Industrial organization and regulation

Solution, week 1, 2017

For week 2 tutorial

1. Economic cost and economic profit

Alex can work in a factory which pays a daily rate of $100. If Alex chooses
not to work in the factory, he can stay home and make one lamp per day,
with materials costing $20. Recall the opportunity cost of a product is
the value of the best forgone alternative use of the resources employed
in making it. The economic profit of a product is its selling price minus
economic cost.

a. What is the accounting cost of a lamp?

b. What is the opportunity cost of a lamp?

c. What is the economic cost of a lamp?

d. Should Alex make lamp when the market price for lamp is $90?

e. Should Alex make lamp when the market price for lamp is $110?

f. Should Alex make lamp when the market price for lamp is $130?

g. Now suppose a machine is necessary for making lamps. Alex paid

$6000 to rent the machine for one year (365 days, no holidays for
simplicity) on January 1st, 2017. On August 1st 2017, the market
price for lamps is $130. Should Alex make lamp on that day?

h. Continue with question [g.]. On January 1st, 2018, Alex needs to

decide whether to renew the letting contract at the same rent $6000.
He expects the lamp price will stay at $130 throughout the year. The
wage of working in the factory is still %100 per day. Should Alex rent
the machine and make lamp in 2018?

Solutions:

1
 a. The accounting cost of making lamp is $20 per day.

b. The opportunity cost of making lamp is &100 per day.

c. The economic cost is the sum of accounting cost and opportunity

cost, i.e., $120 per day.

d. The price is lower than the economic cost so the economic profit is
90 − 120 < 0. Alex should choose to work in the factory.

e. The price is lower than the economic cost so the economic profit is
110 − 120 < 0. Alex should choose to work in the factory.

f. The price exceeds the economic cost so the economic profit is 1300 −
120 > 0. Alex should choose to make lamp.

g. Yes, because the rent has been paid and should be considered as
sunk cost. This is a short-run decision as the rental contract cannot
be altered. Alex should make lamp given that the lamp price exceeds
the economic cost on that day.

h. No. Now Alex can decide whether to continue to rent the machine.
So the rent is an avoidable cost. If Alex chooses to rent the machine
and make lamps for the whole year, his profit will be

365 × ($130 − $20) − $6000 = $34150.

If he instead works in the factory, he can make 365 × $100 = $36500,

which is higher than $34150.

2. Perfectly competitive equilibrium

Assume that the manufacturing of cell phones is a perfectly competitive

industry. The market demand for phones is described by a linear demand
functions QD = 10 − 14 P . There are twenty manufacturers of cell phones
with the same cost function. The total cost function is given by C(q) =
10q + 20q 2 .

a. Calculate the price elasticity of demand.

b. Show that a firm in this industry maximizes profit by setting q =

max P −10


40
,0 .

2
 P −10


c. Derive the industry supply curve, and show that it is QS = max 2
,0 .

d. Plot the demand and supply curves in the (Q, P ) plane.

e. Show that, in equilibrium, P = 20 and Q = 5.

f. Calculate consumer surplus, producer surplus and social welfare at

the perfectly competitive equilibrium.

g. Now assume the government regulates the cell phones market and sets
price P = 24. Calculate the quantity traded under this regulation.
Calculate consumer surplus, producer surplus and social welfare.

Solutions:
dQD P −P
a. The price elasticity of demand is D = dP QD
= 40−P
.

b. A firm takes price P as given and maximizes its profit π(q) = P q −

(10q + 20q 2 ). The first-order condition yields

P − 10
P − (10 + 40q) = 0 ⇔ q= .
40

Since the quantity cannot be negative, each firm supplies q = max( P −10
40
, 0).

c. Since there are 20 firms, the total supply is 20×max( P −10

40
, 0). There-
fore, QS = max P −10


2
,0 .

d. Draw by yourself.
P −10
e. Given total demand QD = 10− 14 P and total supply QS = max


2
,0 ,
QD = QS implies P = 20 and Q = 5 in equilibrium.

f. Consumer surplus is 21 ×5×20 = 50. Producer surplus is 21 ×10×20 =

25. Total welfare is equal to 75.

g. If P = 24, the demand function implies Q = 4. Consumer surplus

is 12 × 4 × 16 = 32. Producer surplus is measured by the area below
price, above supply curve and up to Q = 4. It is 12 × (18 − 10) × 4 +
(24 − 18) × 4 = 40. The total welfare is 72.