Gulf University for Science & Technology Dr.

Khalid Al-Kisswani
Department of Economics & Finance Room: N1-116
ECON 503: Economics for Managers Tel: 2530-7339
Summer – 2010 E-mail: kisswani.k@gust.edu.kw

Practice Questions 5

1. Consider a firm which uses only two inputs in production, capital (K) and labor (L). The firm has production
function Q (K; L) = K1/2L1/2. Let w be the wage rate for L and r be the rental rate of capital. Suppose the firm
wishes to produce 1080 units of the good. Let w = $4 and r = $20.
Find the cost-minimizing bundle of capital and labor for this firm, as well as the associated total cost amount.

LQ = 4L + 20 K + λ (1080 – K1/2L1/2)

𝝏𝑳𝑸 - 1/2 𝑲
= 20 + λ ( - 1/2 K L1/2) = 0 ⟹ λ = 40( )1/2 (1)
𝝏𝑲 𝑳

𝝏𝑳𝑸 1/2 𝑳
= 4 + λ ( - 1/2 K L-1/2) = 0 ⟹ λ = 8 ( )1/2 (2)
𝝏𝑳 𝑲

𝑲 𝑳 𝑲 1/3 𝑳 2/3 𝟓 𝑲𝟏/𝟐 𝑳𝟏/𝟐

From (1) and (2): 40( )1/2 = 8 ( )1/2 ⟹ 81 ( 𝑳 ) = 24 ( ) ⟹ =
𝑳 𝑲 𝑲 𝑳𝟏/𝟐 𝑲𝟏/𝟐
⟹ L=5K (3)

𝝏𝑳𝑸 1/2 1/2

= 1080 – K L =0 (4)
𝝏𝝀

Plug (3) in (4):

1080 – K1/2 (5K)1/2 = 0 ⟹ (5)1/2 K = 1080 ⟹ K = 483
Therefore, L = 5(483) = 2415
Hence, TC = 4(2415) + 20 (483) = 19320

Q = 1000 – P ⟹ P = 1000 – Q ⟹ MR = 1000 – 2 Q

MC = 4 ⟹ MR = MC ⟹ 1000 – 2Q = 4 ⟹ 2Q = 996 ⟹ Q = 498
Then, P = 1000 – 498 = 502
Profit = TR – TC = P.Q – TC = (502)(498) – 4 (498) = 248004

2. A monopolist faces market demand Q = 1000 - P and has a total cost function C (Q) = 4Q.
(a) Find the profit maximizing price and quantity and the resulting profit to the monopolist.
Q = 1000 – P ⟹ P = 1000 – Q ⟹ MR = 1000 – 2 Q
MC = 4 ⟹ MR = MC ⟹ 1000 – 2Q = 4 ⟹ 2Q = 996 ⟹ Q = 498
 Then, P = 1000 – 498 = 502
Profit = TR – TC = P.Q – TC = (502)(498) – 4 (498) = 248004

(b) Assume the monopolist is forced by the government to operate as a competitive firm. Find the profit
maximizing price and quantity and the resulting profit to the monopolist now.

Q = 1000 – P ⟹ P = 1000 – Q
MC = 4 ⟹ P = MC ⟹ 1000 – Q = 4 ⟹ Q = 996
Then, P = 1000 – 996 = 4
Profit = TR – TC = P.Q – TC = (4)(996) – 4 (996) = 0

(c) Now, assume that the market demand Q = 1000 – P is the local demand, and the monopolist also faces an
outside market demand Q = 1000 – 2P. The monopolist is interested in pricing the product in the local market
differently from the outside market. Find the profit maximizing price and quantity and the resulting profit to the
monopolist now.
Inside market:
Q = 1000 – P ⟹ P = 1000 – Q ⟹ MR = 1000 – 2 Q
MC = 4 ⟹ MR = MC ⟹ 1000 – 2Q = 4 ⟹ 2Q = 996 ⟹ Q = 498
Then, P = 1000 – 498 = 502
Profit = TR – TC = P.Q – TC = (502)(498) – 4 (498) = 248004
Outside market:
Q = 1000 – 2P ⟹ P = 500 – 0.5Q ⟹ MR = 500 – Q
MC = 4 ⟹ MR = MC ⟹ 500 – Q = 4 ⟹ Q = 496
Then, P = 500 – 0.5 (496) = 252
Profit = TR – TC = P.Q – TC = (252)(496) – 4 (496) = 123008

(d) Now, assume that the market demand Q = 1000 – P is the local demand, and the monopolist also faces an
outside market demand Q = 1000 – 2P. The monopolist is forced to use a single price for the product in both;
the local market and the outside market. Find the profit maximizing price and quantity and the resulting profit
to the monopolist now.
Total Demand (Q) = Q inside + Q outside = 1000 – P + 1000 – 2P = 2000 – 3P
Q = 2000 – 3P ⟹ P = 2000/3 – 1/3Q ⟹ MR = 2000/3 –2/3 Q
MC = 4 ⟹ MR = MC ⟹ 2000/3 –2/3 Q = 4 ⟹ 2/3 Q = 1988/3
So, Q = 1988/2 = 994
 Then, P = 2000/3 – 1/3 (994) = 335.33
Profit = TR – TC = P.Q – TC = (335.33)(994) – 4 (994) = 329345.33

(e) Now, assume that the market consists of two monopolists facing same market demand: Q = 1000 - P, where

Q = Q 1 + Q 2 , and each has a total cost function Ci (Qi) = 4Qi. The two firms decide to form a cartel and act like
a single firm. Determine the equilibrium price, the quantities and the profits, assuming that both produce one-
half of the cartel quantity and share profits equally.
Q = 1000 – P ⟹ P = 1000 – Q ⟹ MR = 1000 – 2 Q
MC = 4 ⟹ MR = MC ⟹ 1000 – 2Q = 4 ⟹ 2Q = 996 ⟹ Q = 498 (so each will produce 249)
Then, P = 1000 – 498 = 502
Profit = TR – TC = P.Q – TC = (502)(498) – 4 (498) = 248004 (so each will make 124002)
(f) Now, assume that the market consists of two monopolists facing same market demand: Q = 1000 - P, where
Q = Q 1 + Q 2, and each has a total cost function Ci (Qi) = 4Qi , determine the equilibrium price, the quantities
and the profits for each firm if the two firms choose quantities simultaneously in a Cournot (quantity-setting)
equilibrium.
Q = 1000 – P ⟹ P = 1000 – Q = 1000 - Q 1 - Q 2
Π1 = PQ1 – TC1 = (1000 - Q 1 - Q 2) Q1 – 4Q1 = 1000 Q1 – Q12 - Q1Q 2 – 4Q1
𝝏𝝅𝟏
= 0 ⟹ 1000 – 2Q1 – Q2 – 4 = 0
𝝏𝑸𝟏

2Q1 = 1000 - Q2 – 4 ⟹ Q1 = 498 – 0.5Q2 …………………(1)

Π2 = PQ2 – TC2 = (1000 - Q 1 - Q 2) Q2 – 4Q2 = 1000 Q2 - Q1Q 2 – Q22– 4Q2

𝝏𝝅𝟐
= 0 ⟹ 1000 – Q1 – 2Q2 – 4 = 0
𝝏𝑸𝟐
2Q2 = 1000 – Q1 – 4 ⟹ Q2 = 498 – 0.5Q1…………………(2)

Plug (2) into (1):

Q1 = 498 – 0.5(498 – 0.5Q1)
Q1 = 498 – 249 + 0.25Q1
0.75 Q1 = 249
Q1 = 332 = Q2 ⟹ Q = Q1 + Q2 = 332 + 332 = 664

Then, P = 1000 – 664 = 336

Profit (for each) = TR – TC = P.Q – TC = (336)(332) – 4(332) = 110224 (so each will make 110224)
(g) Now, assume that the market consists of two monopolists facing same market demand: Q = 1000 - P, where
Q = Q 1 + Q 2, and each has a total cost function Ci (Qi) = 4Qi , determine the equilibrium price, the quantities
and the profits for each firm if the two firms choose quantities sequentially in a Stackelberg model (leader-
follower setting), where Firm 1 moves first (leader).
Π1 = PQ1 – TC1 = (1000 - Q 1 - Q 2) Q1 – 4Q1
Leader knows reaction of Firm 2: Q2 = 498 – 0.5Q1

Π1 = {1000 - Q 1 – (498 – 0.5Q1)} Q1 – 4Q1

Π1 = {1000 - Q 1 – 498 + 0.5Q1} Q1 – 4Q1
= {502 – 0.5Q 1} Q1 – 4Q1 = 502Q1 – 0.5Q12 - 4Q1

Then, Π1 = 498Q1 – 0.5Q12

𝝏𝝅𝟏
= 0 ⟹ 498 – Q1 = 0 ⟹ Q1 = 498
𝝏𝑸𝟏
Then, Q2 = 498 – 0.5 (498) = 249
Total Q = 498 +249 = 747
Then, P = 1000 – 747 = 253

Π1 = PQ1 – TC1= (253)(498) – 4(498) = 124002

Π2 = PQ2 – TC2 = (253)(249) – 4(249) = 62001

Problem 2 (50 points)

2
Kyle produces chocolate bars with a fixed cost of 16. His variable cost function is: VC = Q + 2Q.
(a) Assuming the market for chocolate bars is competitive, derive Kyle’s supply function?
Supply is MC above minimum AVC: MC = 2Q + 2 = P
Q = 0.5 P - 1
Minimum AVC:
AVC = Q + 2
AVC = MC ⟹ Q + 2 = 2Q + 2 ⟹ Q = 0
⟹ at Q = 0 : AVC = 0 + 2 = 2 = P

Qs = 0.5 P – 1 , when P ≥ 2
{ Qs = 0 , when P < 2
(b) What is Kyle’s production level if the market price is 12? What is his profit?
P = MC = 12
12 = 2Q + 2 ⟹ Q = 5
Π = PQ – TC = (12)(5) – {16 + (5)2 + 2(5)} = 9

(c) Redo part (b) if the market price is 6? Does he want to stay in this market? Explain.
P = MC = 6
6 = 2Q + 2 ⟹ Q = 2
Π = PQ – TC = (6)(2) – {16 + (2)2 + 2(2)} = - 12 (loss)
Since, VC = (2)2 + 2(2) = 8, and TR > VC ⟹ he is staying

(d) Use a graph to show the case of part (c). No numbers are required.
(e) At what price Kyle will have a break-even case (Normal profit)? Explain.
P = MC = min ATC to get Normal Profits
Minimum ATC at: MC = ATC
16/Q + Q + 2 = 2Q + 2
⟹ Q = 16/Q ⟹ Q 2 = 16 ⟹ Q = 4
ATC = 16/4 + 4 + 2 = 10
So at P = 10, the firm will be at Normal profits.