MOUNT KENYA UNIVERSITY

BED1101: INTRODUCTION TO MICROECONOMICS and BED1105: INTRODUCTION TO ECONOMICS

(SEPT- DEC 2020/2021 SEMESTER)

INSTRUCTIONS: ANSWER ALL QUESTIONS

1.) You are a leading consultant with a firm producing milk within Nakuru County. One of your
main roles is to advice the firm on price strategies that would lead to maximize profits. The firm
is a monopolist which sells in two distinct markets, one of which is completely sealed off from
the other.
In line of your assignment, you establish that the total demand for the firms output is given by
the following equation:

Q = 50 – 0.5P

The demand for the firms output in the two markets is:

Q1 = 32 – 0.4P1

Q2 = 18 – 0.1 P2

Where Q= total output

P= Price

Q1= Output sold in market 1

Q2= Output sold in market 2

P1= Price charged in market 1

P2= Price charged in market 2

The total cost of production is given by C= 50 + 40Q, where C= total cost of producing a unit of
milk.

Required:

a) The total output that the firm must produce in order to maximize profits ( 3 marks)
b) What price must be charged in each market in order to maximize profits ( 2 marks)
c) How much profit would the firm earn if it sold the output as a single price, and if the firm
discriminates ( 4 marks)
d) i.) The price elasticity of demand for the two markets at the equilibrium price and
quantity. (4 marks)
ii.) Give a comment on how the price elasticity of demand may be used in making economic
 decisions (3 marks)

Ans: The business firms take into account the price elasticity of demand when they take decisions
regarding pricing of the goods. This is because change in the price of a product will bring about a
change in the quantity demanded depending upon the coefficient of price elasticity.
This change in quantity demanded as a result of, say a rise in price by a firm, will affect the total
consumer’s expenditure and will therefore, affect the revenue of the firm. If the demand for a
product of the firm happens to be elastic, then any attempt on the part of the firm to raise the price
of its product will bring about a fall in its total revenue .

2 a) How does a competitive firm determine its profit maximizing level of output? When does a

profit maximizing competitive firm decide to shut down? When does a profit maximizing firm
decide to exit the market? Please illustrate graphically. (5 marks)

Ans: When a competitive firm doubles the amount it sells, the price remains the same, so its total
revenue doubles.

-The price faced by a profit-maximizing firm is equal to its marginal cost because if price were above
marginal cost, the firm could increase profits by increasing output, while if price were below
marginal cost, the firm could increase profits by decreasing output.

- A profit-maximizing firm decides to shut down in the short run when price is less than average variable
cost. In the long run, a firm will exit a market when price is less than average total cost.

b) Draw the demand, marginal revenue, average total cost, marginal cost curves for a monopolist.
Show the profit maximizing level of output, the profit maximizing price, and the amount of
Profit.
price

profit
Pm
ATCm

MC
ATC

E
F

Demand
 G
Qm Quantity

MR
The monopoly firm maximizes profit by producing an output Qm at point G,
where the marginal revenue and marginal cost curves intersect. It sells this output at price Pm.

- The profit-maximizing price are given by point E on the demand curve.

-  The amount of profit is found by multiplying the firm’s output, Qm, by profit per unit

c) Define price ceiling and price floor give an example of each. Which leads to shortage and
which leads to surplus?
Ans:price ceiling-It’s the maximum price a product must be sold. Normally it’s below the
market equilibrium price
Price floor-It’s the minimum price a product must be sold and its normally above the
equilibrium market price

-When a price ceiling is set below the equilibrium price, quantity demanded will
exceed quantity supplied, and excess demand or shortages will result.
- When a price floor is set above the equilibrium price, quantity supplied will
exceed quantity demanded, and excess supply or surpluses will result.

Jesse Ndegwa. M. 0725420492