Problem Set #3

SOLUTIONS
I. Elasticity

1.) Suppose that the monthly demand for housing in Anchorage is QD = 10000 –10P.

a.) Using the formula for elasticity we have described in class, suppose that the initial
price is $400 dollars, calculate the price elasticity of demand between a price of $500 and
$400. Explain the meaning of your answer using the concept of elasticity.
QD at P = $500 is equal to 5,000 and QD is 6,000 when P = $400. Using the formula
for price elasticity of demand we have,

Q2 Q1 6,000 5,000 1000

(Q2 Q1 ) / 2 (6,000 5,000) / 2 11,000 / 2 2,000 900 2 9 9
   *  *  .8181 1
P2 P1 400 500 100 11,000 200 11 2 11
(P2 P1 ) / 2 (400 500) / 2 900 / 2

Demand is inelastic and is equal to .8181. A one percentage increase in the price of
housing results in a decline of housing of roughly .82%, or a 10%’age increase in the
price of housing results in a decline of housing of roughly 8.2%.

b.) Suppose that the prevailing price is $400. Would you recommend an increase in the
price to $500, why or why not? Explain using the concept of elasticity. If not, describe
the conditions under which you could make such a recommendation.
Yes, because demand is inelastic, increasing the price would increase TR and
decrease TC –unambiguously increasing profit.

c.) Calculate the total revenue first from the sale of houses at a price of $400 and then at a
price of $500. Do you reach a different conclusion regarding the effect of the increase in
price?
TR(price = $400) = $400*6,000 = $24,000
TR(price = $500) = $500*5,000 = $25,000
No, the conclusion is the same. Total revenues increase and total costs decrease as
described above. Profit would increase with an increase in price.

d.) Suppose that when an average customers income increases rises from $18,000 to
$22,000 per year, annual housing purchases increase from 5,500 units to 6,700 units.
Calculate the income elasticity of demand. Is housing a normal good? Why or why
not?
Q2 Q1 6,700 5,500 1200
(Q2 Q1 ) / 2 (6,700 5,500) / 2 12,200 / 2 2,400 40,000 24 40 60
   *  *  .98 0
I2 I1 22,000 18,000 4,000 12,200 8,000 122 8 61
(I2 I1 ) / 2 (22,000 18,000) / 2 40,000 / 2
We can clearly see from the above that housing is a normal good. As income
increases demand for coffee beans increases. A one-percentage increase in income
will increase demand for housing by roughly .98%.

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 Problem Set #3
SOLUTIONS
e.) If the monthly price of rental housing increased by 20% from $400 to $480, use the
concept of cross-price elasticity to carefully explain the impact of this price change on
the demand for townhouses (assuming that the price of other types of housing has
remained relatively constant).
If price increases and houses and townhouses are substitutes then we would expect
the quantity demanded of townhouses to increase –that is, the cross-price elasticity
of demand between houses and townhouses is positive. Similarly, if the price of
houses increased but the quantity demanded of townhouses decreased cross price
elasticity would be negative and we would classify the goods as complements.

f.) Under what condition would you unambiguously recommend a firm to increase their
price?
If a firm is operating on the inelastic portion of their demand curve, an increase in
the price will increase total revenues and decrease total costs unambiguously
increasing profits. As in part (e) above, when a firm is operating on the unit elastic
portion of their demand curve increasing the price does not change total revenue
but it does decrease total costs, consequently profit increases.

S
III. Optimal Choice of Inputs

Jewel was recently was hired to manage Durable Jeans Inc.. The shop sells jeans for $50
each. The fixed cost of keeping the factory open is $200 per day. Jewel is trying to
decide how many workers to employ at $50 per day. Here is some relevant data:

QWorkers TPP MPPL MRPL

0 0 -- --
1 5 5 250
2 15 10 500
3 20 5 250
4 23 3 150
5 24 1 50
6 23 -1 -50

a. The marginal physical product of the 4’

th worker is what? 3.

b. The marginal revenue of product of the 2’

nd worker is what? $500.

c. To minimize costs (and consequently to maximize profits), the store should employ
how many workers? 5 workers (Price of labor = marginal revenue product of
labor)

d. What is the profit maximizing level of output? Does it differ from your answer in
part c? What is the amount of profit? 5 –no –the amount of profit is TR = 24*50
= 1200 minus TC = 5*50 + 200 = 450.

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 Problem Set #3
SOLUTIONS

e. Does the principle of diminishing returns to labor seem to apply in the above
example? Explain how this concept is related to increasing marginal costs.
Yes, as the amount of labor used increases (holding all other inputs constant) the
marginal product of each additional worker declines. Because each additional
unit contributes less to total output, in order to increase total output a firm must
increase their use of inputs at an increasing rate. Consequently, costs are
increasing.

III. Perfect Competition: Long Run and Short Run

Suppose that a representative firm in the perfectly competitive grape juice industry is
producing at a point where price per gallon is equal to $1.50, marginal cost is $1.50,
average cost is $1.50 and quantity is 100 gallons per day. There are 10 such firms in the
industry.

a. Use the space below to illustrate this equilibrium. In the graph at left draw the
industry supply and demand curves, being sure to give values for industry price and
quantity based on the given information. In the graph at right illustrate the cost curves
(average cost, marginal cost and average variable cost) and marginal revenue for the
typical juice firm. Also label price and quantity for the representative firm.
Price
P, MC,
AC, AVC MC

AC

AVC
1.50
1.50

1000 Quantity 100 Quantity

b. Now suppose that a publicized study conclusively demonstrates that regular

consumption of grape juice greatly reduces the risk of heart disease and also acts as a
preventative agent against the common cold. Answer the following questions:

i.) If most people would like to reduce the effects of the common cold as well as their risk
of heart disease, verbally explain what this new study will do to the industry demand for
juice? P
The tastes and preferences of S
individuals will change. Individuals $2

$1.50
D
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 Problem Set #3
SOLUTIONS
will demand more juice. The market demand curve will shift to the right.

ii) In the graph at right, show how the equilibrium price in the industry might change in
the short-run? If the price does change
and you think the price increases label
the new price $2 and the industry supply P, MC,
AC, AVC MC
at 1500. If you think the price will
decrease, then let the new price be $1 AC
and the new supply 500. $2
AVC
1.75
iii) In the graph at right indicate the cost 1.50
curves and the new marginal revenue
curve for representative firm. If all firms
are identical how many units does the
representative firm now produce? Be
sure to label everything, and make your
answer consistent with the price you
chose in part (ii). 150 Quantity
If there are 10 identical firms in the
industry and industry production is 1500 each firm must produce 150.

iv) In the short run, how does industry supply change? How does the firms quantity
supplied change? If average cost is $1.75 at the profit maximizing level of output after
this increase in demand what is the firms profit? Indicate this region in your graph for
part (iii).

The industry supply curve does not change in the short-run, firms enter the
industry in the long-run. The quantity supplied by the representative firm will
increase in the short run as is shown in part (iii). The price the firm now receives is
greater than minimum average cost. Therefore, total revenue (price x quantity) is
greater than total cost (average cost x quantity) and actual profit is:

TR –TC = $2(150) –$1.75(150) = 37.50

The region of profit is shown in the shaded area above.

c. In the long-run, however, we know that negative and positive economic profits cannot
persist.

i.) What will be the long-run response of grape juice producers to this permanent shift in
demand? Explain how this change in the industry will affect equilibrium price and
equilibrium quantity produced.
Because profits in the industry are greater than the normal rate of return, new
firms will enter the industry. As firm’ s enter the industry, this moves the industry
supply curve to the right. This results in a reduction of the market price and an

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 Problem Set #3
SOLUTIONS
increase in quantity. Equilibrium price will fall and the amount produced by the
industry will increase.

ii.) If firms cost curves don’

t change what will be the long-run price? What is the level of
long-term profits? Assuming 10 firms enter the industry what is the new level of industry
output?
As before the increase in demand, the long run price must be equal to the minimum
of average costs (which equals $1.50 in this case) in order for profits to be equal to
zero, which they must be in the long-run. As before, at this level of output the
representative firm produces 100, if there are now a total of 20 firms (10 have
entered) the total industry output is 2000 (20*100).

iii.) What is necessary for a long-run equilibrium in perfect competition? Identify the
key assumption of the perfect competition model that shapes its long-run equilibrium.
Free entry is the key assumption. Because firms are able to enter the industry, the
industry supply curve shifts to the right. Eventually firms produce at the lower
equilibrium price where economic profits = 0, however, industry output increases.
iv.) In the graph on the bottom left show the effects on the industry supply and demand
resulting from the changes in demand and supply. In the graph on the bottom right, show
the new situation faced by the firm in perfect competition, again in the long-run
equilibrium, again, assume that the firms cost curves have not changed.

Price
S1 P, MC,
S2 AC, AVC
MC
AC

$2 $2 AVC
$1.50
$1.50

D2

1500 2000 Quantity 100 Quantity

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 Problem Set #3
SOLUTIONS
IV. Profit Maximization

Suppose that a perfectly competitive firm faces the following cost conditions:

Quantity Total Fixed Variable Marginal Average Average

Supplied Cost Cost Cost Cost Cost Var. Cost
0 20 20 0 ------ ------ ----
1 25 20 5 5 25 5
2 36 20 16 11 18 8
3 48 20 28 12 16 9.333333
4 70 20 50 22 17.5 12.5
5 100 20 80 30 20 16

i.) The variable cost associated with the fourth unit of production is what? $50

ii.) The minimum price that the firm will operate at in the short-run is what? $5 (=min AVC).

iii) The minimum price that the firm will operate at in the long-run is what? $16 (= min AC)

iv) At the minimum price used for question 2 the firms profit would be what? -$20 ( = $5 –$25 = –$20)

v) At a price of $22 the profit maximizing level of production is what? 4 (the quantity where MR=MC)

vi) At a price of $22 the short run profit for the firm is what? TR –TC = $22(4) –70 = $18

vii) If total costs stay the same and all firms have the same cost conditions the long run price will be
what? $16 ( = min AC)

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