcanbedoneintwodifferentways.Youcaneithersetmarginalcost
equaltoaveragevariablecost,oryoucandifferentiateaveragevariable
costwithrespecttoqandsetthisequaltozero. Inbothcases,youcan
solveforqandthenplugintoAVCtofindtheminimumAVC.Herewe
willsetAVCequaltoMC:

AVC q 2 8q 30 3q 2 16q 30 MC
2q2 8q
q 4
AVC(q 4) 4 2 8* 4 30 14.
Hence,thefirmsupplieszerooutputifP<14.

Identifythefirmssupplycurveonyourgraph.

ThefirmsupplycurveistheMCcurveabovethepointwhereMC=AVC.
ThefirmwillproduceatthepointwherepriceequalsMCaslongasMC
isgreaterthanorequaltoAVC.

Atwhatpricewouldthefirmsupplyexactly6unitsofoutput?

The firm maximizes profit by choosing the level of output such that
P=MC.Tofindthepricewherethefirmwouldsupply6unitsofoutput,
setqequalto6andsolveforMC:

## P MC 3q2 16q 30 3(62 ) 16(6) 30 42.

1
9. a. Suppose that a firms production function is q 9x 2 in the short run,
where, therearefixedcostsof\$1,000 , andxisthevariableinput, whose and
thecostofxcostis\$4,000perunit.Whatisthe,writedownthetotalcostof
producing a some level of output q. In other words, identify the total cost
functionC(q).

ThetotalcostfunctionC(x)=fixedcost+variablecost=1000+4000x.
Sincethevariableinputcosts\$4,000perunit, thevariablecostis4000
timesthenumberofunits,or4000x.Nowrewritetheproductionfunction

q2
toexpressxintermsofqsothat x . Wecanthensubstitutethis
81
intotheabovecostfunctiontofindC(q):

4000q2
C(q) 1000 .
81
Writedowntheequationforthesupplycurve.

ThefirmsuppliesoutputwhereP=MCsothemarginalcostcurveisthe
8000q
supplycurve,or P .
81

Ifpriceis\$1000,howmanyunitswillthefirmproduce?Whatisthelevelof
profit?Illustrateonacostcurvegraph.

Tofigurethisout,setpriceequaltomarginalcosttofind:

8000q
P 1000 q 10.125 .
81
Profit is 1000*10.125(1000+(4000*10.125*10.125)/81) = 4062.5.
Graphically,thefirmproduceswherethepricelinehitstheMCcurve.
Sinceprofitispositive,thiswilloccurataquantitywherepriceisgreater
thanaveragecost.Tofindprofitonthegraph,takethedifferenceofthe
revenuebox(pricetimesquantity)andthecostbox(averagecosttimes
quantity).Thisrectangleistheprofitarea.

10. Suppose you are given the following information about a particular
industry:

QD 6500 100PMarketdemand
QS 1200PMarketsupply
q2
C(q) 722 Firmtotalcostfunction
200
2q
MC(q) Firmmarginalcostfunction.
200
Assume that all firms are identical, and that the market is characterized by
purecompetition.

a. Findtheequilibriumprice,theequilibriumquantity,theoutput
suppliedbythefirm,andtheprofitofthefirm.

Equilibriumpriceandquantityarefoundbysettingmarketsupplyequal
to market demand, so that 6500100P=1200P. Solve to find P=5 and
substitute plug back into either equation to find Q=6000. To find the
2q
outputforthefirmsetpriceequaltomarginalcostsothat 5 and
200
q=500. Profit of the firm is total revenue minus total cost or

500 2
pq C(q) 5(500) 722 528. Noticethatsincethetotal
200
outputinthemarketis6000,andthefirmoutputis500,theremustbe
6000/500=12firmsintheindustry.

b. Wouldyouexpecttoseeentryintoorexitfromtheindustryinthelong
run?Explain.Whateffectwillentryorexithaveonmarket
equilibrium?

Entrybecausethefirmsintheindustryaremakingpositiveprofit. As
firmsenter,thesupplycurvefortheindustrywillshiftdownandtothe
right and the equilibrium price will fall, all else the same. This will
reduce each firms profit down to zero until there is no incentive for
furtherentry.
c. Whatisthelowestpriceatwhicheachfirmwouldsellitsoutputinthe
longrun?Isprofitpositive,negative,orzeroatthisprice?Explain.

Inthelongrunthefirmwillnotsellforapricethatisbelowminimum
averagecost.Atanypricebelowminimumaveragecost,profitisnegative
andthefirmisbetteroffsellingitsfixedresourcesandproducing nzero
output. Tofindtheminimumaveragecost, setmarginalcostequalto
averagecostandsolveforq:

2q 722 q

200 q 200
q 722

200 q
q 2 722(200)
q 380
AC(q 380) 3.8.

Therefore,thefirmwillnotsellforanypricelessthan3.8inthelongrun.

d. Whatisthelowestpriceatwhicheachfirmwouldsellitsoutputinthe
shortrun?Isprofitpositive,negative,orzeroatthisprice?Explain.

The firm will sell for any positive price, because at any positive price
marginalcostwillbeaboveaveragevariablecost(AVC=q/2000).Profitis
negativeaslongaspriceisbelowminimumaveragecost,oraslongas
priceisbelow3.8.

## 11. Suppose that a competitive firm has a total cost function

C(q) 450 15q 2q2 and a marginal cost function MC(q) 15 4q . If the
marketpriceisP=\$115perunit,findthelevelofoutputproducedbythefirm.
Findthelevelofprofitandthelevelofproducersurplus.

## Thefirmshould produce wherepriceis equal tomarginal cost sothat

P=115=15+4q=MCandq=25.Profitis

## 115(25) 450 15(25) 2(25 2 ) 800 . Producer surplus is profit

plusfixedcost, whichis1250. Notethatproducersurpluscanalsobe
foundgraphicallybycalculatingtheareabelowthepricelineandabove
themarginalcost(supply)curve,sothatPS=0.5*(11515)*25=1250.

12. Anumberofstoresofferfilmdevelopingasaservicetotheircustomers.
Suppose that each store that offers this service has a cost function
C(q) 50 0.5q 0.08q 2 andamarginalcost MC 0.5 0.16q .
a. Ifthegoingratefordevelopingarolloffilmis\$8.50,istheindustryin
longrunequilibrium?Ifnotfindthepriceassociatedwithlongrun
equilibrium.

Firstfindtheprofitmaximizingquantityassociatedwithapriceof\$8.50
bysettingpriceequaltomarginalcostsothatMC=0.5+0.16q=8.5=P,or
q=50.Profitisthen8.5*50(50+0.5*50+0.08*50*50)=\$150.Theindustry
isnotinlongrunequilibriumbecauseprofitisgreaterthanzero. Ina
long run equilibrium, firms produce where price is equal to minimum
average cost and there is no incentive for entry or exit. To find the
minimumaveragecostpoint,setmarginalcostequaltoaveragecostand
solveforq:

50
MC 0.5 0.16q 0.5 0.08q AC
q
0.08q2 50
q 25.

To find the long run price in the market, substitute q=25 into either
marginalcostoraveragecosttogetP=\$4.50.

b. Supposenowthatanewtechnologyisdevelopedwhichwillreducethe
costoffilmdevelopingby25%.Assumingthattheindustryisinlongrun
equilibrium,howmuchwouldanyonestorebewillingtopayto
purchasethisnewtechnology?

Thenewtotalcostfunctionandmarginalcostfunctioncanbefoundby
multiplyingtheoldfunctionsby0.75(or75%)andareasfollows:

## Cnew (q) .75(50 0.5q 0.08q 2 ) 37.5 0.375q 0.06q 2

MCnew (q) 0.375 0.12q.
Thefirmwillsetmarginalcostequaltoprice,whichis\$4.50inthelong
run equilibrium. Solve for q to find that the firm will develop
approximately 34 rolls of film (rounding down). If q=34 then profit is
\$33.39. Thisisthemostthefirmwouldbewillingtopayforthenew
moreoutput,thenpriceinthemarketwillfallandprofitforeachfirm
willbereducedtozero.

13.Consideracitythathasanumberofhotdogsstandsoperatingthroughout
thedowntownarea.Supposethateachvendorhasamarginalcostof\$1.50per
hotdogsold,andnofixedcost.Supposethemaximumnumberofhotdogsany

a. Ifthepriceofahotdogis\$2,howmayhotdogsdoeseachvendorwant
tosell?

Sincemarginalcostisequalto1.5andthepriceisequalto2,thehotdog
vendorwillwanttosellasmanyhotdogsaspossible,orinotherwords,
100hotdogs.

b. Iftheindustryisperfectlycompetitivewillthepriceremainat\$2fora
hotdog?Ifnot,whatwillthepricebe?

Thepriceshouldfallto\$1.50sothatpriceisequaltomarginalcost.Each
hotdogvendorwillhaveanincentivetolowerthepriceofahotdogbelow
\$2sothey cansell morehotdogsthan their competitors. Nohotdog
vendorwillsellahotdogforapricebelowmarginalcost,sothepricewill
falluntilitreaches\$1.50.

dogsfromvendorsinthecityisQ=44001200P,howmanyvendorsare
there?

Ifpriceis1.50thenQ=44001200*1.5=2600intotal.Ifeachvendorsells
100hotdogsthenthereare26vendors.

d. Supposethecitydecidestoregulatehotdogvendorsbyissuingpermits.
Ifthecityissuesonly20permits,andifeachvendorcontinuestosell100

soldis2000.IfQ=2000thenP=\$2,fromthedemandcurve.

e. Supposethecitydecidedtosellthepermits.Whatisthehighestpricea
vendorwouldpayforapermit?

Atthenewpriceof\$2perhotdogthevendorismakingaprofitof\$0.50
perhotdog,oratotalof\$50.Thisisthemosttheywouldpayonaper
daybasis.

14.Asalestaxof\$1perunitofoutputisplacedononefirmwhoseproductsells
for\$5inacompetitiveindustry.
a. Howwillthistaxaffectthecostcurvesforthefirm?

Withtheimpositionofa\$1taxonasinglefirm,allitscostcurvesshiftup
by\$1.TotalcostbecomesTC+tq,orTC+qsincet=1.Averagecostisnow
AC+1.MarginalcostisnowMC+1.

b. Whatwillhappentothefirmsprice,output,andprofit?

Sincethefirmisapricetakerinacompetitivemarket,theimpositionofthe
taxononlyonefirmdoesnotchangethemarketprice. Sincethefirms
shortrunsupplycurveisitsmarginalcostcurveaboveaveragevariablecost
andthatmarginalcostcurvehasshiftedup(inward),thefirmsuppliesless
tothemarketateveryprice.Profitsarelowerateveryquantity.

c. Willtherebeentryorexitintheindustry?

longrun,priceinthemarketwillbebelowtheminimumaveragecostpoint
ofthisfirm.

## 15. Asalestax of10 percent isplacedon halfthefirms(thepolluters)ina

competitive industry. The revenue is paid to the remaining firms (the
nonpolluters)asa10percentsubsidyonthevalueofoutputsold.

a. Assuming that all firms have identical constant longrun average costs
beforethesalestaxsubsidypolicy,whatdoyouexpecttohappentothe
priceoftheproduct,theoutputofeachofthefirms,andindustryoutput,
intheshortrunandthelongrun?(Hint:Howdoespricerelatetoindustry
input?)

Thepriceoftheproductdependsonthequantityproducedbyallfirmsin
theindustry. Theimmediateresponsetothesalestax=subsidypolicyisa
reduction in quantity by polluters and an increase in quantity by non
polluters. Ifalongruncompetitiveequilibriumexistedbeforethesales
tax=subsidypolicy,pricewouldhavebeenequaltomarginalcostandlong
runminimumaveragecost.Forthepolluters,thepriceafterthesalestaxis
belowlongrunaveragecost;therefore,inthelongrun,theywillexitthe
industry.Furthermore,afterthesubsidy,thenonpollutersearneconomic
profitsthatwillencouragetheentryofnonpolluters.Ifthisisaconstant
costindustry andthelossofthepollutersoutputiscompensatedbyan
increaseinthenonpollutersoutput,thepricewillremainconstant.

b. Cansuchapolicyalwaysbeachievedwithabalancedbudgetinwhichtax
revenuesareequaltosubsidypayments?Whyorwhynot?Explain.
Asthepollutersexitandnonpollutersentertheindustry,revenuesfrom
polluters decrease and the subsidy to the nonpolluters increases. This
imbalanceoccurswhenthefirstpolluterleavestheindustryandpersists