6 January 2017

2 hour
Full points: 40
ECN 201E Final Examination Solutions
Answer all 4 questions below. I suggest you spend 25 minutes on each question. If you are
stuck on a question, I recommend moving on to the next question and returning to the
problem after you have finished answering all the other questions.
Make sure to show all your working and calculations for significant partial credit. You must
show all the steps that you did to get to your answer. If you just give me the answer, you
will get 0 even if it is correct. I will also give you 0 if all you give me is a formula without
any working.
Good luck!
Please write your name and ITU ID number on your answer sheet.
Question 1
The market demand and market supply for a good that has price 𝑝 are 𝐷(𝑝) = 50 − 2𝑝 and
𝑆(𝑝) = 5 + 3𝑝 respectively.
a) What is the equilibrium price 𝒑∗ and equilibrium quantity 𝒒∗ ? [4 points]

b) Suppose a quantity tax of $5 is levied by the government. Find the after-tax equilibrium
price paid by the demander 𝑝𝐷∗ and the after-tax equilibrium price received by the supplier
𝑝𝑆∗ . [4 points]

c) What is the deadweight loss (numerical value) associated with the quantity tax? [2
points]
Question 2
A firm uses two factors of production to produce a single output. Let the amount of factor 1
used in production be 𝑥1 and the amount of factor 2 be 𝑥2 . Let the prices of factor 1 and
factor 2 be 𝑤1 and 𝑤2 respectively. The firm’s production function is 𝑓(𝑥1 , 𝑥2 ) = 𝑥10.5 𝑥20.5 .
The firm wants to produce the output level 𝑦̅ at minimum cost
a) State the firm’s constrained minimization problem. [2 points]

b) Find the firm’s conditional factor demand functions 𝑥1 (𝑤1 , 𝑤2 , 𝑦) and 𝑥2 (𝑤1 , 𝑤2 , 𝑦). [6
points]

c) Find the firm’s cost function 𝑐(𝑤1 , 𝑤2 , 𝑦). [2 points]

Question 3
A monopolist has revenue function 𝑟(𝑦) where 𝑦 is the level of output in the monopoly
market. This implies 𝑟(𝑦) = 𝑝(𝑦)𝑦 where 𝑝(𝑦) is the monopolist’s inverse demand function.
The monopolist’s cost function is 𝑐(𝑦). Use the notations 𝑀𝑅 to denote marginal revenue,
𝑀𝐶 to denote marginal cost, 𝑦 ∗ to denote the monopolist’s profit-maximizing level of output
and 𝜖 to denote the price elasticity of demand in your answers to the following questions.
a) From the first-order condition of the monopolist’s profit-maximization problem, derive
the monopolist’s optimal mark-up pricing formula that involves the monopolist’s price
elasticity of demand. [5 points]

b) With economic logic (not mathematics), prove why the monopolist’s profit-maximizing
price-quantity pair (𝑝𝑚 , 𝑞𝑚 ) would never be a point on the inelastic portion of the
monopolist’s demand curve. [5 points]
Question 4
A firm has a cost function given by 𝑐(𝑦) = 10𝑦 2 + 1000 where 𝑦 is the output level of the
firm.
a) At what output (i.e. level of 𝑦) is average cost minimized? [3 points]
b) Assume the price of the firm’s output is 𝑝. What is the firm’s supply curve? Note that I
want the firm’s supply function or curve not the firm’s inverse supply function. [3 points]
c) The price 𝑝 of the firm’s output increases from $2000 to $4000. What is the change in the
producer’s surplus? What is the change in the firm’s profits? [4 points]
Answer to Question 1
a) The equilibrium price 𝑝∗ can be found by solving the equation below:
𝐷(𝑝∗ ) = 50 − 2𝑝∗ = 5 + 3𝑝∗ = 𝑆(𝑝∗ ).

50 − 2𝑝∗ = 5 + 3𝑝∗ ,
⇒ 5𝑝∗ = 45,
∴ 𝒑∗ = $𝟗.
To find the equilibrium quantity 𝑞 ∗ we can substitute 𝑝∗ into either the demand function
or supply function. Below we substitute into the demand function:
𝑞 ∗ = 𝐷(9) = 50 − 2(9),
∴ 𝒒∗ = 𝟑𝟐 𝒖𝒏𝒊𝒕𝒔.

b) The after-tax equilibrium is determined by the equations below:

𝐷(𝑝𝐷 ) = 50 − 2𝑝𝐷 = 5 + 3𝑝𝑆 = 𝑆(𝑝𝑠 ), (1)
𝑝𝐷 = 𝑝𝑠 + 5. (2)
Substituting 𝑝𝐷 in equation (1) from (2):
50 − 2(𝑝𝑠 + 5) = 5 + 3𝑝𝑆 ,
⇒ 50 − 2𝑝𝑠 − 10 = 5 + 3𝑝𝑆 ,
⇒ 5𝑝𝑆 = 35,
∴ 𝒑∗𝑺 = $𝟕.
 We can find after-tax equilibrium price paid by the demander 𝑝𝐷∗ by substituting 𝑝𝑆∗ in
equation (2):
𝑝𝐷∗ = 𝑝𝑆∗ + 5,
⇒ 𝑝𝐷∗ = 7 + 5,
∴ 𝒑∗𝑫 = $𝟏𝟐.
c) The after-tax equilibrium quantity 𝑞𝑇 is (you will need to find it to calculate the
deadweight loss):
𝑞𝑇 = 𝐷(𝑝𝐷∗ ) = 50 − 2(12),
∴ 𝑞𝑇 = 26 𝑢𝑛𝑖𝑡𝑠.
[It is not necessary to draw the figure to get full points but I would advise you to draw the
figure whenever possible]

From the figure above we see that the deadweight loss is the area of the triangle whose area
equals C and D.
1 1
𝐷𝑒𝑎𝑑𝑤𝑒𝑖𝑔ℎ𝑡 𝑙𝑜𝑠𝑠 = 2 × (12 − 7) × (32 − 26) = 2 × 5 × 6,

∴ 𝑫𝒆𝒂𝒅𝒘𝒆𝒊𝒈𝒉𝒕 𝒍𝒐𝒔𝒔 = $𝟏𝟓.

Answer to Question 2
a) The firm’s cost minimization problem is:
min 𝑤1 𝑥1 + 𝑤2 𝑥2 ,
𝑥1 ,𝑥2

𝑠. 𝑡. 𝑥10.5 𝑥20.5 = 𝑦̅.

b) To find the conditional factor demands, we must solve the above constrained cost
minimization problem. You can use substitution to solve this but I will use a Lagrangian. The
Lagrangian is:
𝐿 = 𝑤1 𝑥1 + 𝑤2 𝑥2 − 𝜆(𝑥10.5 𝑥20.5 − 𝑦̅). (1)
𝜆 is the Lagrangian multiplier. The first-order conditions are:
𝜕𝐿
= 𝑤1 − 𝜆0.5𝑥1−0.5 𝑥20.5 = 0, (2a)
𝜕𝑥1

𝜕𝐿
= 𝑤2 − 𝜆0.5𝑥10.5 𝑥2−0.5 = 0, (2b)
𝜕𝑥2

𝜕𝐿
= 𝑥10.5 𝑥20.5 − 𝑦̅ = 0. (2c)
𝜕𝜆

The three first-order conditions can be re-written as:

𝑤1 = 𝜆0.5𝑥1−0.5 𝑥20.5 , (3a)
𝑤2 = 𝜆0.5𝑥10.5 𝑥2−0.5, (3b)
𝑦 = 𝑥10.5 𝑥20.5 . (3c)
We can multiply 𝑥1 on both sides of (3a) and 𝑥2 on both sides of (3b) and substitute
𝑥10.5 𝑥20.5 = 𝑦̅ in both equations to get:
𝑤1 𝑥1 = 𝜆0.5𝑦̅. (4a)
𝑤2 𝑥2 = 𝜆0.5𝑦̅. (4b)

So that we get:
𝜆0.5𝑦̅
𝑥1 = , (5a)
𝑤1
𝜆0.5𝑦̅
𝑥2 = . (5b)
𝑤2
We can substitute 𝑥1 and 𝑥2 from equations (5a) and (5b) into equation (3c) and solve for 𝜆:
𝜆0.5𝑦̅ 0.5 𝜆0.5𝑦̅ 0.5
( ) ( ) = 𝑦̅,
𝑤1 𝑤2
𝜆0.5𝑦̅
⇒𝑤 0.5 𝑤 0.5
= 𝑦̅,
1 2
𝑤1 0.5 𝑤2 0.5
∴𝜆= . (6)
0.5

Substituting the value of 𝜆 from equation (6) into equations (5a) and (5b), we get the
conditional factor demand functions:
𝜆0.5𝑦̅ 𝑤1 0.5 𝑤2 0.5 0.5𝑦̅ 𝑤2 0.5 𝑦̅
𝑥1 = = . = =𝑤1 −0.5 𝑤2 0.5 𝑦̅, (7a)
𝑤1 0.5 𝑤1 𝑤1 0.5

𝜆0.5𝑦̅ 𝑤1 0.5 𝑤2 0.5 0.5𝑦̅ 𝑤1 0.5 𝑦̅

𝑥2 = = . = =𝑤1 0.5 𝑤2 −0.5 𝑦̅, (7b)
𝑤2 0.5 𝑤2 𝑤2 0.5
The conditional factor demands for factors 1 and 2 are given by equations (7a) and (7b)
respectively:

𝒙𝟏 (𝒘𝟏 , 𝒘𝟐 , 𝒚) = 𝒘𝟏 −𝟎.𝟓 𝒘𝟐 𝟎.𝟓 𝒚, (7a)

𝒙𝟐 (𝒘𝟏 , 𝒘𝟐 , 𝒚) = 𝒘𝟏 𝟎.𝟓 𝒘𝟐 −𝟎.𝟓 𝒚. (7b)
c) The cost function is found by substituting the conditional factor demands into the
objective function:
𝑐(𝑤1 , 𝑤2 , 𝑦) = 𝑤1 𝑥1 (𝑤1 , 𝑤2 , 𝑦) + 𝑤2 𝑥2 (𝑤1 , 𝑤2 , 𝑦),
⟹ 𝑐(𝑤1 , 𝑤2 , 𝑦) = 𝑤1 . 𝑤1 −0.5 𝑤2 0.5 𝑦 + 𝑤2 . 𝑤1 0.5𝑤2 −0.5 𝑦,
∴ 𝒄(𝒘𝟏 , 𝒘𝟐 , 𝒚) = 𝟐𝒘𝟏 𝟎.𝟓 𝒘𝟐 𝟎.𝟓 𝒚. (8)
The cost function is given by equation (8).
Answer to Question 3
a) The monopolists first-order profit maximization condition is:
𝑀𝑅(𝑦 ∗ ) = 𝑀𝐶(𝑦 ∗ ). (9)
We know that:
𝑀𝑅(𝑦) = 𝑟′(𝑦),
⟹ 𝑀𝑅(𝑦) = 𝑝(𝑦) + 𝑦. 𝑝′(𝑦),
𝑦 𝑑𝑝
⟹ 𝑀𝑅(𝑦) = 𝑝(𝑦) [1 + 𝑝 . 𝑑𝑦],

1
⟹ 𝑀𝑅(𝑦) = 𝑝(𝑦) [1 + 𝜖 ],
1
⟹ 𝑀𝑅(𝑦) = 𝑝(𝑦) [1 − |𝜖|]. (10)

Substituting 𝑀𝑅(𝑦) from equation (10) into (9), we have:

1
𝑝(𝑦 ∗ ) [1 − |𝜖|] = 𝑀𝐶(𝑦 ∗ ),

𝑴𝑪(𝒚∗ )
∴ 𝒑(𝒚∗ ) = 𝟏 . (11)
[𝟏−|𝝐|]

Equation (11) is the monopolist’s optimal mark-up pricing formula.

b) We will use proof by contradiction to prove that the monopolist will never operate on the
inelastic part of his demand curve.
Consider that the monopolist is operating on the inelastic part of her demand curve. If she
increases price from this point, revenue increases because demand is inelastic. Because
price is increased, output has to decrease. This implies that the total cost of production
must either decrease or stay the same if output decreases. With an increase in revenue and
a decrease in cost, the monopolist’s profit must increase. This proves that the profit
maximum for the monopolist cannot lie on the inelastic part of her demand curve.
Answer to Question 4
d) The average cost is minimized at the output level 𝑦𝑚𝑖𝑛 at which the marginal cost
curve intersects it.
The marginal cost of the firm is:
𝑚𝑐(𝑦) = 20𝑦.
The average cost of the firm is:
1000
𝑎𝑐(𝑦) = 10𝑦 + .
𝑦

We know that at the output level 𝑦𝑚𝑖𝑛 at which average cost is minimized we have:
𝑚𝑐(𝑦𝑚𝑖𝑛 ) = 𝑎𝑐(𝑦𝑚𝑖𝑛 ),
1000
⟹ 20𝑦𝑚𝑖𝑛 = 10𝑦𝑚𝑖𝑛 + 𝑦 ,
𝑚𝑖𝑛

2
⟹ 𝑦𝑚𝑖𝑛 = 100,
∴ 𝒚𝒎𝒊𝒏 = 𝟏𝟎 𝒖𝒏𝒊𝒕𝒔. (Because output 𝑦 cannot be a negative number, we can rule out -10 as
a solution).
e) The inverse supply curve of the firm is given by the equation:
𝑝 = 𝑚𝑐(𝑦).
Therefore, the firm’s inverse supply function is:
𝑝 = 20𝑦. (1)
Note that (1) is the inverse supply function and not the supply function. To derive the firm’s
supply function we re-arrange equation (1):

𝑝 = 20𝑦,
𝑝
⟹ 𝑦 = 20,
𝒑
∴ 𝑺(𝒑) = 𝟐𝟎. (2)
f) We know from the supply function that 𝑆(2000) = 100 and 𝑆(4000) = 200 . We can
draw the figure below to calculate the change in producer’s surplus.
The grey shaded area is the change in producer’s surplus. Therefore:
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑟 ′ 𝑠 𝑠𝑢𝑟𝑝𝑙𝑢𝑠 = (100 × 2000) + (0.5 × 100 × 2000),
∴ 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒓′ 𝒔 𝒔𝒖𝒓𝒑𝒍𝒖𝒔 = $𝟑𝟎𝟎, 𝟎𝟎𝟎.
The change in profits is equal to the change in producer’s surplus so the change in the firm’s
profits is also $300,000.