Practice Questions

Q. Ron’s Window Washing Service is a small business that operates in the perfectly competitive
residential window washing industry in Evanston, Illinois. The short-run total cost of
production is STC(Q) = 40+ 10Q + 0.1Q2, where Q is the number of windows washed per day.
The corresponding short-run marginal cost function is SMC(Q) = 10 + 0.2Q. The prevailing
market price is $20 per window
a) How many windows should Ron wash to maximize profit
b) What is Ron’s maximum daily profit
c) What is Ron’s short-run supply curve, assuming that all of the $40 per day fixed costs are sunk?

Solution:
In order to maximize profit Ron should operate at the point where P = MC .
20 = 10 + 0.20Q
Q = 50

b) Ron’s profit is given by  = TR − TC .

 = 20(50) − (40 + 10(50) + 0.10(50) 2 )
 = 210
If all fixed costs are sunk, then ANSC = AVC = (10Q + 0.1Q2)/Q = 10 + 0.1Q. So the first
step is to find the minimum of ANSC by setting ANSC = SMC, or 10 + 0.1Q = 10 + 0.2Q
which occurs when Q = 0. The minimum level of ANSC is thus 10. For prices below 10 the
firm will not produce and for prices above 10, its supply curve is found by setting P = SMC:

P = 10 + .2Q
Q = 5P − 50

The firm’s short-run supply curve is thus

0 if P  10
s( P) = 
5 P − 50 if P  10

Q. By virtue of a product patent Blue Ocean Co. Pvt. Ltd. is a monopoly producer of a
particular enzyme. The forecasted annual demand function is P = 1500 – 0.5Q. Q is the
quantity demanded and P is the price. Prices are in dollars per ounce and quantities are
in ounces. The annual cost of production and distribution is given as C = 100000 +
100Q + 0.5𝑄 2 , where Q is the quantity produced annually. Find the profit maximizing
quantity and the price. How much is the annual profit of Blue Ocean Co. Pvt. Ltd.?
Soln:
P = 1500 – 0.5Q
PQ = 1500Q -0.5𝑄 2
MR = 1500 – Q
MC = 100+Q
Thus, at profit maximizing quantity MR = MC
1500 – Q = 100 + Q
2Q = 1400
Q = 700
P = 1500 – 350 = 1150
Profits = (1150*700) – [100000+100(700)+0.5(700)(700)]
= 805000 – [100000+70000+245000]
= 805000 – 415000 = 390000

Q. Assume that a monopolist sells a product with a total cost function TC = 1,200 + 0.5Q2. The market
demand curve is given by the equation P = 300 - Q.
a) Find the profit-maximizing output and price for this monopolist. Is the monopolist profitable?
b) Calculate the price elasticity of demand at the monopolist’s profit-maximizing price?
c) Is this the optimal price to be charged by the monopolist, given the inverse elasticity pricing rule.
Justify by calculation.

Soln: If demand is given by P = 300 − Q then MR = 300 − 2Q . To find the optimum set
MR = MC .
300 − 2Q = Q
Q = 100

At Q = 100 price will be P = 300 − 100 = 200 . At this price and quantity total revenue will
be TR = 200(100) = 20, 000 and total cost will be TC = 1200 + .5(100)2 = 6, 200 . Therefore,
the firm will earn a profit of  = TR − TC = 13,800 .

b) The price elasticity at the profit-maximizing price is

Q P
 Q, P =
P Q

With the demand curve Q = 300 − P , Q

P = −1 . Therefore, at the profit-maximizing price
  200 
 Q, P = −1 
 100 
 Q, P = −2

The marginal cost at the profit-maximizing output is MC = Q = 100. The inverse elasticity
pricing rule states that at the profit-maximizing price

P − MC 1
=−
P  Q, P

In this case we have

200 − 100 1
=−
200 −2
1 1
=
2 2

Q. Which of the following are examples of first-degree, second-degree, or third-degree price

discrimination?
a) The publishers of the Journal of Price Discrimination charge a subscription price of $75
per year to individuals and $300 per year to libraries.
b) The U.S. government auctions off leases on tracts of land in the Gulf of Mexico. Oil
companies bid for the right to explore each tract of land and to extract oil.
c) Ye Olde Country Club charges golfers $12 to play the first 9 holes of golf on a given day,
$9 to play an additional 9 holes, and $6 to play 9 more holes.
d) The telephone company charges you $0.10 per minute to make a long-distance call from
Monday through Saturday and $0.05 per minute on Sunday.
e) You can buy one computer disk for $10, a pack of 3 for $27, or a pack of 10 for $75.
f) When you fly from New York to Chicago, the airline charges you $250 if you buy your
ticket 14 days in advance, but $350 if you buy the ticket on the day of travel
Q. Suppose that Acme Pharmaceutical Company discovers a drug that cures the common cold.
Acme has plants in both the United States and Europe and can manufacture the drug on either
continent at a marginal cost of 10. Assume there are no fixed costs. In Europe, the demand for
the drug is QE = 70 - PE, where QE is the quantity demanded when the price in Europe is PE.
In the United States, the demand for the drug is QU = 110 - PU, where QU is the quantity
demanded when the price in the United States is PU.
a) If the firm can engage in third-degree price discrimination, what price should it set on each
continent to maximize its profit?
b) Assume now that it is illegal for the firm to price discriminate, so that it can charge only a
single price P on both continents. What price will it charge, and what profits will it earn?
c) Will the total consumer and producer surplus in the world be higher with price discrimination
or without price discrimination? Will the firm sell the drug on both continents?
Solution: With third-degree price discrimination the firm should set MR = MC in each
market to determine price and quantity. Thus, in Europe setting MR = MC
70 − 2QE = 10
QE = 30

At this quantity, price will be PE = 40 . Profit in Europe is then

 E = ( PE −10)QE = (40 −10)30 = 900 . Setting MR = MC in the US implies

110 − 2QU = 10
QU = 50

At this quantity price will be PU = 60 . Profit in the US will then be

 U = ( PU − 10)QU = (60 − 10)50 = 2500 . Total profit will be  = 3400 .

b) If the firm can only sell the drug at one price, it will set the price to maximize total
profit. The total demand the firm will face is Q = QE + QU . In this case
Q = 70 − P + 110 − P
Q = 180 − 2 P

The inverse demand is then P = 90 − 0.5Q . Since MC = 10 , setting MR = MC implies

90 − Q = 10
Q = 80

At this quantity price will be P = 50 . If the firm sets price at 50, the firm will sell QE = 20
and QU = 60 . Profit will be  = 50(80) − 10(80) = 3200 .

c) The firm will sell the drug on both continents under either scenario. If the firm can
price discriminate, total consumer surplus will be 0.5(70 – 40)30 + 0.5(110 – 60)50 = 1700
and producer surplus (equal to profit) will be 3400. Thus, total surplus will be 5100. If the
firm cannot price discriminate, consumer surplus will be 0.5(70 – 50)20 + 0.5(110 – 50)60 =
2000 and producer surplus will be equal to profit of 3200. Thus, total surplus will be 5200.

Q. Vivek produces pens, using as inputs only labour (L) and machines (K). His production function is
given by the following equation, q = 10(K)2/3 + (L)1/2. What type of returns to scale does Vivek’s
production function exhibit?

A: The production function exhibits decreasing returns to scale: F (2K, 2L) = 10(2K)2/3 +
(2L)1/2 = 10*22/3K 2/3 + 21/2L 1/2 < 2*[10(K)2/3 + (L)1/2] = 2F(K,L)
Q. Suppose you own a home remodeling company. You are currently earning short-run profits.
The home remodeling industry is an increasing-cost industry. In the long run, what do you
expect will happen to
a. Your firm’s costs of production? Explain.
b. The price you can charge for your remodeling services? Why?
c. Profits in home remodeling? Why?
Solution:
a. Production costs will rise because the entry of new firms encouraged by economic profits
will bid up input prices for all the firms in the remodeling industry. Input prices would not be
bid up if the industry is a constant cost industry.
b. Price will fall because profit will encourage entry, supply will shift rightward, and
equilibrium price will fall.
c. Economic profits will fall to zero as entry occurs in the long run.