Problem Set 8 - Sample Solutions

ECON 511

Fall 2019

Exercise 1: Allocation between Consumers



640 − 20p
 if p < 32
Suppose Ann has demand xA (p) =

0
 if p ≥ 32


300 − 15p
 if p < 20
and Bob has demand xB (p) = .

0
 if p ≥ 20

(a) Ann and Bob are the only individuals who are interested in good x.

There are Q̄ = 275 units of the good available. Suppose QA = 200 units are given to Ann and QB = 75

units are given to Bob.

Provide a dollar measure of the economic inefficiency at this allocation. Show your work or explain.

1
(b) Suppose,in addition to Ann and Bob, Carl is also interested in the good. He has demand function

60 − 5p if p < 12

xC (p) = . His income elasticity for the good is zero.

0
 if p ≥ 12
With these three individuals, what is the marginal social value at Q = 600? Show your work or explain.

Exercise 2: Optimal Production

This problem concerns a firm with a Cobb-Douglas production function Q = f (L, K). Suppose the price of

labor is w = 10 per unit and the price of capital is r = 40 per unit.

(a) For a general Cobb-Douglas production function, f (L, K), what is true about the expansion path

corresponding to input price w = 10 and r = 40? As part of your answer, be sure to explain what an

expansion path is.

Solution The expansion path contains all optimal (cost minimizing) input bundles (L∗ (w, r, y), K ∗ (w, r, y)) ∈

R2+ corresponding to different output targets y ≥ 0 holding input prices fixed at (w, r) = (10, 40).

The production function f is a Cobb-Douglas function, therefore, all optimal input bundles must be

interior bundles, because f (0, K) = f (L, 0) = f (0, 0) = 0.

w 1
At an optimal interior bundle M RT S(L∗ , K ∗ ) = = must hold. The Cobb-Douglas production
r 4
1
function is homothetic, therefore all bundles (L∗ (w, r, y), K ∗ (w, r, y)) with M RT S(L∗ , K ∗ ) = lie on
4
the same ray through the origin.

The expansion path is the set (L∗ , K ∗ ) ∈ R2++ M RT S(L∗ , K ∗ ) = 1


4

ECON 511, Fall 2019 - B.Klose 2 Problem Set 8 - Solutions

For Parts (b) and (c), suppose the firm’s Cobb-Douglas production function has strictly decreasing returns

to scale. Moreover, suppose the input bundle (L, K) = (25, 70) is on the firm’s expansion path for w = 10

and r = 40 and f (25, 70) = 250.

(b) What can you say about f (50, 140)? Explain.

Solution

250 = f (25, 70) < f (50, 140) = f (2 · 25, 2 · 70) < 2 · f (25, 70) = 2 · 250 = 500.

Because f is a Cobb-Douglas production function with decreasing returns to scale, we know that

f (50, 140) ∈ (250, 500).

(c) What can you say about the cost to produce Q = 500 at prices w = 10 and r = 40? Explain.

Solution The expansion path is a ray through the origin and (L, K) = (25, 70). Therefore, (L, K) =

(50, 140) also lies on the expansion path. By part (b), we know that f (50, 140) < 500. Therefore,

C(500) > 10 · 50 + 40 · 140 = 500 + 5600 = 6100 = 2 · C(250).

(d) Give an example of a Cobb-Douglas production function f (L, K) with strictly decreasing returns to

scale.

Solution Any Cobb-Douglas function f (L, K) = La · K b with a + b < 1 has decreasing returns to

scale. For example

f (L, K) = L0.5 · K 0.25 .

ECON 511, Fall 2019 - B.Klose 3 Problem Set 8 - Solutions

Exercise 3: Long-run Cost Function

Firm A produces its single output using two inputs, labor and capital, with a constant returns to scale tech-

nology. The firm’s isoquants are smooth, with strictly decreasing marginal rate of technological substitution

(MRTS). For any strictly positive output target and input prices, its optimal (cost minimizing) input bundle

is always an interior bundle.

• With input prices w = 10 and r = 30, its long-run cost function is C(Q). If its input price for labor

were twice as large, w̃ = 2w = 20, but its capital price were unchanged (r̃ = r = 30), its corresponding

long-run cost function would be C̃(Q).

Decide whether the following statement is true or false or uncertain and explain/justify your choice.

C̃(Q) < 2 · C(Q) for every Q > 0.

That is, for any strictly positive output target, Q, the new long-run cost is always strictly less than twice

the old long-run cost.

Solution The statement is true.

Let (L∗, K ∗ ) ∈ R2++ be the optimal (i.e. cost minimizing) input bundle at prices w = 10 and r = 30.
w 1
(L∗ , K ∗ ) is an interior bundle, therefore M RT S(L∗ , K ∗ ) = = and f (L∗ , K ∗ ) = Q must hold.
r 3
With the new prices w̃ = 2w = 20 and r̃ = r = 30, the new optimal bundle (L̃∗ , K̃ ∗ ) ∈ R2++ is also an
w̃ 2
interior bundle. (L̃∗ , K̃ ∗ ) must satisfy M RT S(L̃∗ , K̃ ∗ ) = = and f (L̃∗ , K̃ ∗ ) = Q.
r 3
The production technology has not changed, therefore, we could still choose input bundle (L∗ , K ∗ ),

however, the MRTS at (L∗, K ∗ ) is too low. That is, the slope of the isoquant is flatter than the slope of

the isocost line and the firm can do strictly better (decrease cost) by choosing (L̃∗ , K̃ ∗ ) with L̃∗ < L∗ and

K̃ ∗ > K ∗ .

C̃(Q) = 20L̃∗ + 30K̃ ∗

< 20L∗ + 30K ∗

< 2 · (10L∗ + 30K ∗ )

= 2 · C(Q)

ECON 511, Fall 2019 - B.Klose 4 Problem Set 8 - Solutions

Exercise 4: Efficient Allocation of Resources Between Firms

Each of two firms uses labor, L, and capital, K, to produce the same output good. The first firm has pro-

duction function f1 (L1 , K1 ) and the second firm has production function f2 (L2 , K2 ), where each production

function has strictly diminishing marginal rate of technical substitution (MRTS).

• At input bundle (L1 , K1 ) = (7, 15), the first firm’s production function has output f1 (7, 15) = 63 and

its marginal products are M P L1 = 2 for labor and M P K1 = 4 for capital.

• At input bundle (L2 , K2 ) = (8, 10), the second firm’s production function has output f2 (8, 10) = 320

and its marginal products are M P L2 = 3 for labor and M P K2 = 6 for capital.

• Throughout this problem, the total amount of resources available to be split between the two firms is

(L̄, K̄) = (7, 15) + (8, 10) = (15, 25).

For each of the two statements below, decide whether it is true, or false, or uncertain, and explain.

(a) It is not possible to produce more than Q1 + Q2 = 63 + 320 = 383 units of the good in total using the

two firms.

Solution False.

M P L1 = 2 < 3 = M P L2 ⇒ M P L1 6= M P L2 and

M P K1 = 4 < 6 = M P K2 ⇒ M P K1 6= M P K2 .

Therefore, if we reallocated a small amount of resources (labor and/or capital) from firm 1 to firm 2

where their marginal product is strictly greater, total output Q1 + Q2 increases.

(b) It is not possible to produce more than Q2 = 320 in firm 2 if firm 1 is required to produce Q1 = 63.

Solution True.

2 1 3
M RT S1 (7, 15) = = = = M RT S2 (8, 10) ⇒ M RT S1 (7, 15) = M RT S2 (8, 10) and
4 2 6
Q1 = f (7, 15) = 63.

ECON 511, Fall 2019 - B.Klose 5 Problem Set 8 - Solutions

 Both production functions have strictly diminishing MRTS, therefore the solution is a global maximizer

of the constrained problem. At the optimal resource allocation Q2 = f (8, 10) = 320. Therefore, it is not

possible to produce more than Q2 = 320 in firm 2 if firm 1 is required to produce Q1 = 63.

Exercise 5: Individual Supply

A firm has the following cost function, with an avoidable fixed cost:


0
 if q = 0
c(q) = .
62.5 + 2.5q 2 + 15q

 if q > 0

Find the firm’s supply function (show all the steps of your derivations).

Solution The relevant (non-sunk) cost is c(q), because none of it is sunk.

The firm has an avoidable fixed cost, therefore q ∗ = 0 (i.e. shutting down) is a local maximizer. q ∗ = 0 is

a global maximizer if p < ac(q) for all q > 0. That is, p < minq>0 ac(q) = ac(q̂) where mc(q̂) = ac(q̂). Here,

c(q) 62.5
ac(q) = = 2.5q + 15 +
q q
dc(q)
mc(q) = = 5q + 15.
dq

Therefore,

mc(q̂) = ac(q̂)
62.5
⇔ 5q̂ + 15 = 2.5q̂ + 15 +
q̂
62.5
⇔ 2.5q̂ =
q̂
⇔ q̂ 2 = 25 ⇒ q̂ = 5.

The minimum of average cost is ac(5) = mc(5) = 40. Hence, s(p) = 0 for p < 40 and s(p) ∈ {0, 5} if p = 40.

ECON 511, Fall 2019 - B.Klose 6 Problem Set 8 - Solutions

 There also exists another local maximizer q ∗∗ > 0 which is the global maximizer for p > 40.

p = mc(q ∗∗ )

⇔ 5q ∗∗ = p − 15
1
⇔ q ∗∗ = p−3
5
 
Note that marginal costs are increasing everywhere d
dq mc(q) = 5 > 0 , therefore q ∗∗ satisfies second-order

conditions and is indeed a maximizer. For q ∗∗ > q̂ = 5 ⇔ p > 40, p = mc(q ∗∗ ) > ac(q ∗∗ ) and q ∗∗ = 15 p − 3

is the global maximizer.

Altogether, 



 0 if p < 40

s(p) = 0 or 5 if p = 40 .



 1p − 3

if p > 40
5

Exercise 6: Aggregate Supply and Output Allocation

A firm has two plants that it may use to produce its output. The two plants have cost functions

C1 (Q1 ) = (Q1 )2 and

1
C2 (Q2 ) = Q2 + (Q2 )2 ,
2

respectively.

1. If the firm has a target total output Q = Q1 + Q2 > 0, how should the firm divide total output Q

between the two plants in order to minimize total costs?

Solution The firm’s problem is to choose Q1 , Q2 ≥ 0 such that Q1 + Q2 = Q and C(Q) = C1 (Q1 ) +

C2 (Q2 ) is minimized. To solve this minimization problem, we may substitute Q1 = Q − Q2 in the

objective and minimize

2 1
C(Q) = C1 (Q − Q2 ) + C2 (Q2 ) = (Q − Q2 ) + Q2 + (Q2 )2 .
2

ECON 511, Fall 2019 - B.Klose 7 Problem Set 8 - Solutions

 The first-order condition for this problem is,

∂
[C1 (Q − Q2 ) + C2 (Q2 )] = (−1) · 2 · (Q − Q2 ) + 1 + Q2
∂Q2
= 3Q2 + 1 − Q

=0
 
2 1 1
⇔ Q2 = Q − ≥0⇔Q≥ .
3 3 2

The second-order condition for a strict local minimizer is always satisfied,

∂2
[C1 (Q − Q2 ) + C2 (Q2 )] = 3 > 0.
(∂Q2 )2

Therefore,

1
Q if Q ≤


2
Q∗1 =
1 1 1
3Q + if Q >


3 2

1
0 if Q ≤


2
Q∗2 = .
2 1 1
3Q − if Q >


3 2

We could have also found these solutions using the marginal costs for each plant.

dC1 (Q1 )
M C1 (Q1 ) = = 2Q1 and
dQ1
dC2 (Q2 )
M C2 (Q2 ) = = 1 + Q2 .
dQ2

Note that M C2 (Q2 ) ≥ 1. At an interior allocation Q1 , Q2 > 0, we must have M C1 (Q1 ) = M C2 (Q2 )

(Otherwise, if M Ci (Qi ) < M Cj (Qj ) reallocating a small amount of output from plant j to plant i

would strictly lower costs).

2Q1 = 1 + Q2 and Q1 + Q2 = Q
1 1 2 1
⇔ Q1 = Q + and Q2 = Q − .
3 3 3 3

For Q ≤ 12 ,

M C1 (Q) ≤ M C2 (0),

therefore, we have a corner solution (Q1 , Q2 ) = (Q, 0) in this case.

ECON 511, Fall 2019 - B.Klose 8 Problem Set 8 - Solutions

 [Alternatively, we could have found the solution to the allocation problem using aggregate supply,

S(p) = s1 (p) + s2 (p), where si (p) is plant i’s individual supply (Compare to Exercise 1).

For the first plant,

M C1 (Q1 ) = 2Q1

AC1 (Q1 ) = Q1 .

Both average and marginal costs are strictly increasing and M C1 (Q1 ) = 2AC1 (Q1 ) for all Q1 > 0.

AC1 > 0 for all Q1 > 0 and lim AC1 (Q1 ) = 0, hence average cost is ”minimized at Q1 = 0”
Q1 →0
(technically, AC is not defined at Q = 0).

1
M C1 (Q1 ) = p ⇔ Q1 = p
2

Therefore,
1
s1 (p) = p for all p ≥ 0
2

For the second plant,

M C2 (Q2 ) = 1 + Q2
1
AC2 (Q2 ) = 1 + Q2 .
2

Both average and marginal costs are strictly increasing and M C2 (Q2 ) > AC2 (Q2 ) for all Q2 > 0.

AC2 > 1 for all Q2 > 0 and lim AC2 (Q2 ) = 1, hence average cost is ”minimized at Q2 = 0”
Q2 →0
(technically, AC is not defined at Q = 0).

M C2 (Q2 ) = p ⇔ Q2 = p − 1

Therefore, 
0 if p ≤ 1


s2 (p) =
 p−1

if p > 1

ECON 511, Fall 2019 - B.Klose 9 Problem Set 8 - Solutions

 Altogether, aggregate supply is

s1 (p) if p ≤ 1


S(p) =
 s1 (p) + s2 (p) if p > 1


 1p

if p ≤ 1
2
=
3
2p −1 if p > 1



Find p∗ such that S(p∗ ) = Q. 

1
2Q if Q ≤


2
p∗ =
2 1
3 (Q + 1) if Q >


2

And the optimal output allocation is


1
Q if Q ≤


2
Q∗1 (Q) ∗
= s1 (p ) = ,
1 1
3 (Q + 1) if Q >


2

1
0 if Q ≤


2
Q∗2 (Q) = s2 (p∗ ) = .
2 1 1
3Q − if Q >


3 2

2. What is the resulting total cost for the firm, C(Q)?

Solution

C(Q) = C1 (Q∗1 ) + C2 (Q∗2 )


1
C1 (Q) if Q ≤


2
=
 C1 1 Q + 1 + C2 2 Q − 1 1



if Q >

3 3 3 3 2

Q2 if Q ≤ 12


=
 1 Q2 + 2 Q − 1 if Q > 1

3 3 6 2

ECON 511, Fall 2019 - B.Klose 10 Problem Set 8 - Solutions

Now suppose the first plant has an avoidable fixed cost of 4, the cost function for the second plant remains

the same. That is,


0 if Q1 = 0


C1 (Q1 ) = and
 (Q1)2 + 4

if Q1 > 0
1
C2 (Q2 ) = Q2 + (Q2 )2 .
2

3. For which levels of total output, Q, is it better to avoid the fixed cost and only use plant 2?

Solution If the firm uses both plants, it is still optimal to allocate output in the same manner as

proposed above, because marginal costs are not affected by the avoidable fixed cost. Therefore, if the

firm uses both plants, its resulting total cost is


1
Q2 + 4 if Q ≤


2
C(Q) + 4 = .
1 2
3Q + 23 Q − 1
+4 if Q > 1


6 2

If the firm avoids the fixed cost by only using the second plant, its resulting total cost is

1
C2 (Q) = Q + Q2 .
2

1
If Q ≤ 2 then C2 (Q) < C(Q) + 4, because Q + 12 Q2 < Q2 + 4 ⇔ Q − 12 Q2 < 4 holds. Hence, it is

optimal to avoid the fixed cost.

If Q > 12 ,

C2 (Q) < C(Q) + 4

1 1 2 1
⇔ Q + Q2 < Q2 + Q − + 4
2 3 3 6
1 2 1 1
⇔ Q + Q+ <4
6 3 6
⇔ (Q + 1)2 < 24
√
⇔ Q < 24 − 1 ≈ 3.9

√
Altogether, the firm should optimally avoid the fixed cost, whenever its output target Q < 24 − 1. It
√
should use both plants and pay the fixed cost whenever Q > 24 − 1. The firm is indifferent between
√
using both plants or only the second plant when Q = 24 − 1.

ECON 511, Fall 2019 - B.Klose 11 Problem Set 8 - Solutions

 4. If the firm has a target total output Q = Q1 + Q2 > 0, how should the firm divide total output Q

between the two plants in order to minimize total costs.

Solution

√

0 if Q ≤ 24 − 1


Q∗1 (Q) = √
1 1
3Q + if Q > 24 − 1


3

√

Q if Q ≤ 24 − 1


Q∗2 (Q) = √ .
2 1
3Q − if Q > 24 − 1


3

5. What is the resulting total cost for the firm, C(Q)?

Solution

√

C2 (Q) if Q ≤ 24 − 1


C(Q) = √
1 1 2 1



 C1
3 Q + 3 + C2 3Q − if Q > 24 − 1

3

√

Q + 12 Q2 if Q ≤ 24 − 1


= √
1 2
3Q + 32 Q − 1
+4 if Q > 24 − 1


6

√

Q + 12 Q2 if Q ≤ 24 − 1


= √
1


2Q2 + 4Q + 23 if Q > 24 − 1


6

6. For each total output level Q > 0, compare the amount produced in the first plant, Q1 (Q), in parts 1

and 4 (i.e. with and without an avoidable fixed cost).

Solution Without the avoidable fixed cost (part 1), the first plant is always used, i.e. Q∗1 > 0 for all

Q > 0. With the avoidable fixed cost (part 4), the first plant is only used if output is sufficiently large,
√ √
Q > 24 − 1. If the first plant is used, i.e. if Q > 24 − 1, then the amount produced at the first

plant is the same for parts 1 and 4.

ECON 511, Fall 2019 - B.Klose 12 Problem Set 8 - Solutions