9 January 2016

2 hour
Full points: 40
ECN 201E Final Examination Solutions
Answer all 4 questions below. I suggest you spend 25 minutes on each question. If you are
stuck on a question, I recommend moving on to the next question and returning to the
problem after you have finished answering all the other questions.
Make sure to show all your working and calculations for significant partial credit. You must
show all the steps that you did to get to your answer. If you just give me the answer, you
will get 0 even if it is correct. I will also give you 0 if all you give me is a formula without
any working.
Good luck!
Please write your name and ITU ID number on your answer sheet.
Question 1
The market demand and market supply for a good that has price 𝑝 are 𝐷(𝑝) = 60 − 3𝑝 and
𝑆(𝑝) = 6 + 3𝑝 respectively.
a) What is the equilibrium price 𝒑∗ and equilibrium quantity 𝒒∗ ? [4 points]

b) Suppose a quantity tax of $6 is levied by the government. Find the after-tax equilibrium
price paid by the demander 𝑝𝐷∗ and the after-tax equilibrium price received by the supplier
𝑝𝑆∗ . [4 points]

c) What is the deadweight loss (numerical value) associated with the quantity tax? [2
points]
Question 2
Suppose a firm has the Cobb-Douglas the production function 𝑓(𝑥1 , 𝑥2 ) = 𝑥10.3 𝑥20.3 where 𝑥1
is the amount of factor 1 that the firm uses in the production process and 𝑥2 is the
corresponding amount of factor 2. Let the price of the firm’s output be 𝑝 and the factor
prices of good 1 and good 2 be 𝑤1 and 𝑤2 respectively. Find the long-run supply function
of the firm by solving the profit-maximization problem of the firm. [10 points]
Question 3
A firm produces 𝑦 units of its output using 𝑥1 units of input factor 1 and 𝑥2 units of input
factor 2. The prices of factor 1 and factor 2 are 𝑤1 and 𝑤2 respectively.
a) Find the firm’s cost function 𝑐(𝑤1 , 𝑤2 , 𝑦) if the two factors of production are perfect
complements i.e. 𝑓(𝑥1 , 𝑥2 ) = min⁡{𝑥1 , 𝑥2 }. [5 points]

b) Find the firm’s cost function 𝑐(𝑤1 , 𝑤2 , 𝑦) if the firm has perfect substitutes technology
i.e. 𝑓(𝑥1 , 𝑥2 ) = 𝑥1 + 𝑥2 . [5 points]
HINT: Try to use economic reasoning to come to the answer in both parts instead of
mathematics.
NOTE: For both parts (a) and (b) you must show the working or write the economic
argument of how you arrived at your answer. If you just give me the answer without
any explanation you will be marked with a 0.
Question 4
A monopolist faces the market demand curve given by 𝐷(𝑝) = 100 − 2𝑝 where 𝑝 is the
price of the output the monopolist sells. The monopolist’s cost function is 𝑐(𝑦) = 2𝑦 where⁡𝑦
is the level of the monopolist’s output.
a) Find the monopolist’s optimal level of price and output (𝑝𝑚 , 𝑦𝑚 ). [4 points]

b) Find the competitive level of output 𝑦𝑐 if we could costlessly force the monopolist to
behave like a firm in a purely competitive market i.e. charge its marginal cost as its output
price. [3 points]

c) What is the deadweight loss of the monopoly? [3 points]

Answer to Question 1
a) The equilibrium price 𝑝∗ can be found by solving the equation below:
𝐷(𝑝∗ ) = 60 − 3𝑝∗ = 6 + 3𝑝∗ = 𝑆(𝑝∗ ).

60 − 3𝑝∗ = 6 + 3𝑝∗ ,
⇒ 6𝑝∗ = 54,
∴ 𝒑∗ = $𝟗.
To find the equilibrium quantity 𝑞 ∗ we can substitute 𝑝∗ into either the demand function
or supply function. Below we substitute into the demand function:
𝑞 ∗ = 𝐷(9) = 60 − 3(9),
∴ 𝒒∗ = 𝟑𝟑⁡𝒖𝒏𝒊𝒕𝒔.
b) The after-tax equilibrium is determined by the equations below:
𝐷(𝑝𝐷 ) = 60 − 3𝑝𝐷 = 6 + 3𝑝𝑆 = 𝑆(𝑝𝑠 ), (1)
𝑝𝐷 = 𝑝𝑠 + 6. (2)
Substituting 𝑝𝐷 in equation (1) from (2):
60 − 3(𝑝𝑠 + 6) = 6 + 3𝑝𝑆 ,
⇒ 60 − 3𝑝𝑠 − 18 = 6 + 3𝑝𝑆 ,
⇒ 6𝑝𝑆 = 36,
∴ 𝒑∗𝑺 = $𝟔.
We can find after-tax equilibrium price paid by the demander 𝑝𝐷∗ by substituting 𝑝𝑆∗ in
equation (2):
𝑝𝐷∗ = 𝑝𝑆∗ + 6,
⇒ 𝑝𝐷∗ = 6 + 6,
 ∴ 𝒑∗𝑫 = $𝟏𝟐.
c) The after-tax equilibrium quantity 𝑞𝑇 is (you will need to find it to calculate the
deadweight loss):
𝑞𝑇 = 𝐷(𝑝𝐷∗ ) = 60 − 3(12),
∴ 𝑞𝑇 = 24⁡𝑢𝑛𝑖𝑡𝑠.
[It is not necessary to draw the figure to get full points but I would advise you to draw the
figure whenever possible]

From the figure above we see that the deadweight loss is the area of the triangle whose area
equals C and D.
1 1
𝐷𝑒𝑎𝑑𝑤𝑒𝑖𝑔ℎ𝑡⁡𝑙𝑜𝑠𝑠 = 2 × (12 − 6) × (33 − 24) = 2 × 6 × 9,

∴ 𝑫𝒆𝒂𝒅𝒘𝒆𝒊𝒈𝒉𝒕⁡𝒍𝒐𝒔𝒔 = $𝟐𝟕.
Answer to Question 2
The firm’s profit-maximization problem is:
max 𝑝𝑥10.3 𝑥20.3 − 𝑤1 𝑥1 − 𝑤2 𝑥2 . (3)
𝑥1 ,𝑥2

The first-order conditions are:

0.3𝑝𝑥1−0.7 𝑥20.3 − 𝑤1 = 0, (4a)

0.3𝑝𝑥10.3 𝑥2−0.7 − 𝑤2 = 0. (4b)

Multiply both sides of equation (4a) by 𝑥1 , and similarly, both sides of equation (4b) by 𝑥2 :

0.3𝑝𝑥10.3 𝑥20.3 − 𝑤1 𝑥1 = 0, (5a)

0.3𝑝𝑥10.3 𝑥20.3 − 𝑤2 𝑥2 = 0. (5b)
Let 𝑦 = 𝑥10.3 𝑥20.3 denote the output level of the firm. Substituting 𝑦 into equations (5a) and
(5b) and re-arranging:
0.3𝑝𝑦 = 𝑤1 𝑥1 , (6a)
0.3𝑝𝑦 = 𝑤2 𝑥2 . (6b)
Solving for 𝑥1 and 𝑥2 we have:
0.3𝑝𝑦
𝑥1∗ = , (7a)
𝑤1

0.3𝑝𝑦
𝑥2∗ = . (7b)
𝑤2

We can substitute 𝑥1∗ and 𝑥2∗ back into the Cobb-Douglas production function and solve for 𝑦:
0.3𝑝𝑦 0.3 0.3𝑝𝑦 0.3
( ) ( ) = 𝑦,
𝑤1 𝑤2

0.3𝑝 0.3 0.3𝑝 0.3

⇒(𝑤 ) (𝑤 ) 𝑦 0.6 = 𝑦,
1 2

0.3 0.3 0.3 0.3

⇒ (𝑤 ) (𝑤 ) 𝑝0.6 = 𝑦 0.4,
1 2

0.3 0.75 0.3 0.75

⇒ 𝑦 = (𝑤 ) (𝑤 ) 𝑝1.5,
1 2

𝟎.𝟏𝟔𝟒
∴ 𝒚 = 𝒘𝟎.𝟕𝟓 𝒘𝟎.𝟕𝟓 𝒑𝟏.𝟓 . (8)
𝟏 𝟐

Equation (8) is the long-run supply function of the firm.

Answer to Question 3
a) When 𝑓(𝑥1 , 𝑥2 ) = min⁡{𝑥1 , 𝑥2 } we need at least 𝑦 amount of factor 1 and 𝑦 amount of
factor 2 to produce 𝑦 amount of output. Thus the minimal cost of production will be:
𝒄(𝒘𝟏 , 𝒘𝟐 , 𝒚) = 𝒘𝟏 𝒚 + 𝒘𝟐 𝒚 = (𝒘𝟏 + 𝒘𝟐 )𝒚.

b) When 𝑓(𝑥1 , 𝑥2 ) = 𝑥1 + 𝑥2 , the firm will use whichever of the two inputs that is cheaper.
That is, to produce 𝑦 amount of output the firm will use 𝑤1 𝑦 of input factor 1 or 𝑤2 𝑦 of
input factor 2 depending on which is less. Therefore the minimum cost of production of 𝑦
amount of output is: 𝒄(𝒘𝟏 , 𝒘𝟐 , 𝒚) = 𝒎𝒊𝒏{𝒘𝟏 𝒚, 𝒘𝟐 𝒚} = 𝒎𝒊𝒏{𝒘𝟏 , 𝒘𝟐 }𝒚.
Answer to Question 4
a) We can re-arrange the market demand curve 𝐷(𝑝) = 100 − 2𝑝 to get the market inverse
demand curve 𝑝(𝑦) = 50 − 0.5𝑦. The revenue function of the firm 𝑟(𝑦) is thus:
𝑟(𝑦) = 𝑝(𝑦)𝑦 = 50𝑦 − 0.5𝑦 2 . The monopolist’s profit-maximization is:

max 𝑟(𝑦) − 𝑐(𝑦),

𝑦

⟹ max 50𝑦 − 0.5𝑦 2 − 2𝑦.

𝑦
The first-order condition for the profit-maximization problem is:
 50 − 𝑦 − 2 = 0,
∴ 𝒚𝒎 = 𝟒𝟖⁡𝒖𝒏𝒊𝒕𝒔.
We can find the monopoly price 𝑝𝑚 by substituting 𝑦𝑚 into the market inverse demand
function:
𝑝𝑚 = 50 − 0.5(48),
∴ 𝒑𝒎 = $𝟐𝟔.

b) A competitive firm will produce where its price will equal its marginal cost. Therefore, if
the monopolist was forced to behave like a competitive firm it would produce output level
𝑦𝑐 where:

𝑐 ′ (𝑦) = 𝑝(𝑦),
⟹ 2 = 50 − 0.5𝑦,
∴ 𝒚𝒄 = 𝟗𝟔⁡𝒖𝒏𝒊𝒕𝒔.

c) [It is not necessary to draw the figure to get full points but I would advise you to draw the
figure whenever possible]

Area A represents the deadweight loss because of the monopoly. Therefore, we can
calculate the area A to find the deadweight loss:
1 1
𝐷𝑒𝑎𝑑𝑤𝑒𝑖𝑔ℎ𝑡⁡𝑙𝑜𝑠𝑠 = × (26 − 2) × (96 − 48) = × 24 × 48,
2 2

∴ 𝑫𝒆𝒂𝒅𝒘𝒆𝒊𝒈𝒉𝒕⁡𝒍𝒐𝒔𝒔 = $𝟓𝟕𝟔.