University of Economics, HCMC MBA Program

International School of Business PS 2

ECONOMICS PG
PROBLEM SET 2 ANS
Due date:
1. Answer the questions below using the cost curves for the price-taking firm shown in the following
graph:

a. If price is $7 per unit of output, draw the marginal revenue curve. The manager should produce
_______________ units to maximize profit?
b. Because average total cost is $___________ for this output, total cost is $ _____________.
c. The firm makes a profit of $ _______________.
d. At __________units, profit margin (or average profit) is maximized. Why is this output level
different from the answer to part a?
e. Let price fall to $3, and draw the new marginal revenue curve. The manager should now produce
________________units to maximize profit.
f. Total revenue is now $ ________and total cost is $ ____________. The firm makes a loss of $
__________.
g. Total variable cost is $_____________, leaving $___________ to apply to fixed cost.
h. If price falls below $____________, the firm will produce zero output. Explain why?

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University of Economics, HCMC MBA Program
International School of Business PS 2
ANS
a. If price is $7 per unit of output, draw the marginal revenue curve. The manager should produce 600
units to maximize profit?
b. Because average total cost is $5 per unit for this output, total cost is $3,000 (=$5 x 600).
c. The firm makes a profit of $ 1,200 (= 7 x 600 – 5 x 600).
d. At __500________units, profit margin (or average profit) is maximized. Why is this output level
different from the answer to part a? Because at Q = 500 profit margin (P- ATC) is maximized but
total profit is not maximized [$1,100 (=7*500 – 4.8*500) < $1,200]
e. Let price fall to $3, and draw the new marginal revenue curve. The manager should now produce
_400__units to maximize profit.
f. Total revenue is now $1,200 (=$3 x 400) and total cost is $2,000 (= 5 x 400). The firm makes a loss
of $800 (=1,200 – 2,000).
g. Total variable cost is $ 800 (=2x 400), leaving $ 1200 to apply to fixed cost.
h. If price falls below $1.75, the firm will produce zero output. Explain why? Because if price falls
below $1.75 => P < AVCmin the more this firm produces the larger the loss it faces.

2. Suppose that the manager of a firm operating in a competitive market has estimated the firm’s
average variable cost function to be
AVC = 10 - 0.03Q + 0.00005Q2
Total fixed cost is $600.
a. What is the corresponding marginal cost function?
b. At what output is AVC at its minimum?
c. What is the minimum value for AVC?
If the forecasted price of the firm’s output is $10 per unit:
d. How much output will the firm produce in the short run?
e. How much profit (loss) will the firm earn?
If the forecasted price is $7 per unit:
f. How much output will the firm produce in the short run?
g. How much profit (loss) will the firm earn?
If the forecasted price is $5 per unit:
h. How much output will the firm produce in the short run?
i How much profit (loss) will the firm earn?
ANS
a. What is the corresponding marginal cost function?
AVC = 10 – 0.03Q + 0.00005Q2
TVC = AVC*Q = 10Q – 0.03Q2 + 0.00005Q3

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University of Economics, HCMC MBA Program
International School of Business PS 2
MC = TVC/Q = 10 – 0.06Q + 0.00015Q2
b. At what output is AVC at its minimum?
AVC = MC

10 – 0.03Q + 0.00005Q2 = 10 - 0.06Q+0.00015Q2

0.0001Q2 - 0.03Q = 0

Q (0.0001Q - 0.03) = 0

Q = 0 or Q =0.03/0.00010 = 300 units

c. What is the minimum value for AVC?

At Q = 300, AVC = 10-0.03(300)+0.00005(3002) = $5.5 (minimum)

If the forecasted price of the firm’s output is $10 per unit:

d. How much output will the firm produce in the short run?
If P = $10 per unit
P = MC
10 = 10 – 0.06Q + 0.00015Q2
0.06Q - 0.00015Q2 = 0
Q(0.06 - 0.00015Q) = 0
Q = 0, or Q = 0.06/0.00015 = 400 units
At Q=400 units
AVC = 10 – 0.03Q + 0.00005Q2
AVC = 10 – 0.03(400) + 0.00004 (4002) = $6 (minimum) < P = $10
In the short run, firm will only produce 400 units at the price of $10 to maximize profit

e. How much profit (loss) will the firm earn?

Profit = TR – TC
= (P x Q) – (FC + VC)
= (P x Q) – (600+10Q-0.03Q2+0.00005Q3)
= (10 x 400) – (600 + 10(400) – 0.03(4002) + 0.00005(4003))
= 4,000 – 3,000
= $1,000
If the forecasted price is $7 per unit:
f. How much output will the firm produce in the short run?

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University of Economics, HCMC MBA Program
International School of Business PS 2
If P = $7 per unit
P=MC
$7 = 10 - 0.06Q + 0.00015Q2
0.00015Q2 - 0.06Q + 3= 0

We solve the Q using quadratic formula below:

ax2+bx+c=0 (a≠0)

Q1=341.42 ~ 341 units ; or Q2=58.57 ~ 59 units

At Q = 341 units,
AVC = 10 – 0.03Q + 0.00005Q2
AVC = 10 - 0.03(341) + 0.00005(341)2 = $5.58 (minimum) < P =$7

In the short run, firm will only produce 341 outputs at the price of $7.

At Q = 59 units,
AVC = 10 – 0.03Q + 0.00005Q2
AVC = 10 - 0.03(59) + 0.00005(59)2 = $8.4 (minimum) > P =$7

In the short run, firm should shut down.

g. How much profit (loss) will the firm earn?

Profit = TR – TC
= (P x Q) – (FC + VC)
= (P x Q) – (600 +10Q-0.03Q2 + 0.00005Q3)
= (7 x 341) – (600 +10(341) - 0.03(3412) + 0.00005(3413))
= 2387 - 2504
= - $117 (Loss)

If the forecasted price is $5 per unit:

h. How much output will the firm produce in the short run?
If P = $5 per unit
P=MC
$5 = 10 - 0.06Q + 0.00015Q2
0.00015Q2 - 0.06Q + 5= 0

Solving using the quadratic formula:

ax2+bx+c=0 (a≠0)

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University of Economics, HCMC MBA Program
International School of Business PS 2
Q1=118.35 ~ 118 units; or Q2=281.65 ~ 282 units

At Q = 118 units,
AVC = 10 – 0.03Q + 0.00005Q2
AVC = 10 - 0.03(118) + 0.00005(118)2 = $7.1 (Minimum) > P = $5
Firm should shut down

At Q = 282 units,
AVC = 10 – 0.03Q + 0.00005Q2
AVC = 10 - 0.03(282) + 0.00005(282)2 = $5.51 (minimum) > P = $5

In this case, firm should shut down

i How much profit (loss) will the firm earn?

Profit = TR – TC
= (PxQ) – (FC + VC)
= (PxQ) – (600 + 10Q - 0.03Q2 + 0.00005Q3)
= 0 – 600 = -600
Since firm shuts down it has to pay only fixed costs

3. The manager of a monopoly firm obtained the following estimate of the demand func tion for its
output:
Q = 2,600 − 100P + 0.2M − 500PR
From an econometric forecasting firm, the manager obtained forecasts for the 2022 values of M and
PR as, respectively, $20,000 and $2. For 2022 what is:
a. The forecasted demand function?
b. The inverse demand function?
c. The marginal revenue function?
The manager estimated the average variable cost function as
AVC = 20 − 0.07Q + 0.0001Q2
where AVC was measured in dollars per unit and Q is the number of units sold.
d. What is the estimated marginal cost function?
e. What is the optimal level of production in 2022?
f. What is the optimal price in 2022?
g. Check to make sure that the firm should actually produce in the short run rather than shut down.
In addition, the manager expects fixed costs in 2022 to be $22,500.
h. What is the firm’s expected profit or loss in 2022?

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University of Economics, HCMC MBA Program
International School of Business PS 2
ANS:
a. The forecasted demand function?
Q = 2,600 − 100P + 0.2M − 500PR
Q = 2,600 – 100P + 0.2(20,000) – 500(2)
Q = 5,600 – 100P
b. The inverse demand function?
Q = 5,600 – 100P
100P = 5,600 - Q
P = 56 – 0.01Q
c. The marginal revenue function?
TR = P*Q = (56 – 0.01Q)*Q
MR = TR/Q = 56 – 2(0.01)Q
MR = 56 – 0.02Q
The manager estimated the average variable cost function as
AVC = 20 − 0.07Q + 0.0001Q2
where AVC was measured in dollars per unit and Q is the number of units sold.
d. What is the estimated marginal cost function?
TVC = AVC * Q = (20 − 0.07Q + 0.0001Q2)*Q = 20Q − 0.07Q2 + 0.0001Q3
MC = TVC/Q = 20 – 2(0.07)Q + 3(0.0001)Q2
MC = 20 – 0.14Q + 0.0003Q2

e. What is the optimal level of production in 2022?

Set MR = SMC
56 – 0.02Q = 20 – 0.14Q + 0.0003Q2
0.0003Q2 – 0.12Q – 36 = 0
Solving using the quadratic formula:
ax2+bx+c=0 (a≠0)

=> Q* = 600 units

f. What is the optimal price in 2022?

P*= 56 – 0.01Q = 56 – 0.01(600) = $50

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University of Economics, HCMC MBA Program
International School of Business PS 2
g. Check to make sure that the firm should actually produce in the short run rather than shut down.
AVC600= 20 − 0.07(600) + 0.0001(6002)
AVC600= $14
Since P* = $50 > AVC600= $14
Therefore the firm should actually produce in the short run.

In addition, the manager expects fixed costs in 2022 to be $22,500.

h. What is the firm’s expected profit or loss in 2022?
π = TR − TVC – TFC
= ($50 x 600) – ($14 x 600) - $22,500
= -$900

4. Find the solution to the following advertising decision game between Coke and Pepsi by using the
method of successive elimination of dominated strategies.

a. Does Coke have a dominated strategy in the original payoff table? If so, what is it and why is it
dominated? If not, why not?
b. Does Pepsi have a dominated strategy in the original payoff table? If so, what is it and why is it
dominated? If not, why not?
c. After the first round of eliminating any dominated strategies that can be found in the original
payoff table, describe the strategic situation facing Coke and Pepsi in the reduced payoff table.
d. What is the likely outcome of this advertising decision problem?
e. Pepsi’s highest payoff occurs when Coke and Pepsi both choose high ad budgets.
Explain why Pepsi will not likely choose a high ad budget.
ANS
a. Does Coke have a dominated strategy in the original payoff table? If so, what is it and why is it
dominated? If not, why not?
ANS: Coke does have a dominated strategy which is High since given strategies chosen by
Pepsi Coke never chooses High
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University of Economics, HCMC MBA Program
International School of Business PS 2

b. Does Pepsi have a dominated strategy in the original payoff table? If so, what is it and why is it
dominated? If not, why not?
ANS: For Pepsi, Low is a dominated strategy because regardless what Coke chooses, Pepsi
nevers chooses Low.

c. After the first round of eliminating any dominated strategies that can be found in the original
payoff table, describe the strategic situation facing Coke and Pepsi in the reduced payoff table.
ANS:
Pepsi
Medium High
Coke Low $320 $720 $560 $600
Medium $450 $525 $540 $500

d. What is the likely outcome of this advertising decision problem?

ANS: E (Medium, Medium); Pepsi will definitely choose Medium, therefore Coke will
choose Medium too
e. Pepsi’s highest payoff occurs when Coke and Pepsi both choose high ad budgets.
Explain why Pepsi will not likely choose a high ad budget.
ANS: Yes, Pepsi’s highest payoff occurs when Coke and Pepsi both choose high ad budgets.
However, Coke will never choose high budget since it is a dominated strategy, therefore, Pepsi
will not likely choose a high ad budget

5. Sony and Zenith must each decide which technology to utilize in building their 2005 model high
definition television (HDTV) sets: either Alpha technology or Beta technology. Sony has a technological
advantage in using Alpha technology and Zenith has a technological advantage in using Beta technology.
The payoff table below shows the profit outcomes for both firms in the various possible technology
choice outcomes.

Suppose the technology decision between Alpha and Beta will be made simultaneously. Answer the
following questions:

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University of Economics, HCMC MBA Program
International School of Business PS 2
a. Sony’s dominant strategy is _______________(Alpha, Beta, neither: it has no dominant strategy).
b. Zenith’s dominant strategy is _______________(Alpha, Beta, neither: it has no dominant strategy).
c. This simultaneous decision game has TWO Nash equilibrium cells: _______ (A, B, C, D) and ______
(A, B, C, D).
Now suppose that Sony decides to make a strategic commitment to one of the technologies so that it can
make the first move in a sequential decision game.
d. Complete the following game tree for the sequential game in which Sony moves first, by filling in the
blanks using the information in the preceding payoff table.

e. For the sequential game in part d, use the roll-back method to find the Nash equilibrium decision path.
Circle this decision path on the game tree above. Sony earns a profit of $__________ and Zenith earns a
profit of $________.
Suppose instead that Zenith decides to make a strategic commitment to one of the technologies so that it
can make the first move in a sequential decision game.
f. Complete the following game tree for the sequential game in which Zenith moves first, by filling in the
blanks using the information in the payoff table.

For the sequential game in part f, use the roll-back method to find the Nash equilibrium decision path.
Circle this decision path on the game tree above. Sony earns a profit of $__________ and Zenith earns a
profit of $________.
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University of Economics, HCMC MBA Program
International School of Business PS 2
h. Does either firm have a first-mover advantage? Explain.
i. Does either firm have a second-mover advantage? Explain.
ANS

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University of Economics, HCMC MBA Program
International School of Business PS 2
6. Texas Petroleum Company is a producer of crude oil that is considering two drilling projects with
the following profit outcomes and associated probabilities:

a. Compute the expected profit for both drilling projects.

E(ProfitA) = __________ and E(ProfitB) = __________
b. Based on the expected value rule, Texas Petroleum should choose drilling project _______.
c. Compute the standard deviations of both projects:
σA = __________ and σB = __________
d. Which drilling project has the greater (absolute) risk?
_______________________________________________________________________________
_______________________________________________________________________________
e. Use mean-variance rules, if possible, to decide which drilling project to undertake. Explain.
f. Compute the coefficient of variation for both projects:
υA = __________ and υB = __________
Using the coefficient of variation rule, Texas Petroleum should choose project _____.

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University of Economics, HCMC MBA Program
International School of Business PS 2

227,475,000,000
227,475,000,000 476,943

B A σA<σB

7. Suppose the manager of a firm has a utility function for profit U(π) = 12ln(π ), where π is the dollar
amount of profit. The manager is considering a risky project with the following profit payoffs and
probabilities:

a. The expected profit is _______________.

b. The expected utility of profit is _____________.
c. Fill in the blanks in the following table showing the marginal utility of an additional $1,000 of profit.
d. The manager is risk _________ because the marginal utility of profit is __________.

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University of Economics, HCMC MBA Program
International School of Business PS 2

8. Two used car dealerships compete side by side on a main road. The first, Harry's Cars, always sells
high quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry's
$8000to buy and service each car that it sells. The second dealership, Lew's Motors, always sells
lower-quality cars. On average, it costs Lew's only $5000 for each car that it sells. If consumers knew
the quality of the used cars they were buying, they would pay $10,000on average for Harry's cars and
only $7000 on average for Lew's cars.
Without more information, consumers do not know the quality of each dealership's cars. In this case,
they would figure that they have a 50-50 chance of ending up with a high-quality car and are thus
willing to pay $8500for a car. Harry has an idea: He will offer a bumper-to-bumper warranty for all
cars that he sells. He knows that a warranty lasting Y years will cost $500Y on average, and he also
knows that if Lew tries to offer the same warranty, it will cost Lew $1000Y on average.
a. Suppose Harry offers a one-year warranty on all of the cars he sells.
i. What is Lew's profit if he does not offer a one-year warranty? If he does offer a one-year
warranty?
πL(No warranty)=7000-5000=2000$
πL(Warranty)=8500-5000-1000=2500$
ii. What is Harry's profit if Lew does not offer a one-year warranty? If he does offer a one-year
warranty?
πH(No warranty by Lew)=10000-8000-500=1500$
πH(Warranty by Lew)=8500-8000-500=0$
iii. Will Lew's match Harry's one-year warranty?
Yes because it is his best-response.
iv. Is it a good idea for Harry to offer a one-year warranty?
No. Because Lew will imitate Harry and Harry will end up with no profit at all.
b. What if Harry offers a two-year warranty? Will this offer generate a credible signal of quality?
What about a three-year warranty?
πL(No Warranty)=7000-5000=2000$
πL(Warranty)=8500-5000-2000=1500$
πH(No Warranty from Lew)=10000-8000-1000=1000$
πH(Warranty from Lew)=8500-8000-1000=-500$
The offer generates a credible signal about the quality of Harry’s cars because it is too costly for Lew
to imitate. The signal generates a separating equilibrium.
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University of Economics, HCMC MBA Program
International School of Business PS 2
c. If you were advising Harry, how long a warranty would you urge him to offer? Explain why.
We want Lew’s profits to be higher without the warranty than with so he doesn’t imitate Harry.
πL(No warranty) >πL(warranty)
7000-5000 > 8500 – 5000 – 1000t
2000 > 3500 -1000t
1500 < 1000t
1.5 < t
A warranty of a year and a half is sufficient to generate a seperating equilibrium.

9. As chairman of the board of ASP Industries, you estimate that your annual profit is given by the
table below. Profit (II) is conditional upon market demand and the effort of your new CEO. The
probabilities of each demand condition occurring are also shown in the table.

You must design a compensation package for the CEO that will maximize the firm's expected profit.
While the firm is risk neutral, the CEO is risk averse. The CEO's utility function is
Utility = W0.5 when making low effort;
Utility = W0.5 -100 when making high effort;
where W is the CEO's income. (The -100 is the "utility cost" to the CEO of making a high effort.)
You know the CEO's utility function, and both you and the CEO know all of the information in the
preceding table. You do not know the level of the CEO's effort at time of compensation or the exact
state of demand. You do see the firm's profit, however. Of the three alternative compensation
packages below, which do you as chairman of ASP Industries prefer? Why?
Package 1: Pay the CEO a flat salary of $575,000 per year
Facing a flat salary of $575,000 per year, the CEO has no incentive to make a high level of effort.
Therefore, that a fixed payment will lead to an inefficient outcome. The chairman will earn an
expected profit of $10 million.

Package 2: Pay the CEO a fixed 6 percent of yearly firm profits

Expected Salary (low effort) = $600,000
Expected Salary (high effort) = $ 846,000
Utility (low effort) = 774.5966692
Utility (high effort) = 819.782583

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University of Economics, HCMC MBA Program
International School of Business PS 2
Under this package, the CEO will choose to make a high level of effort. This arrangement makes
the owners better off than before because they get an expected profit of $14,100,000 and a net
expected profit of $13,254,000

Package 3: Pay the CEO a flat salary of $500,000 per year and then 50 percent of any firm profits
above $15 million
If  = $5; $10 or $15 million => Expected Salary = $500,000 => Utility (1) = 707.1067812
If  = $17 billion => Expected Salary = 0.3*$500,000$+ 0.4*$500,000$ + 0.3*[500,000 +
50%*(17,000,000 – 15,000,000)] = $800,000 => Utility (2) = 794 > Utility (1)
Under this package, the CEO will choose to make a high level of effort. This arrangement makes
the owners better off than before because they get an expected profit of $14,100,000 and a net
expected profit of $ 13,300,000.

 As chairman of ASP Industries, I prefer package 3 because both package 2 and 3 reward the
outcome of high levels of effort of the CEO, but at package 3, I have to pay less for the CEO and
my net expected profit increases.

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