PRACTICE QUESTIONS

1. Sal’s satellite company broadcasts TV to subscribers in Los Angeles and New York.
The demand functions for each of these two groups are
QNY = 60 - 0.25PNY QLA = 100 - 0.50PLA
where Q is in thousands of subscriptions per year and P is the subscription price per
year.

The cost of providing Q units of service is given by

C = 1000 + 40Q

where Q = QNY + QLA.

a. What are the profit-maximizing prices and quantities for the New York and Los
Angeles markets?
Sal should pick quantities in each market so that the marginal revenues are equal to
one another and equal to marginal cost. To determine marginal revenues in each
market, first solve for price as a function of quantity:
PNY = 240 - 4QNY, and
PLA = 200 - 2QLA.
Since marginal revenue curves have twice the slope of their demand curves (true
for linear demand), the marginal revenue curves for the respective markets are:
MRNY = 240 - 8QNY , and
MRLA = 200 - 4QLA.
Set each marginal revenue equal to marginal cost, which is $40, and determine the
profit-maximizing quantity in each submarket:
40 = 240 - 8QNY, or QNY = 25 thousand, and
40 = 200 - 4QLA, or QLA = 40 thousand.
Determine the price in each submarket by substituting the profit-maximizing
quantity into the respective demand equation:
PNY = 240 - 4(25) = $140, and
PLA = 200 - 2(40) = $120.
b. As a consequence of a new satellite that the Pentagon recently deployed, people in
Los Angeles receive Sal’s New York broadcasts, and people in New York receive
Sal’s Los Angeles broadcasts. As a result, anyone in New York or Los Angeles can
receive Sal’s broadcasts by subscribing in either city. Thus, Sal can charge only a
single price. What price should he charge, and what quantities will he sell in New
York and Los Angeles?
 Sal’s combined demand function is the horizontal summation of the LA and NY
demand functions. Above a price of $200 (the vertical intercept of the LA demand
function), the total demand is just the New York demand function, whereas below a
price of $200, we add the two demands:
QT = 60 - 0.25P + 100 - 0.50P, or QT = 160 - 0.75P.
Solving for price gives the inverse demand function:
P = 213.33 - 1.333Q,
and therefore, MR = 213.33 - 2.667Q.
Setting marginal revenue equal to marginal cost:
213.33 - 2.667Q = 40, or Q = 65 thousand.
Substitute Q = 65 into the inverse demand equation to determine price:
P = 213.33 - 1.333(65), or P = $126.67.
Although a price of $126.67 is charged in both markets, different quantities are
purchased in each market.
QNY  60  0.25(126.67)  28.3 thousand, and
QLA  100  0.50(126.67)  36.7Q LA =100−0.50 ( 126.67 ) =36.7
thousand.
Together, 65 thousand subscriptions are purchased at a price of $126.67 each.
c. In which of the above situations, a or b, is Sal better off? In terms of consumer
surplus, which situation do people in New York prefer and which do people in Los
Angeles
prefer? Why?
Sal is better off in the situation with the highest profit, which occurs in part a with
price discrimination. Under price discrimination, profit is equal to:
 = PNYQNY + PLAQLA - [1000 + 40(QNY + QLA)], or
 = $140(25) + $120(40) - [1000 + 40(25 + 40)] = $4700 thousand.
Under the market conditions in b, profit is:
 = PQT - [1000 + 40QT], or
 = $126.67(65) - [1000 + 40(65)] = $4633.33 thousand.
Therefore, Sal is better off when the two markets are separated.
Under the market conditions in a, the consumer surpluses in the two cities are:
CSNY = (0.5) (25) (240 - 140) = $1250 thousand, and
CSLA = (0.5) (40) (200 - 120) = $1600 thousand.
Under the market conditions in b, the respective consumer surpluses are:
 CSNY = (0.5) (28.3) (240 - 126.67) = $1603.67 thousand, and
CSLA = (0.5) (36.7) (200 - 126.67) = $1345.67 thousand.
New Yorkers prefer b because their price is $126.67 instead of $140, giving them a
higher consumer surplus. Customers in Los Angeles prefer a because their price is
$120 instead of $126.67, and their consumer surplus is greater in a.

2. In an unregulated, competitive market, consumers and producers are initially

buying and selling at the prevailing market price. The government later makes it
illegal for producers to charge more than a ceiling price set below the market
clearing level.
a. What is the deadweight loss?

In the above diagram, Pe and Qe are competitive equilibrium price and quantity
respectively. P1 is the ceiling price imposed by the government which lies below
the equilibrium price and creates an excess demand equal to (Q2 – Q1).

In the table below, we compare the consumer and producer surplus in the two
situations:

Surplus At Eqm. Price, Pe At ceiling price, Change

P1
Consumer Surplus A +B A+ C C- B
(CS)
Producer Surplus C + D + E E - (C + D)
(PS)
Total Surplus= CS A + B+ C + D + E A+C+E - (B + D)
+ PS

Therefore, there is a deadweight loss equal to (B + D)

b. Do producers lose for sure?
 Since the producer surplus is negative, producers definitely lose out because of
the price ceiling. This happens because some producers leave the market leading
to a decline in total production ( the loss represented by D) and producers who
remain in the market receive a lower price for their product ( the loss
represented by C).

c. Do consumers lose for sure?

Some consumers are worse off as a result of the policy and others are better off.
Those who have been rationed out of the market because of the reduction in
production from Qe to Q1 are worse off (the loss represented by B). Other
consumers who can purchase the good at a lower price because of the price
ceiling are better off (the gain represented by C).
Overall, whether consumers are better off or worse off depends on which one
has larger area, rectangle C or triangle B. If C > B, consumer surplus (C- B) is
positive and consumers will be better off. If B > C, consumers will be worse off
since consumer surplus will be negative in this case.
3. Suppose a profit-maximizing monopolist is producing 800 units of output and is
charging a price of $40 per unit.
a. If the elasticity of demand for the product is –2, find the marginal cost of
the last unit produced.

MC= P (1 + 1/ elasticity)
= 40 (1 – ½)
= $20

b. What is the Lerner’s index at this price level?

Lerner’s Index = P – MC / P
= 40 -20 /40
= 1/2

4. Suppose that an industry is characterized as follows: C = 100 + 2q 2 is each firm’s

total cost function. The industry demand curve is given by P = 90 – 2Q.
a. If there is only one firm in the industry, find the monopoly price, quantity,
and level of profit.
MC = dTC/ dq = 4q
TR= (90- 2Q) Q= 90 Q- 2Q2
Therefore, MR= 90- 4Q
Putting MR= MC, we get,
90- 4Q= 4Q
Therefore Q= 11.25
Price, P = 90 – 2 (11.25)
Therefore, P = 67.5
Profit = TR – TC
= {90 (11.25) – 2(11.25) 2}- {100 + 2 (11.25) 2}
= 406.245
 b. Graphically illustrate the demand curve, marginal revenue curve, average
and marginal cost curve for part (a). Also, illustrate the monopoly price,
quantity and level of profit.

C 100
Average cost = = +2 Q
Q Q
Average cost at Q=11.25
= 100/11.25 + 2(11.25) =31.38
Therefore, profit= (AR- AC) Q
= (67.5- 31.38)11.25
=406.35

5. A drug company has a monopoly on a new patented medicine. The product can be
made in either of the two plants. The costs of production for the two plants are
MC1 = 20 + 2Q1 and MC2 = 10 + 5Q2. The firm’s estimate of demand for the product
is P = 20 - 3(Q1 + Q2). How much should the firm plan to produce in each plant?
And, at what price should it plan to sell the product?
First, notice that only MC2 is relevant because the marginal cost curve of the first
plant lies above the demand curve.
 This means that the demand curve becomes P = 20 - 3Q2. With an inverse linear
demand curve, we know that the marginal revenue curve has the same vertical
intercept but twice the slope, or MR = 20 - 6Q2. To determine the profit-maximizing
level of output, equate MR and MC2:
20 - 6Q2 = 10 + 5Q2, or Q2 = 0.91.
Also, Q1 = 0, and therefore total output is Q = 0.91. Price is determined by
substituting the profit-maximizing quantity into the demand equation:
P = 20 - 3(0.91) = $17.27.

6. A computer company produces hardware and software using the same plant and
labour. The total cost of producing computer processing units H and software
programs S is given by TC = aH + bS - cHS where a, b, and c are positive. Is this total
cost function consistent with the presence of economies or diseconomies of scale?
With economies or diseconomies of scope?

If each product were produced by itself there would be neither economies nor
diseconomies of scale. To see this, define the total cost of producing H alone (TCH) to
be the total cost when S= 0. Thus TCH = aH. Similarly, TCS = bS. In both cases, doubling
the number of units produced doubles the total cost. Also, AC H= a, and ACS= b, which
are independent of the values of H and S. So, there are no economies or
diseconomies of scale.
Economies of scope exist if degree of economies of scope SC> 0, where,
C (q1 )  C (q2 )  C (q1 , q2 )
SC 
C (q1 , q2 ) .
In our case, C(q1) is TCH, C(q2) is TCS, and C (q1, q2) is TC. Therefore,
aH  bS  (aH  bS  cHS ) cHS
SC  
aH  bS  cHS aH  bS  cHS .
Because cHS (the numerator) and TC (the denominator) are both positive, it follows
that SC> 0, and hence there are economies of scope.
7. Japanese rice producers have extremely high production costs, due in part to the
high opportunity cost of land and to their inability to take advantage of economies
of large-scale production. Analyze two policies intended to maintain Japanese rice
production: (1) a per-pound subsidy to farmers for each pound of rice produced, or
(2) a per-pound tariff on imported rice. Illustrate with supply-and-demand diagrams
the equilibrium price and quantity, domestic rice production, government revenue
or deficit, and deadweight loss from each policy. Which policy is the Japanese
government likely to prefer? Which policy are Japanese farmers likely to prefer?
Assume that initially the Japanese rice market is open, meaning that foreign producers
and domestic (Japanese) producers both sell rice to Japanese consumers. The world
price of rice is PW. This price is below P0, which is the equilibrium price that would occur
in the Japanese market if no imports were allowed. In the diagram below, S is the
domestic supply, D is the domestic demand, and Q0 is the equilibrium quantity that
would prevail if no imports were allowed. The horizontal line at PW is the world supply
of rice, which is assumed to be perfectly elastic.
Initially Japanese consumers purchase QD rice at the world price. Japanese farmers
supply QS at that price, and QD - QS is imported from foreign producers.
Now suppose the Japanese government pays a subsidy to Japanese farmers equal to
the difference between P0 and PW. Then Japanese farmers would sell rice on the open
market for PW plus receive the subsidy of P0 - PW. Adding these together, the total
amount Japanese farmers would receive is P0 per pound of rice. At this price they would
supply Q0 pounds of rice. Consumers would still pay PW and buy QD. Now Japan would
import QD - Q0 pounds of rice.
This policy would cost the government (P0 - PW) Q0, which is the subsidy per pound times
the number of pounds supplied by Japanese farmers. It is represented on the diagram
as areas B + E. Producer surplus increases from area C to C + B, so change in PS = B.
Consumer surplus is not affected and remains as area A + B + E + F.
Deadweight loss is area E, since Govt. loses B+E while producers gain B and consumers
remain the same as before. So, it is the cost of the subsidy minus the gain in producer
surplus.
 Instead, suppose the government imposes a tariff rather than paying a subsidy. Let the
tariff be the same size as the subsidy, P0 - PW. Now foreign firms importing rice into
Japan will have to sell at the world price plus the tariff: PW + (P0 -PW) = P0. But at this
price, Japanese farmers will supply Q0, which is exactly the amount Japanese consumers
wish to purchase. Therefore, there will be no imports, and the government will not
collect any revenue from the tariff. The increase in producer surplus equals area B, as it
is in the case of the subsidy. Consumer surplus is area A, which is less than it is under
the subsidy because consumers pay more (P0) and consume less (Q0). Consumer surplus
decreases by B + E + F. Deadweight loss is E + F: the difference between the decrease in
consumer surplus and the increase in producer surplus.
Under the assumptions made here, it seems likely that producers would not have a
strong preference for either the subsidy or the tariff, because the increase in producer
surplus is the same under both policies. The government might prefer the tariff because
it does not require any government expenditure. On the other hand, the tariff causes a
decrease in consumer surplus, and government officials who are elected by consumers
might want to avoid that. Note that if the subsidy and tariff amounts were smaller than
assumed above, some tariffs would be collected, but we would still get the same basic
results.

8. Suppose the firm’s cost function is C(q) = 4q2 + 16.

a. Find variable cost, fixed cost, average cost, average variable cost, and average
fixed cost.
Variable cost is that part of total cost that depends on q (so VC = 4q ) and fixed cost
2

is that part of total cost that does not depend on q (so FC = 16).
 VC  4q 2
FC  16
C (q ) 16
AC   4q 
q q
VC
AVC   4q
q
FC 16
AFC  
q q
b. Show the average cost, marginal cost, and average variable cost curves on a
graph.

Average cost is U-shaped. Average cost is relatively large at first because the firm is
not able to spread the fixed cost over very many units of output. As output
increases, average fixed cost falls quickly, leading to a rapid decline in average cost.
Average cost will increase at some point because the average fixed cost will become
very small and average variable cost is increasing as q increases. MC and AVC are
linear in this example, and both pass through the origin. Average variable cost is
everywhere below average cost. Marginal cost is everywhere above average
variable cost. If the average is rising, then the marginal must be above the average.
Marginal cost intersects average cost at its minimum point, which occurs at a
quantity of 2 where MC and AC both equal $16.

c. Find the output that minimizes average cost.

Minimum average cost occurs at the quantity where MC is equal to AC:
 16
AC  4q   8q  MC
q
16
 4q
q
16  4q 2
4  q2
2  q.
d. At what range of prices will the firm produce a positive output?
The firm will supply positive levels of output in the short run as long as P = MC >
AVC, or as long as the firm is covering its variable costs of production. In this case,
marginal cost is above average variable cost at all output levels, so the firm will
supply positive output at any positive price.
e. At what range of prices will the firm earn a negative profit?
The firm will earn negative profit when P = MC < AC, or at any price below minimum
average cost. In part c we found that the minimum average cost occurs where q = 2.
Plug q = 2 into the average cost function to find AC = 16. The firm will therefore
earn negative profit if price is below 16.
f. At what range of prices will the firm earn a positive profit?
In part e we found that the firm would earn negative profit at any price below 16.
The firm therefore earns positive profit as long as price is above 16.

9. Suppose you are the manager of a watchmaking firm operating in a competitive

market. Your cost of production is given by C = 200 + 2q2 where q is the level of
output and C is total cost. What is the firm’s supply curve?
In a competitive market, MC curve is the supply curve.
MC = dC/dq = 4q
(As MC curve is passing through the origin with slope 4, it will be above the AVC curve
= 2q, so in this question entire MC curve is the supply curve)

10. A monopoly faces market demand Q = 30 − P and has a cost function C(Q) = 0.5
Q2. Assume that the government puts a price ceiling on the monopolist at P = 18.
How much output will the monopolist produce? What will be the profit of the
monopolist? Calculate CS, PS, and DWL. Find the same for P = 15.
For monopolist
The monopoly produces at the point where MR = MC.
In this question MR = dQ = 30 − 2Q dC and MC = dQ = Q.
Equating MR and MC gives us Q = 10.
From the demand equation we can find P = 30 − Q = 20.
Profit = P Q − C(Q) = 20 · 10 − 50 = 150.
 Price and quantity from demand curve and MC
equating demand and MC: 30−Q = Q. That means Q = 15 and P = 30 − Q = 15. Instead,
monopoly sells Q = 10 at P = 20, which generates DWL = (20 − 10)(15 − 10)/2 = 25. CS = (30 −
20)· 10/2 = 50 and P S = (20 · 10) − 102/2 = 150. Note that the producer surplus is equal to
the profit, in the absence of the fixed cost.

At P = 18.
Monopoly sells Q = 30 − 18 = 12 at this price. The resulting profit is 18 · 12 − 12 · 12/2 = 144.
CS = 12 · 12/2 = 72, P S = profit = (18 + 6) · 12/2 = 144, and DWL = 6 · 3/2 = 9. The DWL is
smaller now because price is lower than under monopoly and output is higher.

At P = 15.
If monopoly is to sell at this price, then total surplus will be maximized and there will be no
deadweight loss. Thus, the government has to set maximum price equal to $15. The
monopoly will sell Q = 30 − 15 = 15 at the price P = 15. Profit = 15 · 15/2 = 112.5, and DWL =
0.