Assignment 2 with answers

Chapter 3
1. The demand curve for a product is given by Qdx = 1,200 – 3Px – 0.1Pz
Where Pz = SR300.
a. What is the own price elasticity of demand when Px = SR140? Is demand elastic or
inelastic at this price? What would happen to the firm’s revenue if it decided to
charge a price below SR140?
b. What is the own price elasticity of demand when Px = SR240? Is demand elastic or
inelastic at this price? What would happen to the firm’s revenue if it decided to
charge a price above SR240?
c. What is the cross price elasticity of demand between good X and good Z when
Px =SR140? Are good X and good Z substitutes or complements?
Answer:
a. At the given prices, quantity demanded is 750 units: Qdx = 1200 − 3(140) − 0.1(300)
= 750. Substituting the relevant information into the elasticity formula gives:
𝐸𝑄dx,x=−3(𝑃x/𝑄x) = −3(140/750) = −0.56. Since this is less than one in absolute value,
demand is inelastic at this price. If the firm charged a lower price, total revenue
would decrease.

b. At the given prices, quantity demanded is 450 units: 𝑄dx = 1,200 −3(240) −0.1(300) =
450. Substituting the relevant information into the elasticity formula gives: 𝐸𝑄x,x =
−3(𝑃x/𝑄x) = −3(240/450) = −1.6. Since this is greater than one in absolute value,
demand is elastic at this price. If the firm increased its price, total revenue would
decrease.

c. At the given prices, quantity demanded is 750 units, as shown in part a. Substituting
the relevant information into the elasticity formula gives: 𝐸𝑄x,𝑃z = −0.1(𝑃𝑧/𝑄x =
−0.1(300/750) = −0.04. Since this number is negative, goods X and Z are
complements.
 2. Suppose the own price elasticity of demand for good X is -4, its income elasticity is 2, its
advertising elasticity is 3, and the cross price elasticity of demand between it and good Y
is -6. Determine how much the consumption of this good will change if:
a. The price of good X increases by 10%.
b. The price of good Y decreases by 5%.
c. Advertising increases by 14%.
d. Income decreases by 8%.
Answer:
a. Use the own price elasticity of demand formula to write %Δ𝑄dx/10 = −4. Solving, we
see that the quantity demanded of good X will decrease by 40 percent if the price of
good X increases by 10 percent.

b. Use the cross-price elasticity of demand formula to write %Δ𝑄dx/−5 = −6. Solving,
we see that the demand for X will increase by 30 percent if the price of good Y
decreases by 5 percent.

c. Use the formula for the advertising elasticity of demand to write %Δ𝑄dx/14 = 3.
Solving, we see that the demand for good X will increase by 42 percent if advertising
increases by 14 percent.

d. Use the income elasticity of demand formula to write %Δ𝑄dx/−8 = 2. Solving, we see
that the demand of good X will decrease by 16 percent if income decreases by 8
percent.

3. Suppose the cross price elasticity of demand between goods X and Y is 4. How much
would the price of good Y have to change in order increase the consumption of good X
by 20 percent?
Answer: Using the cross price elasticity formula, 20%/Δ𝑃y = 4. Solving, we see that the price
of good Y would have to increase by 5 percent in order to increase the consumption of good X
by 20 percent.
Chapter 4
1. A consumer has $300 to spend on goods X and Y. the market prices of these two goods
are Px = $15 and Py = $5.
a. What is the market rate of substitution between goods X and Y?
b. Illustrate the consumer’s opportunity set in a carefully labeled diagram.
c. Show how the consumer’s opportunity set changes if income increases by $300. How
does the $300 increase in income alter the market rate of substitution between goods
X and Y?
Answer:
a. The market rate of substitution is –𝑃𝑥/𝑃𝑦 = −15/5 = −3.
b. See diagram in the slides that illustrate income change.
c. Increasing income to $600 (by $300) expands the budget set, as shown in Figure 4-1.
Since the slope is unchanged, so is the market rate of substitution.

2. A consumer must divide $600 between the consumption of product X and product Y.
The relevant market prices are Px = $10 and Py = $40.
a. Write the equation for the consumer’s budget line.
b. Show how the consumer’s opportunity set changes when the price of good X
increases to $20. How does this change alter the market rate of substitution between
good X good Y?
Answer:
a. The consumer’s budget line is $600 = $10X + $40Y. Rearranging terms and solving
for Y results in Y = 15 – 0.25X.
b. When the price of X increases to $20, the budget line becomes $600 = $20X + $40Y,
which is equivalent to Y = 15 – 0.5X (after rearranging and simplifying terms). The
market rate of substitution changes from –𝑃𝑥/𝑃𝑦 = −10/40 = −0.25 to –𝑃𝑥/𝑃𝑦 =
−20/40 = −0.5

3. Consider the following budget line:

100=1𝑋+5𝑌
a. What is the maximum amount of X that can be consumed?
b. What is the maximum amount of Y that can be consumed?
c. What is rate at which the market trades goods X and Y?
Answer:
a. Maximum X is: 𝑋=100/1 = 100units.
b. Maximum Y is: 𝑌=100/5 = 20units.
c. Market rate of substitution: −𝑃𝑋/𝑃𝑌 = −1/5.
 4. A consumer must spend all of his income on two goods X and Y. In each of the
following scenarios, include whether the equilibrium consumption of goods X and Y will
increase or decrease. Assume good X is a normal good and good Y is an inferior good.
a. Income doubles.
b. Income quadruples and prices double.
c. Income and all prices quadruples.
d. Income is halved and all prices double.
Answer:
a. Consumption of good X will increase and consumption of good Y will decrease.
b. Consumption of good X will increase and consumption of good Y will decrease.
c. Nothing will happen to the consumption of either good.
d. Consumption of good X will decrease and consumption of good Y will increase

Chapter 5
1. A firm can manufacture a product according to the production function Q = F(K, L) =
K3/4 L1/4
a. Calculate the average product of labor, LPL, when the level of capital is fixed at 10
units and the firm uses 50 units of labor. How does the average product of labor
change when the firm uses 170 units of labor?
b. Find an expression for the marginal product of labor, MPL, when the amount of
capital is fixed at 10 units. Then illustrate that the marginal product of labor depends
on the amount of labor hired by calculating the marginal product of for 10 and 50
units of labor.
c. Suppose capital is fixed at 50 units. If the firm can sell its output at a price of $210
per unit and can hire labor at $55 per unit, how many units of labor should the firm
hire in order to maximize profits?
Answer:
a. When K = 10 and L = 50, Q = (10)0.75(50)0.25 = 14.95. Thus, APL = Q/L =
14.95/50 = 0.3. When K = 10 and L =170, Q = (10)0.75(170)0.25 = 20.3. Thus, APL
= 20.3/170 = 0.12.
b. The marginal product of labor is MPL = (1/4)(10)0.75(L)-3/4 = 1.4(L)-3/4. When L =
10, MPL = 1.4(10)-3/4 = 0.25. When L = 50, MPL = 1.4(50)-3/4 = 0.08. Thus, as the
number of units of labor hired increases, the marginal product of labor decreases
MPL(10) = 0.25 > 0.08 = MPL(50), holding the level of capital fixed.
c. We must equate the value marginal product of labor to the wage and solve for L.
Here, VMPL = (P)(MPL) = ($210)4.7(L)-3/4=294(L)-3/4. Setting this equal to the
wage of $55 gives 294(L)-3/4 = 55. Solving for L, the optimal quantity of labor is
𝐿≅47.
 2. The manager of a national retailing outlet recently hired an economics to estimate the
firm’s production function. Based on the economist’s report, the manager now knows
that the firm’s production functions given by Q = K1/2L1/2 and that capital is fixed at 1
unit.
a. Calculate the average and marginal product of labor when 9 units of labor are
utilized.
b. Calculate the marginal product of labor when 9 units of labor are utilized.
c. Suppose the firm can hire labor at a wage of $10 per hour and output can be sold at a
price of $100 per unit. Determine the profit-maximizing levels of labor and output.
d. What is the maximum price of capital at which the firm still make nonnegative
profits?
Answer:
a. Q = (1)1/2 (9)1/2 = 3. The average product of labor is thus Q/L = 3/9
b. MPL = .5K1/2L1/2 = .5(1)1/2(9)-1/2 = 1/6
c. The profit maximizing level of labor and output is achieved where VMPL = w, where
VMPL = .5($100)L-1/2) and w = $10. Solving for L yields L = $25. The corresponding
level of output is Q = (25)-1/2 = 5
d. The firm’s variable costs are (25)($10), while its total revenues are 5 * $100 = $500.
The maximum price of capital, hence, cannot be greater than $250 per unit.

3. An economist estimated that the cost function of a single products firm is

C(Q) = 230 + 12Q + 8Q2 + 10Q3

Based on this information, determine:

a. The fixed cost of producing 7 units of output.
b. The variable cost of producing 7 units of output.
c. The total cost of producing 7 units of output.
d. The average fixed cost of producing 7 units of output.
e. Average variable cost of producing 7 units of output.
f. Average total cost of producing 7 units of output.
g. The marginal cost when Q = 7.
Answer:
a. FC = $230.
 b. VC(7) = 12(7) + 8(7)2 + 10(7)3 = $3,906
c. C(7) = 230 + 12(7) + 8(7)2 + 10(7)3 = $4,136
d. 𝐴𝐹𝐶(7) = $23/7 = $32.85
e. 𝐴𝑉𝐶(7) = 𝑉𝐶(7)/7 = $3,906/7 = $558
f. ATC(7) = AFC(7) + AVC(7) = $590.85.
g. MC(7) = 12 + 16(7) + 30(7)2 = $1,594.

Chapter 8
1. A firm sells its product in a perfectly competitive market where other firms charge a price
of $75 per unit. The firm’s total costs are C(Q) = 45 +15Q +3Q2
a. How much output should the firm produce in the short run?
b. What price should the firm charge in the short run?
c. What are the firm’s short run profits?
d. What adjustment should be anticipated in the long run?
Answer:
a. Set P = MC to get $75 = 15 + 6Q. Solve for Q to get Q = 10 units.
b. $75.
c. Revenues are R = ($75)(10) = $750, costs are C = 45 + 15(10) + 3(10)2 = $495, so
profits are $255.
d. Entry will occur, the market price will fall, and the firm should plan to reduce its
output. In the long-run, economic profits will shrink to zero.

2. You are the manager of a monopoly, and your demand and cost functions are given by P
= 225 – 2Q and C(Q) = 1,100 + 3Q2, respectively.
a. What price –quantity combination maximizes your firm’s profits?
b. Calculate the maximum profits.
c. Is demand elastic, inelastic, or unit elastic at the profit maximizing price quantity
combination?
d. What price-quantity combination maximizes revenue?
e. Calculate the maximum revenue.
Answer:
a. MR = 225 – 4Q and MC = 6Q. Setting MR = MC yields 225 – 4Q = 6Q. Solving yields
Q = 22.5 units. The profit-maximizing price is obtained by plugging this into the demand
equation to get P = 225 - 2(22.5) = $180.
b. Revenues are R = ($180)(22.5) = $4,050 and costs are C = 1100 + 3(22.5)2 = $2,618.75,
so the firm’s profits are $1,431.25.
c. Elastic.
d. TR is maximized when MR = 0. Setting MR = 0 yields 225 – 4Q = 0. Solving for Q
yields Q = 56.25 units. The price at this output is P = 225 – 2(56.25) = $112.5.
e. e. Using the results from part d, the firm’s maximum revenues are R = ($112.5)(56.25) =
$6,328.12.