Problem set 1 hints

Question 1
Elasticity = 1. Monopolist should produce 1 unit.

Question 2
After the tax, the monopolist will increase prices by 3 rupees.

Question 3

Part 1
We know that the marginal cost is the derivative of the cost function. Hence
Z
C (y1 ) = M C (y1 ) dy1 + const

= 4y1 + y12 + const

If fixed cost = 0, then const = 0. Hence the cost function is given by

C (y1 ) = 4y1 + y12 .

Based on the information given we have,

4y1 + y12 = 2x1

This follows from the fact that if there is only one input, x1 , with w1 = 2, costs for y1 = f (x1 ) is
w1 x1 = 2x1 . We thus get a quadratic equation in y1 :

4y1 + y12 2x1 = 0

p
4± 16 + 8x1
) y1 =
2

As y1 is output, it must be non-negative, so

p
4+16 + 8x1
y1 =
p 2
= 4 + 2x1 2 = f (x1 ) .

1
Part 2
If y = y1 + y2 , then y2 = y y1 . So firm’s problem is the following:

max py C1 (y1 ) C2 (y y1 ) .
y,y1

The first order conditions are:

p M C2 (y y1 ) = 0,
M C1 (y1 ) + M C2 (y y1 ) = 0.

Hence we get

4 + 2y1 = 1 + 3y2
= 1 + 3 (y y1 )
3y 3
) y1 = .
5
2y+3
If y > 1, then both plants are operating, as then y1 > 0 and y2 = y y1 = 5 > 0.
If 0 < y  1, then = 0, but y2⇤
y1⇤ =y y1⇤ > 0. Thus only plant 2 will be operating. Clearly if
y = 0, then no production, y1⇤ = y2⇤ = 0. Hence
8
>
> 0 if y = 0,
>
<
C (y) = C2 (y) if 0 < y  1
>
> ⇣ ⌘ ⇣ ⌘
>
:C2 2y+3 + C1 3y 3
5 5 if y > 1.

Thus
8
>
> 0 if y = 0,
>
<
M C (y) = M C2 (y) if 0 < y  1
>
> ⇣ ⌘ ⇣ ⌘
>
: M C2
2 2y+3 3 3y 3
5 5 + 5 M C1 5 if y > 1.

Substituting the expressions for the marginal costs we obtain,

8
>
> 0 if y = 0,
>
<
M C (y) = 1 + 3y if 0 < y  1
>
>
>
: 14 + 6y
5 5 if y > 1

2
Question 4
1. 100

2. 1250

3. 150

Question 5
The cost function associated with technology F is
8
< wq if w < 2
2
CF (q) =
:q if w 2

The cost function associated with technology G is

8
<wq if w  1
2
CG (q) =
:q if w > 1
2 2

We observe that if w < 1, CF (q) < CG (q). Hence technology F is preferred. On the other hand if
w > 1, technology G is preferred. At w = 1, the firm is indifferent.

Question 6
Clearly x2 cannot be strictly more than 4. (Why?) Consider separetely two cases x2 = 4 and x2  4.

2
In case x2 = 4, the cost to produce q is r1 q4 + 4r2 .

In case x2  4, write the problem in the standard way and use the method of substitution in-
stead of Lagrangean method, since weqhave an additional inequality constraint compared to the
r1 p
usual case. One can show that x2 = q r2 . In this case total cost becomes 2 r1 r2 q.

Hence the firm’s cost function is given by

8 p q
< 2 r1 r2 q if q  4 rr21 ,
C (q) = q
:r q2
+ 4r2 if q > 4 rr21 .
1 4

3
Question 7
The cost function is given by
8
<(w + w ) q if w1 + w2  w3 + w4 ,
1 2
C (w1 , w2 , w3 , w4 , q) =
:(w + w ) q if w1 + w2 > w3 + w4 .
3 4

Question 8
1. We have
✓ ◆
dAC (q) d T C (q)
=
dq dq q
M C (q) T C (q)
=
q q2
1
= (M C (q) AC (q)) .
q

Hence if M C (q) AC (q), AC (q) is (weakly) increasing, while if M C (q)  AC (q), AC (q)
is (weakly) decreasing.
dAC(q)
2. Suppose AC(q) is U-shaped. At it’s lowest point, dq = 0. Hence AC(q) = M C (q), based
on the above relation.

Question 9
1. CRS

2. CRS

3. IRS

4. DRS