ECON460: Answer Key to Problem Set 1

Instructions: In answering the following questions, do not restrict yourself to nding answers that are natural numbers. Instead, provide decimal answers where you compute them to be so, even though it may lack some intuition. 1. Consider the following total cost function for an individual rm: C(q) = 10 + q + 1 q 2 4 a. At what level of output is average cost at its lowest? Also draw a graph showing rm average cost and marginal cost curves. 1 Answer: AC = 10q 1 + 1 + 4 q d(AC) 1 = 10q 2 + 4 = 0 dq 2 = q = 40 = q = 6.32 b. Consider a short-run perfectly competitive equilibrium with 2 identical rms, each with the above cost function. What is the equation for the industry supply curve? Answer: Individual rm inverse supply function is given by p = 1 + 1 qi , qi 0, where 0 is the minimum of the AVC function. 2 Individual rm supply curve is then given by qi = 2p 2, p 1, where 1 is the price corresponding the minimum of the AVC function. The combined supply curve from two identical rms is Q = q1 + q2 Q = 4p 4, p 1 Since we draw the inverse supply curve, this is given by p = 1 Q + 1, Q 0. 4 c. The industry demand curve is estimated to be Q = 100 p. If there are two rms operating in the market, what is the equation for the residual demand curve for each rm? d s Answer: q1 = Qd q2 = (100 p) (2p 2) = 102 3p, p 1 d. Solve for the short-run perfectly competitive equilibrium levels of price and output in which there are two rms.What are prots of each rm in this short-run equilibrium? Answer: need to nd the intersection of the industry demand curve and the 2-rm supply curve above: Q = 100 p = 4p 4 = p = 20.8, Q = 79.2 Prots: q = 79.2/2 = 39.6 i = REV EN U E COST S = 20.8 39.6 10 + 39.6 +
1 4

39.62 = 382.04

2. What would a monopolys marginal revenue be if it chose a point on the demand curve where the price elasticity of demand equals -1? Why would it never be optimal to choose such a point, given positive marginal costs? Would the monopoly rather produce less or more? Answer: Using the Lerner index, the monopolys marginal revenue would be zero. If its marginal costs are positive, this implies that the monopoly earns less on the marginal unit of output than it cost to produce that unit. Prots would therefore rise if it reduced its output. 3. Solve for the Nash equilibria of the following normal-form game. (Ignore mixed strategies - if you dont know what this means, never mind). Player 2 Strategy B Strategy C (-1,3) (0,1) (0,7) (-1,1) (1,-1) (1,2)

Strategy A player 1 Strategy B Strategy C

Strategy A (1,3) (6,6) (1,2)

Answer: The only Nash Equilibrium is (C,C) where both players choose strategy C. 1

4. An industry consists of three rms with identical costs C(q) = 18q + q 2 . Market demand is Q = 150 p. a. Write down the prot function for rm 1. b. Solve for the Cournot best-response function for rm 1. c. Compute the Cournot equilibrium level of total market output. d. Compute equilibrium prices and prots for each rm. Answer:
2 1 = P q1 C(q1 ) = [150 (Q1 + q1 )] q1 18q1 q1 , where Q1 = q2 + q3 1 = 132 Q1 4q1 = 0 b. q1 = 4q1 = 132 Q1 1 BR = q1 = 33 Q1 4 c. Since all rms are identical, the best-response functions are symmetric and in equilibrium all rms will choose the same levels of output. Hence, each rm will choose q to satisty : 1 q1 = 33 (2q1 ) 4 = q1 = 22 and Q = 3q1 = 66

a.

d.

p = 150 Q = $84

1 = 2 = 2 = $968

5. As a recent graduate you have landed a job in production management for Universal Clones, Inc. You are responsible for the entire company on weekends. Quantity 500 501 Average Total Cost 200 201

Your current level of production is 500 units. All 500 units have been ordered by your regular customers. The phone rings. Its a new customer who wants to buy 1 unit of your product. This means you would have to increase production to 501 units. Your new customer oers you $450 to produce the extra unit. a. Should you accept this oer? b. What is the net change in the rms prot? Answer: a. T C(500units) = 500 200 = $100, 000 T C(501units) = 501 201 = $100, 701 M C = 100, 000 100, 701 = $701 M R = $450 Since the marginal revenue is less than the marginal cost of production you should not accept the oer. b. 701 450 = $251 = Net change in prots