Problem Set 2 Solutions

1.
a) M RP = M R M P = 10 (12 2E) = 120 20E. So the
inverse demand curve is P = 120 20E.
b) E = 4.5 when P = 30.
c) E = 4.4 when P = 30 + and = 2.
d) In the long run we would expect factor demand to be more
elastic. Firms are likely to make investments in technology
that would make the firm less reliant on a single (volatile)
energy source.
2.
a) AP L =

q
L

b) M P L =

E 1/4
L

q
L

3
4

2
L1/4

E 1/4
L

c) M RT SL,E = FFEL = 3 E
L
c) The firms profit function is = L3/4 E 1/4 3LrE. Taking
the derivatives with respect to L and E gives us the two first
order conditions (FOCs),
1
4

L 3/4
E

=r

3
4

E 1/4
L

=3

Dividing the first FOC by the second and setting L = E

yields the answer, r = 1.
3.

L
80

70

60

50

40

30

20

C
A

10

0
10

20

30

40

50

60

a) The figure above shows that the substitution effect (moving

from A to B) unambiguously increases E and decreases L.
b) In the figure above, the scale effect (moving from B to C)
increases both E and L as the firm responds to the lower
prices by expanding production.
c) Since the price of energy falls in both relative and absolute
terms, we can say that the firm will use more energy. However, since the price of labor only falls in absolute terms, the
change in the firms labor use is ambiguous.

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