Problem Set 3 (Solution)

Managerial Economics - MGE(B23-1)

XLRI - Xavier School of Management

1. Calculate the elasticity of scale of the following production functions:

f (x1 , x2 ) = xa1 xb2 (1)

1
f (x1 , x2 ) = [xρ1 + xρ2 ] ρ (2)

2. Find the cost and supply functions for the following production functions, where labour
(L) and capital (K) are the two inputs:

q = Lα K β (α + β ≤ 1) (3)
q = aL + bK (a, b > 0) (4)
 
L k
q = min , (5)
a b

Solution:
The firm solves the following problem:

min wL + rK subject to q = Lα K β .
K,L

The Lagrangian is
L = wL + rK + λ[q − Lα K β .]
FOC implies that

w = λαLα−1 K β (6)
r = λβLα K β−1 (7)
q = Lα K β (8)

From equation (8) and 9, we get

w αK
=
r βL
Using this in the production function, we get the conditional input demands
 β
 β+α
αr 1
L= q α+β (9)
βw
 α
 β+α
βw 1
K= q α+β (10)
αr

1
Therefore the cost function is

c(q) = wL + rK
1
= Aq α+β

where β α 
  α+β   α+β
α β α β
A= + w α+β r α+β .
β α

The supply function is given by p = c′ (q), that is

A 1−α−β
q α+β = p
α+β
.
Which can be written as α+β
  1−α−β
p(α + β)
q(p) =
A

Cost function for the linear production function q = aL + bK.

Here, for any production target q, there is a corner solution, i.e., the firm uses either
only L or only K. More precisely
 
q a w
(L, K) = ,0 if >
a b r
 
q a w
= 0, if <
b b r
Therefore the cost function is
 wq a w
a
if b
> r
c(q) = rq a w
b
if b
< r

The firm’s average and marginal costs are constant and given by min{ wa , rb }. Therefore
the supply function is given by

if p < min{ wa , rb }

 0
q(p) = ∈ [0, ∞) if p = min{ wa , rb }
∞ if p > min{ wa , rb }


 
L k
bf The cost function for the Leontif production function q = min ,
a b
.

2
 The firm will always choose L and K such that
L K
= = q.
a b

Therefore its cost function is

c(q) = wL + rK = (wa + rb)q.

Since marginal and average costs are constant at wa+rb, we have the horizontal supply
function


 0 if p < wa + rb
q(p) = ∈ [0, ∞) if p = wa + rb
∞

if p > wa + rb

3. A firm has a production function given by f (x1 , x2 ) = min{2x1 + x2 , x1 + 2x2 }. What

is the cost function for this production function? What is the conditional demand
function for factors 1 and 2 as a function of factor prices (w1 , w2 ) and output Q ?
Solution:
The easier way to solve this problem, draw the isoquant of the production function.
First draw 2x1 + x2 = y or x2 = y − 2x1 as dotted blue line and secondly draw
x1 + 2x2 = y or x2 = y2 − x21 as dotted green line.

x2

y
slope of this part is −2

y
2 slope of this part is − 21
y
3

y y y x1
3 2

ˆ If w1
w2
> 2, then x1 = 0 and x2 = y (x2 is cheaper). The cost for this case is
c(w2 , y) = w2 y.

3
 ˆ If w
w1
2
< 12 , then x1 = y and x2 = 0 (x1 is cheaper). The cost function for this case
is c(w1 , y) = w1 y.
ˆ If 2 > w1
w2
> 12 , then x1 = x2 = y3 . The cost function for this case is c(w1 , w2 , y) =
(w1 + w2 ) y3 .

Hence the cost function for the firm is

 
(w1 +w2 )
c(w1 , w2 , y) = min w1 , w2 , 3 y.

4. Derive the supply function for a price taking firm when

1 3
(a) the firm’s production function is Q = l 4 k 4 , and the prices of inputs l and k are
w and r respectively.
Solution:
The profit maximization problem is
1 1
max pl 4 k 2 − wl − rk
k,l

FOC implies that

1 −3 1 w
l 4k2 =
4 p
1 1 −1 r
l4k 2 =
2 p
Dividing we get
l w
=
2k r
Using this above we get the unconditional input demand functions:

p4
l=
64w2 r2
p4
k=
32wr3
We can put these into production function and get the supply function:

p3
y(p) =
14wr2

4
 (b) the firm can produce the output in two different factories with individual cost
functions c1 (y1 ) = ay12 and c2 (y2 ) = by22 , and the firm’s total output is y = y1 + y2 .
Solution: We solve the following problem

max p(y1 + y2 ) − ay12 − by22 .

y1 ,y2

p p
FOC implies that y1 = 2a
and y2 = 2b
. Therefore the supply is

p(a + b)
y(p) =
2ab
5. The market for Hyderabadi Biryani is perfectly competitive. Each firm has a cost
function given by
c(q) = 8 + 2q 2
where q is the output produced by the firm. Any firm which stops production has no
cost. The demand function is given by

Q = 20 − p.

(a) Suppose the number of firms in the market is fixed at 4. Find the equilibrium
price and quantity.
Solution:
For each firm supply is given by p = c’(q) and hence q = p4 . Also note that the
firm’s average cost is minimized where average and marginal costs are equal, i.e.,
c(q) 8
= c′ (q) =⇒ + 2q = 4q =⇒ q = 2.
q q
Hence the min average cost is 8. The supply curve is then
 p
4
if p ≥ 8
q(p) =
0 otherwise

Given there are 4 firms, market supply is given by


p if p ≥ 8
Q=
0 otherwise
Equating demand and supply:

p = 20 − p =⇒ p∗ = 10 and Q∗ = 10.

Since the price is greater than 8, firms will indeed supply the requisite amount
since they are making positive profits.

5
 (b) Now suppose there is free entry and exit in this market. New entrants will have
the same cost function. What is the equilibrium price, quantity and number of
firms in the long run?
Solution:
In the long run, profits are 0, hence p = ACmin = 8. Then, from the demand
function, Q = 20 − p ⇒ Q = 12. Each firm produces 2 units (that is the
quantity where average cost is lowest). Therefore there are 6 firms in the long run
equilibrium.
(c) The government imposes a sales tax of 2 per unit on producers. Find the effect
on market price, quantity and number of firms in the long run. What is the
dead-weight loss due to the tax?
Solution:
This increases ACmin from 8 to 10, hence long run p = 10, Q = 10. The number
of firms in the industry is 5.

6. In a perfectly competitive market there are n firms. Each firm produces output q
according to an identical cost function c(q) = f + q 2 where f > 0. Market demand
amounts to be Qd = a − p (with a > 0).

(a) Determine the profit-maximizing output of an individual firm.

Solution: The marginal cost of the firm is c′ (q) = 2q. The supply function is
2q = p which implies q ∗ = p2 .
(b) Determine the market price and amount produced by each firm in the short-term
market equilibrium.
Solution: The market supply is Qs = N q ∗ = N2p . The market demand and supply
is equal implies
Np 2a
=a−p =⇒ p∗ =
2 N +2
∗ p a
Each firm produces q = 2 = N +2 .
(c) How many firms are active in this market in the long-term equilibrium?
Solution: In the long run, profits are 0, hence p = ACmin . Min Ac could be
calculated first finding the level of quantity where AC = M C. Thus,
f p
AC = M C =⇒ + q = 2q =⇒ q= f
q
√
Therefore, ACmin = 2 f = p implies zero profit in the long-run.

6
 Now we get total amount demand in the long-run from the demand function,
√ √
Qd = a − p = a − 2 f . Since each firm produces q ∗ = p2 = f . Optimal number
of firms is
Qd a
N∗ = ∗ = √ − 2
q f
7. A monopolist with unit cost of c and fixed cost of F is confronted with the following
inverse market demand: p = α − βq with α > β > 0, α > c and (α − c) > 4βF .

(a) Calculate the output, price and profit of the monopolist.

Solution: M R = M C implies that
α−c α+c
α − 2βq = c =⇒ q∗ = , p∗ =
2β 2
The profit for the monopolist is

(α − c)2
π ∗ = (p∗ − c)q ∗ − F = −F
4β

(b) Calculate the dead-weight loss and show that this is positive.
Solution: To calculate dead-weight loss due to monopoly we compare the sur-
plus losses compared to perfectly competitive market. The perfectly competitive
market price and output are pc = c and q c = α−c
β
. The dead-weight loss due to
monopoly is

(α − c)2
   
1 m c c m 1 a+c α−c α−c
DL = (p − p )(q − q ) = −c · − =
2 2 2 β 2β 8β

(c) What price must the monopolist set if she is obliged by the government to set the
price so as to maximize the sum of consumer and producer surpluses? Show that
this kind of regulation cannot be feasibly implemented with respect to the long
term.
The price that maximizes the sum of consumer and producer surpluses is p =
M C = c. Thus it holds for profit that:

π = pq − cq − F = −F < 0

The monopolist can no longer cover her fixed costs. In the long term, she will
have to leave the market.

8. Consider a monopolist with cost function c(q) = cq with c > 0, facing demand function
q(p) = αp−ϵ where ϵ > 0.

7
 (a) Show that if ϵ ≤ 1, then the monopolist’s optimal price is not well-defined.
(b) Assume that ϵ > 1. Derive the monopolist’s optimal price, quantity, and price
m
cost margin p pm−c . Calculate the resulting dead-weight welfare loss.

9. A monopolist sells in two markets. The inverse demand curve in market 1 is p = 200−q1
and in market 2 is 300 − q2 . The firm’s total cost function is C(q1 + q2 ) = (q1 + q2 )2 .

(a) What are the optimal quantities that the monopolist will sell in market 1 and 2?
Solution: We get the following two equations equation M R1 = M C and M R2 =
MC

200 − 2q1 = 2(q1 + q2 ) =⇒ q2 = 100 − 2q1

300 − 2q2 = 2(q1 + q2 ) =⇒ q1 = 150 − 2q2

Solving them we get q1 = 25 and q2 = 50.

(b) What are the optimal prices in both the market?

10. Suppose a retailer can identify two distinct groups of customers, youngsters and the
old. The demand by the youngsters qy and the old qo are given by

qy = 100 − 8py
qo = 100 − 4po

respectively. The total demand Q = qy + qo = 200 − 12p. The retailer’s cost of Rs. 2
per unit is constant regardless of the number of units supplied.

(a) What is the optimal price if the retailer charges the same price to all?
(b) Show that retailer can earn more profit charging differently to each group.

11. You manage a plant that mass-produces engines by teams of workers using assembly
machines. The technology is summarized by the production function q = 5KL where
q is the number of engines per week, K is the number of assembly machines, and L
is the number of labor teams. Each assembly machine rents for r = 10, 000 per week,
and each team costs w = 50004per week. Engine costs are given by the cost of labor
teams and machines, plus Rs. 2000 per engine for raw materials. Your plant has a
fixed installation of 5 assembly machines as part of its design.

(a) What is the cost function for your plant - namely, how much would it cost to
produce q engines? What are average and marginal costs for producing q engines?
How do average costs vary with output?

8
 (b) How many teams are required to produce 250 engines? What is the average cost
per engine?
(c) You are asked to make recommendations for the design of a new production
facility. What capital/labor (K/L) ratio should the new plant accommodate if it
wants to minimize the total cost of producing at any level of output q?

12. Suppose you are the manager of a watchmaking firm operating in a competitive market.
Your cost of production is given by C(q) = 200 + 2q 2 , where q is the level of output
and C is total cost.

(a) If the price of watches is $100, how many watches should you produce to maximize
profit?
(b) What will the profit level be?
(c) At what minimum price will the firm produce a positive output?

13. A competitive firm has the following short-run cost function: C(q) = q 3 − 8q 2 + 30q + 5.

(a) Find M C, AC, and AV C and sketch them on a graph.

(b) At what range of prices will the firm supply zero output?
(c) Identify the firm’s supply curve on your graph.
(d) At what price would the firm supply exactly 6 units of output?

14. Consider the area in front of Jublee Park (Jamshedpur) that has a number of tea
vendors selling tea there. Suppose that each vendor has a marginal cost of Rs 4.50 per
cup of tea sold and no fixed cost. Suppose the maximum number of cups of tea that
any one vendor can sell is 100 per day.

(a) If the price of a cup of tea is Rs. 5, how many cups of tea does each vendor want
to sell?
(b) If the industry is perfectly competitive, will the price remain at Rs. 5 for a cup
of tea? If not, what will the price be?
(c) If each vendor sells exactly 100 cups of tea a day and the demand for tea from
vendors in the city is Q = 4400 − 400p, how many vendors are there?
(d) Suppose the city decides to regulate tea vendors by issuing permits. If the city
issues only 20 permits and if each vendor continues to sell 100 cups a day, what
price will a cup of tea sell for?
(e) Suppose the city decides to sell the permits. What is the highest price that a
vendor would pay for a permit?