P ROBLEM SET 5: S OLUTION

1. Suppose a monopolist faces a linear market demand curve P = a − bQ and has a constant
marginal cost M C(Q) = c and no fixed costs.

(a) What is the monopolist’s profit-maximizing quantity and price?

Total revenue, T R = P Q = (a − bQ)Q.
Marginal Revenue, M R(Q) = a − 2bQ.
Since there are no fixed costs, at the profit-maximizing quantity M R(Q) = M C(Q).
⇐⇒ a − 2bQ = c
a−c
⇐⇒ Q =
2b
a−c
Hence, the profit-maximizing quantity is Q = and profit-maximizing price is
2b
a−c
P =a−b× = a − .5(a − c) = .5(a + c).
2b
(b) What is the aggregate surplus at the monopolist’s profit maximizing quantity?
Aggregate surplus is the green shaded region in the diagram below.
a+c a−c a+c a−c 3(a − c)2
Aggregate surplus = 0.5 × (a − )× +( − c) × =
2 2b 2 2b 8b

(c) What is the quantity that will maximize the aggregate surplus?
The aggregate surplus will be maximum when the demand and the marginal cost
surves intersect. So, a − bQ = c
a−c
⇐⇒ Q = .
b

2. Suppose a monopolist faces a demand curve given by P = 120 − 3Q. The monopolist has
two plants. The first has a marginal cost curve given by M C1 = 10, and the second plant’s

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 marginal cost curve is given by M C2 = 60. The monopolist also does not have any fixed
costs.

(a) Find the monopolist’s optimal total quantity and price.

Since the marginal cost of first plant is lower than the marginal cost of the second plant,
the monopolist will never produce any unit of output using the second plant. Hence,
the marginal cost of the monopolist is 10.
Total revenue = P Q = (120 − 3Q)Q
Marginal Revenue= 120 − 6Q.
By the quantity-rule of profit maximization, M R = M C.
⇐⇒ 120 − 6Q = 10
⇐⇒ 6Q = 110
⇐⇒ Q = 18.33
P = 120 − 3(110/6) = 120 − 55 = 65.

(b) Find the optimal division of the monopolist’s quantity between its two plants.
Since, the marginal cost of first plant is lower than the marginal cost of the second
plant, the monopolist will never produce any unit of output using the second plant.
Hence, the monopolist will produce 18.33 units in the first plant and 0 units in the
second plant.

3. Suppose a monopolist has a constant marginal cost M C = 2 and faces the demand curve
P = 20 − Q. There are no fixed costs.

(a) Suppose price discrimination is not allowed (or is not possible). How large will the
producer surplus be?
If the monopolist cannot price discriminate, then it will produce a quantity where
M R = M C.
Total revenue = P Q = (20 − Q)Q
Marginal Revenue= 20 − 2Q.
By the quantity-rule of profit maximization, M R = M C.
⇐⇒ 20 − 2Q = 2
⇐⇒ 2Q = 18
⇐⇒ Q = 9

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 P = 20 − 9 = 11
The producer surplus =(11 − 2) × 9 = 81

(b) Suppose the firm can engage in perfect first-degree price discrimination. How large
will the producer surplus be?
If the firm can engage in perfect price discrimination then it will produce the quantity
where the demand curve intersects M C, which is also the equilibrium quantity in a
perfectly competitive market.
2 = 20 − Q
⇐⇒ Q = 18.
The producer surplus= Aggregate surplus at Q = 18.
The producer surplus=0.5 × (20 − 2) × 18 = 162.

4. Softco is a software company that sells a patented computer program to businesses. Each
business it serves has the demand for Softco’s product: P = 70 − 0.5Q. The marginal cost
for each program is $10. Assume there are no fixed costs.

(a) If Softco sells its program at a uniform price, what price would maximize profit? How
many units would it sell to each business customer? How much profit would it earn
from each business customer?
Total revenue = P Q = (70 − 0.5Q)Q
Marginal Revenue= 70 − Q.
By the quantity-rule of profit maximization, M R = M C.
⇐⇒ 70 − Q = 10
⇐⇒ Q = 60
P = 70 − 0.5 × 60 = 70 − 30 = 40.
Profit from each business = 40 × 60 − 10 × 60 = 30 × 60 = 1800.

(b) Softco would like to know if it is possible to improve its profit by implementing block
pricing. Suppose that Softco were to sell the first block at the price you determined in
(a), and that the quantity for that block is the quantity you determined in (a). Find the
profit-maximizing quantity and price per unit for the second block. How much extra
profit would Softco earn from each of its business customers?
The first block is Q1 = 60 and price is P = 40. Let us truncate the demand curve

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 and focus on Q > 60 as the price of the first 60 units is fixed already. The maximum
willingness to pay for Q > 60 will be P = 70 − 0.5Q = 70 − .5(60 + Q2 ) = 40 − .5Q2
where Q2 is the additional units beyond the first block. The associated total revenue
= (40 − .5Q2 )Q2 . The marginal revenue = 40 − Q2 . The profit maximizing Q2 will be
when 40 − Q2 = M C.
⇐⇒ 40 − Q2 = 10
⇐⇒ Q2 = 30.
P = 40 − 15 = 25.
Hence, the price of second block is 25 and the size of the second block is 30.
Softco will sell the first 60 units at 40 per piece and the next 30 units at 25 per piece.
The profit will be 40 × 60 + 25 × 30 − 10 × 90 = 2250. Softco earns an extra profit of 450
by implementing block pricing.

5. Col. Tom Barker is about to open his newest amusement park, Elvis World. Elvis World
features a number of exciting attractions: you can ride the rapids in the Blue Suede Chutes,
climb the Jailhouse Rock and eat dinner in the Heartburn Hotel. Col. Tom figures that
Elvis World will attract 1,000 people per day, and each person will take x = 50 − 50p rides,
where p is the price of a ride. Everyone who visits Elvis World is pretty much the same and
negative rides are not allowed. The marginal cost of a ride is essentially zero.

(a) If Col. Tom sets the price to maximize profit, how many rides will be taken per day by
a typical visitor?
As M C = 0, if the price is set so that profit is maximized, he will set M R = 0.
x
Total revenue=1000px = 1000(1 − )x
x 50
Marginal revenue=1000(1 − ).
x 25
So, 1 − = 0.
25
⇐⇒ x = 25.
Each visitor will take 25 rides.

(b) What will the price of a ride be?

x
The price of a ride will be p = 1 − = 0.5.
50
(c) What will Col. Tom’s profits be per person?
Col. Tom’s profit per person = 0.5 × 25 = 12.5.

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(d) What is the aggregate surplus maximizing price of a ride? If Col. Tom charged this
price for a ride, how many rides would be purchased?
The aggregate surplus is maximum when the demand curve intersect the marginal cost
curve. Since, M C = 0, the aggregate surplus maximizing price is p = M C = 0. At p=0,
each visitor will ride x = 50 rides. Since, there are 1000 visitors per day, the number of
rides that will be purchased is 50000.

(e) How much consumers’ surplus would be generated at this price and quantity?
Each visitor’s consumer surplus = .5 × 1 × 50 = 25. Since, there are 1000 visitors per
day the consumers’ surplus = 25 × 1000 = 25000

(f) If Col. Tom decided to use a two-part tariff, what admission fee and price per ride
should he charge?
Since all the visitors have identical demand curves, the admission fee = consumer
surplus of each visitor = 25 and the price per ride p = 0.