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Department of Economics ECO 204 Microeconomic Theory for Commerce 2012 2013 Ajaz Hussain
Test 3 Solutions

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published by the Faculty of Arts and Sciences.

Exam details:
Duration: 1 hour and 50 minutes
Total number of questions: 4 (see last page of test for breakdown of points)
Total number of pages: 22 (including title page)
Total number of points: 100

Please answer all questions. To earn credit you must show all calculations. Please see last page of this exam for the allocation of points
across questions.

Exam aids:
This is a closed note and closed book exam.
You may use a non-programmable calculator. Sharing is not allowed.

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ALL QUESTIONS MUST BE ANSWERED SEQUENTIALLY. THAT IS, QUESTION 1 THEN QUESTION 2 AND
SO ON. KEEP ANSWERS SHORT AND TO THE POINT. DO NOT WASTE TIME GIVING UNECCESARILY LONG
ANSWERS AND WATCH THE TIME.
Question 1 [20 POINTS]
A company produces output according to the Cobb-Douglas production function

where . Let

price of labor,

price of capital, and the companys target output (assume ).

Solve this companys long run CMP and derive expressions for the optimal labor and capital in terms of the parameters

(but do not solve for any Lagrange multipliers and the cost function). Show all calculations and state all
assumptions. You are expected to solve this problem by using the appropriate constrained optimization method.
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Question 2 [25 POINTS]
Ajax Inc. produces output according to the Cobb-Douglas production function

where . Currently,

and

.
(2.1) [5 POINTS] THIS PART IS INDEPENDENT OF ALL OTHER PARTS BELOW In order to triple its output, will Ajax scale up all inputs
by a factor greater than, smaller than, equal to . ? Give a brief explanation.









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(2.2) [5 POINTS] Use your answer to Question 1 to derive Ajaxs optimal mix of inputs and its cost function for producing
an arbitrary target output . Show all calculations and state all assumptions.



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(2.3) [5 POINTS] THIS PART IS INDEPENDENT OF ALL OTHER PARTS BELOW Without solving the following problem use economic
intuition to derive values for Ajaxs optimal Lagrange multipliers

in the following Lagrangian equation:

Show all calculations and state all assumptions.

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(2.4) [5 POINTS] THIS PART IS INDEPENDENT OF ALL OTHER PARTS BELOW What is the impact on Ajaxs optimal labor and capital (in
percentage terms) due to a 1% increase in the price of capital? Show all calculations and state all assumptions. Hint: Use
your answer to Question 1.
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ECO 204, 2012 - 2013, Test 3
This test is copyright material and cannot be used for commercial purposes or posted anywhere without prior permission. Report violations to eco.204@utoronto.ca
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(2.5) [5 POINTS] Suppose Ajax Inc. sells its product into a competitive market and has a production capacity of
units. Please graph Ajaxs competitive supply curve below assuming that Ajax is irrational and Ajax is
rational.
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Question 3 [25 POINTS]
Adam Inc. produces output according to the complements production function ( ) where .
Currently,

and

(same as Ajaxs price of labor and capital).

(3.1) [5 POINTS] THIS PART IS INDEPENDENT OF ALL OTHER PARTS BELOW Without solving Adams long run Cost Minimization
Problem give a brief explanation on whether (and why) Adams or .







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(3.2) [5 POINTS] Use your answers to questions 1 and 2 to show that if Adam Inc. always uses the same amount of labor
and capital as Ajax Inc. (in question 2) to produce output then Adams production is (

). Show all
calculations and state all assumptions.



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(3.3) [5 POINTS] THIS PART IS INDEPENDENT OF ALL OTHER PARTS BELOW How many units of capital does Adam Inc. use per unit of
labor? Give a brief explanation.




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(3.4) [5 POINTS] Derive Adams cost function and indicate whether it exhibits economies of scale, constant scale
economies, or diseconomies of scale. Show all calculations and state all assumptions.






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(3.5) [5 POINTS] What is the impact on Adams total cost of production (in percentage terms) due to a 1% increase in the
price of capital? Show all calculations and state all assumptions.
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Question 4 [30 POINTS]
Suppose Adam Inc. (from question 3) is a dominant firm with market power.
(4.1) [5 POINTS] THIS PART IS INDEPENDENT OF ALL OTHER PARTS BELOW In practice, how would we measure/confirm that Adam is
a dominant firm? Give a brief explanation.









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(4.2) [5 POINTS] Suppose Adam Inc.s management (from question 3) believes that next month theres a 80% chance that
the demand curve will be and a 20% chance that the demand curve will be where
units and $/unit. Solve Adams ex-ante uncertainty Profit Maximization Problem (PMP) for the optimal price and
output given that Adams capacity is of the maximum potential market size. You are expected to solve this
problem by using the appropriate constrained optimization method. Show all calculations and state all assumptions. In
this problem you can assume that and that capacity. Hint: You derived Adams cost function in question 3.

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(4.3) [5 POINTS] Use the optimal price rule to confirm that your answer to part (4.2) maximizes Adams expected profits
and indicate whether ex-ante uncertainty Adam should expands its capacity. Show all calculations and state all
assumptions.











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(4.4) [10 POINTS] Suppose that 50% of Adams total cost is the cost of producing output while the remaining 50% is the
cost of shipping this output. Suppose that after Adam has produced the output in part (4.2) but before it is shipped out
its management finds out that the actual demand curve is Solve Adams ex-post uncertainty Profit
Maximization Problem given that another company, Infinity-Ink, has offered to buy an unlimited quantity from Adam at
a profit of $75/unit. You are expected to solve this problem by using the appropriate constrained optimization method.
For this question, you can assume that

capacity (think about what this is) and

.

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(4.5) [5 POINTS] Use the optimal pricing rule to confirm that Adams ex-post uncertainty price is indeed the profit
maximizing price. Show all calculations.