IE54500 – Exam 2

Dr. David Johnson

Fall 2022
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your assumptions.

Note: The total number of points from all questions is 60, with the potential to reach a maximum score
of 63 out of 60 with the extra credit portion of Question 3.

1. Monopoly Production Decisions

Consider a firm that produces a widget that is protected by a patent and for which there are no other
close substitutes. Because of the patent protection, no other firm can duplicate the widget, giving this
firm monopoly power. The inverse demand curve for this widget is given by 𝑃 = 200 − 𝑄 + 2𝐴, where
𝑃 is price, 𝑄 is quantity, and 𝐴 is a measure of the widget’s quality. From this equation, we can see that
higher quality allows the firm to sell the same quantity of widgets at a higher price.

The firm gets to choose the level of quality for their product, such that the cost of developing a design
with quality 𝐴 is 𝐶(𝐴) = 𝐴2 . However, higher-quality designs also require more expensive parts and
complex production. As a result, once the design has been developed, a widget can be produced for a
constant marginal cost per unit of 10 + 𝐴. Finally, the producer incurs other fixed costs 𝐹 for research
and development (R&D).

a) Write down the equation that defines the producer’s profits (5 points).
𝜋 = (200 − 𝑄 + 2𝐴) ∙ 𝑄 − (10 + 𝐴) ∙ 𝑄 − 𝐴2 − 𝐹

b) Given this profit function, what levels of quantity and quality should the producer choose? (6)
In choosing quantity and quality, we have two first-order conditions, for Q and A, which we set
equal to zero and solve for optimal values 𝑄 ∗ and 𝐴∗ :
𝜋𝑄 = 200 − 𝑄 + 2𝐴 − 𝑄 − 10 − 𝐴 = 190 − 2𝑄 + 𝐴 = 0
𝜋𝐴 = 2𝑄 − 𝑄 − 2𝐴 = 𝑄 − 2𝐴 = 0
 ∴ 𝐴∗ = 𝑄/2
⇒ 190 = 2𝑄 − 𝐴 = 3𝑄/2 ⇒ 𝑄 ∗ = 190 ∗ 2/3 = 126.67, 𝐴∗ = 63.33

c) What price can the producer charge for this combination of quantity and quality? (2 points)
𝑃 = 200 − 𝑄 + 2𝐴 = 200

d) What are the producer’s profits if the fixed costs are 𝐹 = 10000? (2 points)
𝜋 = 200 ∙ 126.67 − (10 + 63.33) ∙ 126.67 − 63.332 − 10000 = 2033.33

e) A consumer group accuses the firm of selling the widget at an inflated price. The producer
responds by claiming that it must charge this price to cover its R&D costs. Is the producer’s
argument valid? Why or why not? In what sense is the producer’s price “inflated?” (5 points)
No. the firm’s price equates marginal revenue with marginal cost, which is independent of the
fixed costs (see the fact that F does not appear in the first-order conditions). The price is inflated
in the sense that it exceeds the marginal cost because the firm can exploit its market power as a
monopolist. The marginal cost is the price that would obtain in a perfectly competitive market.

f) What is the difference between the quantity and quality produced under the monopoly and the
socially optimal levels? (10 points)
To answer this question, note that the socially optimal levels of quantity and quality are defined
as those that maximize the total surplus in the economy:

𝑄
𝑄2
𝑇𝑆(𝑄, 𝐴) = ∫ 𝑃(𝑄, 𝐴)𝑑𝑄 − 𝐶(𝑄, 𝐴) = 200𝑄 − + 2𝐴𝑄 − (10 + 𝐴)𝑄 − 𝐴2 − 𝐹
0 2

A benevolent social planner would therefore seek to maximize total surplus by choosing quantity
and quality. Taking first-order conditions for the total surplus expression:

𝑇𝑆𝑄 = 200 − 𝑄 + 2𝐴 − 10 − 𝐴 = 190 − 𝑄 + 𝐴 = 0

𝑇𝑆𝐴 = 2𝑄 − 𝑄 − 2𝐴 = 𝑄 − 2𝐴 = 0

Solving these two equations simultaneously yields solutions 𝐴 = 190 and 𝑄 = 380. So, the
monopolist therefore chooses to produce less quantity and less quality than is socially optimal.
This happens because the monopolist chooses quantity and quality to equate marginal costs
with their private marginal revenue, whereas the social planner equates marginal costs with the
marginal benefits (i.e., marginal total surplus to society).

2. The Value of Gambles

In this question, we will distinguish between the concepts of buying and selling gambles. If we sell a
gamble, that implies we own it or have a right to it in the first place; imagine a situation where you’ve
had a stellar performance review at work, such that you’ve earned a bonus. However, your boss tells
you the bonus is expressed as a gamble, where you have a probability 𝑝 of being awarded a good bonus
in the amount 𝐺 and a probability 1 − 𝑝 of being awarded a bad bonus in the amount 𝐵, where 𝐵 < 𝐺
and 0 < 𝑝 < 1. Suppose you have initial wealth 𝑊 and a utility function 𝑢(𝑤) that obeys all of our
normal assumptions about rationality.

a) In this case, you have a right to the bonus gamble but wish to “sell” it by asking your boss to
instead offer you a bonus with a fixed amount (i.e., you will get the same constant bonus with
certainty). Provide a mathematical equation that characterizes the minimum price, 𝑀𝑆 , for
which you would be willing to sell the gamble. In other words, if you had a functional form for
𝑢(𝑤), what is the equation you would solve in order to find 𝑀𝑆 ? Explain. (5 points)
The minimum price is where the utility associated with existing wealth plus the sale price is equal
to the expected utility of keeping the gamble:
𝑝 ∙ 𝑢(𝑊 + 𝐺) + (1 − 𝑝) ∙ 𝑢(𝑊 + 𝐵) = 𝑢(𝑊 + 𝑀𝑆 )

b) Now imagine that your co-worker has gotten a bad performance review, such that they would
not ordinarily be given a bonus at all. However, your employer will allow them to “buy” the
same bonus gamble that you earned by paying some amount of money 𝑀𝐵 in exchange for
getting access to the gamble. Provide a mathematical equation that characterizes the maximum
price 𝑀𝐵 your co-worker should be willing to pay to buy the gamble. Explain. (5 points)
If we buy the gamble, we pay 𝑀𝐵 and then gain either 𝐵 or 𝐺. The maximum price we would be
willing to pay to buy it equalizes expected utility after buying the gamble with the certain utility
of keeping all of our existing wealth:
𝑝 ∙ 𝑢(𝑊 − 𝑀𝐵 + 𝐺) + (1 − 𝑝)𝑢(𝑊 − 𝑀𝐵 + 𝐵) = 𝑢(𝑊)

c) Explain conceptually why both of the values from parts a) and b), 𝑀𝑆 and 𝑀𝐵 , should be greater
than 𝐵 and less than 𝐺. (3 points)
We should never be willing to sell the gamble for less than 𝐵, because we will always get at least
𝐵 from the gamble, with certainty. Since 0 < 𝑝 < 1, the expected value of the gamble must be
less than 𝐺, which means a risk averse individual would at least be willing to sell for a value
equal to the expected value. We have said that 𝑢(𝑤) obeys our standard assumptions about
rationality, which means the individual should be risk averse.

A similar argument can be made regarding 𝑀𝐵 .

d) Explain conceptually why the values 𝑀𝑆 and 𝑀𝐵 should be different, and specifically, why
𝑀𝑆 < 𝑀𝐵 . (3 points)
This is similar to the argument for why compensating and equivalent variations are different.
Suppose that 𝑀𝑆 = 𝑀𝐵 instead. The marginal increase in utility gained from 𝑀𝑆 is smaller in
magnitude than the marginal utility lost when paying 𝑀𝐵 . Mathematically, denote the bonus as
the random variable 𝑋, such that 𝑋 ∈ {𝐵, 𝐺}. We can subtract the equation in b) from the
equation in a):
𝔼[𝑢(𝑊 + 𝑋)] − 𝔼[𝑢(𝑊 − 𝑀𝐵 + 𝑋)] = 𝑢(𝑊 + 𝑀𝑆 ) − 𝑢(𝑊)

On both sides of this equation, we’re taking the difference between two expected utilities that
have been shifted by a constant amount, either 𝑀𝑆 or −𝑀𝐵 . Because of diminishing marginal
utility, for these two quantities to be equal, we must have that 𝑀𝑆 < 𝑀𝐵 .
 e) For the specific case where you and your co-worker each have initial wealth 𝑊 = 10 and
potential bonuses 𝐺 = 10 and 𝐵 = 5, with 𝑝 = 0.5 and 𝑢(𝑤) = −𝑤 2 + 100𝑤, calculate the
values 𝑀𝑆 and 𝑀𝐵 . (4 points)
Now we just have to substitute in the numbers and utility functions, which in both cases will lead
to a quadratic equation that can be solved for 𝑀𝐵 and 𝑀𝑆 .

To sell:
−(10 + 𝑀𝑆 )2 + 100(10 + 𝑀𝑆 ) = −𝑀𝑆2 + 80𝑀𝑆 + 900 =
0.5 ∙ [−202 + 100 ∙ 20] + 0.5 ∙ [−152 + 100 ∙ 15]
⇒ 𝑀𝑆2 − 80𝑀𝑆 + 537.5 = 0 ⇒ 𝑀𝑆 ∈ {7.40, 72.60}
However, we know that the value must be between 5 and 10, so 𝑀𝑆 = 7.40.

To buy:
0.5 ∙ [−(20 − 𝑀𝐵 )2 + 100(20 − 𝑀𝐵 )] + 0.5 ∙ [−(15 − 𝑀𝐵 )2 + 100(15 − 𝑀𝐵 )] =
−102 + 100 ∙ 10 = 900
⇒ 1800 = −400 + 40𝑀𝐵 − 𝑀𝐵2 + 2000 − 100𝑀𝐵
−225 + 30𝑀𝐵 − 𝑀𝐵2 + 1500 − 100𝑀𝐵
⇒ 𝑀𝐵2 + 130𝑀𝐵 − 1075 = 0 ⇒ 𝑀𝐵 ∈ {−72.42, 7.42}
We know the value must be between 5 and 10, so 𝑀𝐵 = 7.42.

3. Intertemporal Production Choices

Suppose your employer, The Factory, has been contracted to supply a total of 𝑁 widgets over the next
two years, but the buyer is indifferent to how many units are supplied in the first year versus the second
year. The Factory produces their widget using raw materials 𝐾 and labor 𝐿, according to a production
function 𝑓(𝐾, 𝐿), and they do not expect this production function to change over time. Production is
𝜕2 𝑓
increasing in each input, but with diminishing returns to productivity, and you can assume 𝜕𝐾𝜕𝐿 = 0.

However, The Factory knows that we are currently experiencing substantial inflation at a rate of 𝑖
percent per year. This inflation affects the unit cost of raw materials, which is 𝑟 in Year 1, but the unit
wage paid for labor, 𝑤, is expected to remain constant in both years. The contract specifies that every
widget will be sold at a price 𝑝 that is fixed in both years, so The Factory decides that they can simply
minimize their total costs over the two-year period to produce 𝑁 widgets. You can ignore any
discounting or interest effects when calculating total costs, and you can assume that The Factory can
adjust their raw materials usage from year to year without any issue.

a) Set up the firm’s cost minimization problem, including the objective function, decision variables,
and any constraints. You can express raw material and labor values in Year 1 as 𝐾1 and 𝐿1
respectively, and values in Year 2 as 𝐾2 and 𝐿2 . (5 points)
The Factory minimizes their costs over two periods to make a total of N widgets, and the
difference in Year 2 is the cost of capital, so

min 𝐾1 𝑟 + 𝐾2 𝑟(1 + 𝑖) + 𝑤(𝐿1 + 𝐿2 )

𝐾1 ,𝐾2 ,𝐿1 ,𝐿2
subject to a constraint that
𝑓(𝐾1 , 𝐿1 ) + 𝑓(𝐾2 , 𝐿2 ) = 𝑁
b) Demonstrate mathematically that The Factory will utilize less raw materials in Year 2 than in
Year 1. (5 points)
The first-order conditions for raw materials in each time period are
ℒ𝐾1 = 𝑟 − 𝜆𝑓𝐾 (𝐾1 , 𝐿1 ) = 0
ℒ𝐾2 = 𝑟(1 + 𝑖) − 𝜆𝑓𝐾 (𝐾2 , 𝐿2 ) = 0

This implies that

𝑓𝐾 (𝐾2 , 𝐿2 ) = (1 + 𝑖)𝑓𝐾 (𝐾1 , 𝐿1 ) ⇒ 𝑓𝐾 (𝐾2 , 𝐿2 ) > 𝑓𝐾 (𝐾1 , 𝐿1 )

Because our production function exhibits diminishing marginal productivity in each input, this
𝜕2 𝑓
must mean that 𝐾2 < 𝐾1 . This relies on the assumption that 𝜕𝐾𝜕𝐿 = 0, because this means that
the marginal productivity 𝑓𝐾 is unaffected by the level of labor, so even if 𝐿1 and 𝐿2 are different,
the conclusion about raw materials is the same.

𝜕2 𝑓
c) (EXTRA CREDIT: 3 points) If 𝜕𝐾𝜕𝐿 > 0, would the number of widgets produced in Year 1 be less
𝜕2 𝑓
than, equal to, or greater than the original case where 𝜕𝐾𝜕𝐿 = 0, or are you unable to tell? Be
sure to explain your reasoning.
𝜕2 𝑓
Under the original condition where 𝜕𝐾𝜕𝐿 = 0, the first order conditions for labor imply that in
equilibrium, the marginal productivity of labor must be equal in both time periods. Because raw
materials have no effect on the marginal productivity of labor, this must mean that labor usage
would be equal in both time periods. So originally, 𝐿1 = 𝐿2 and 𝐾1 > 𝐾2 .

This new inequality means that increasing The Factory’s usage of labor also makes the use of
𝜕2 𝑓
raw materials more productive. Consider this change in 𝜕𝐾𝜕𝐿 as if it were an exogenous shock to
the system. When deviating from the equilibrium choices resulting from the original assumption,
The Factory will devote relatively more inputs to whichever time period had its marginal
productivity increase the most. In other words, for a small shock, it will depend on the
relationship between
𝜕 2 𝑓(𝐾1 , 𝐿1 ) 𝜕 2 𝑓(𝐾2 , 𝐿2 )
𝑎𝑛𝑑
𝜕𝐾𝜕𝐿 𝜕𝐾𝜕𝐿

Since we don’t know whether one is larger than the other, or if they are equal, we cannot tell
whether the number of widgets in Year 1 will increase, decrease, or stay the same.