Microeconomic Theory Key of Quiz 2 Dr.

Heman Das Lohano

17 April 2024

Q1: For given input prices and technology, the short-run cost function of a firm producing milk
is as follows:
𝑆𝐶(𝑞) = 1000 + 100𝑞 + 𝑞 2

where q is quantity of milk in liters and the cost is in PKR. The milk industry is perfectly
competitive. Each firm in the industry is a price taker and the price of milk is determined in the
market equilibrium.

(a) Currently, the price of milk is PKR 200 per liter. (i) Find the profit maximizing quantity of
milk for this firm. (ii) Compute the firm’s profit.
(b) Find the firm’s short-run supply function.
(c) Draw the firm’s short-run supply curve.

Note: General cost function is a function of input prices and quantity of output: 𝑆𝐶(𝑣, 𝑤, 𝑞).
For any given input prices, the cost function can be specified as a function of quantity of output:
𝑆𝐶(𝑞), as given above.

Key:
(a) (i) The firm’s profit maximization problem is as follows:

max 𝜋(𝑞) = 𝑃𝑞 − 𝑆𝐶(𝑞)

𝑞≥0

First order necessary condition (FONC) for interior solution (q* > 0) is as follows:

𝑑𝜋(𝑞) 𝑑𝑆𝐶
=𝑃− =0
𝑑𝑞 𝑑𝑞

𝑑𝜋(𝑞)
= 𝑃 − 𝑀𝐶(𝑞) = 0
𝑑𝑞
This equation is re-written as:
P = MC(q)

For finding MC function, we take derivative of cost function with respect to q:

𝑑𝑆𝐶(𝑞)
𝑀𝐶(𝑞) = = 100 + 2𝑞
𝑑𝑞
The profit maximization condition is:
𝑃 = 𝑀𝐶(𝑞)
200 = 100 + 2𝑞
𝑞 ∗ = 50 𝑙𝑖𝑡𝑒𝑟𝑠

For the second order condition, we verify that the second derivative of profit is negative:
𝑑2 𝜋
= −2 < 0
𝑑𝑞 2
To determine whether the optimal solution is q* = 0, or q* > 0, we compare AVC with P:

𝐴𝑉𝐶 = 100 + 𝑞 = 100 + 50 = 150

As P = 200, this shows that P > AVC. Thus, the solution is interior:
𝑞 ∗ = 50 𝑙𝑖𝑡𝑒𝑟𝑠
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(ii) Firm’s profit:
𝜋 = 𝑝𝑞 − (1000 + 100𝑞 + 𝑞 2 ) = 200 × 50 − (1000 + 100 × 50 + 502 ) = 1500 𝑃𝐾𝑅

(b)
From FONC:
𝑃 = 𝑀𝐶(𝑞)

𝑃 = 100 + 2𝑞

𝑞 = −50 + 0.5𝑃
Firm’s short-run supply function:
𝑞 = −50 + 0.5𝑃

For the second order condition, we verify that the second derivative of profit is negative:
𝑑2 𝜋
= −(2) < 0
𝑑𝑞 2
To determine when the optimal solution is q* = 0, we compare AVC with P:

𝐴𝑉𝐶 = 100 + 𝑞

The minimum AVC is 100. If P < 100, then P < AVC, so optimal decision will be shut down:
q = 0 when P < 100.

Now we check for the case when P ≥ 100. As MC = 100 + 2q, for any q ≥ 0 we have AVC ≤
MC. Profit maximizing condition for interior solution is P = MC, thus AVC ≤ P for any positive
q. Thus, the supply function is:

−50 + 0.5𝑃 if 𝑃 ≥ 100

𝑞∗ = {
0 if 𝑃 < 100
(c)
Using the above supply function, the firm’s supply curve is drawn as follows:

100

q*

Note:
The supply curve is graphical representation of inverse supply function: 𝑃 = 100 + 2𝑞
The right-hand side of inverse supply function is MC function: 𝑀𝐶 = 100 + 2𝑞

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Q2: During a debate among several young managers who had recently graduated, one of the
managers flatly stated, “The most this company can lose is the amount on its fixed costs.”
Not everyone agreed with this statement.
(a) In what sense is this statement correct? Briefly explain.
(b) Under what circumstances could this statement be false? Briefly explain.

Key:
(a) If the company takes into account the corner solution (shut down decision) in finding the
optimal solution with the objective function to maximize profit, then “the most this
company can lose is the amount on its fixed costs.”

(b) If the optimal solution is to shut down but the firm continues to produce, then the loss will
be more than the fixed costs.

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