ME Problem Set VI

PGP 2016-18
1. A producer operating in a perfectly competitive market has chosen his output level
to maximize profit. At that output, his revenue and costs are as follows:
Revenue $200
Variable costs $120
Sunk fixed costs $60
Nonsunk fixed costs $40
Calculate his producer surplus and his profits. Which (if either) of these should he use to
determine whether he should exit the market in the short run?
2. Daves Fresh Catfish is a northern Mississippi farm that operates in the perfectly
competitive catfish farming industry. Daves short-run total cost curve is
STC (Q)=400+ 2Q+0.5 Q 2, where Q is the number of catfish harvest per
month. The corresponding short-run marginal cost curve is SMC (Q)=2+Q .
All of the fixed costs are sunk.
(a) What is the equation for the average variable cost ( AVC )?
(b) What is the minimum level of average variable costs?
(c) What is Daves short-run supply curve?
3. Rons Window Washing Service is a small business that operates in the perfectly
competitive residential window washing industry in Evanston, Illinois. The shortrun 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 Rons maximum daily profit?
c) Graph SMC, SAC, and the profit-maximizing quantity. On this graph, indicate the
maximum daily profit.
d) What is Rons short-run supply curve, assuming that all of the $40 per day fixed
costs are sunk?
e) What is Rons short-run supply curve, assuming that if he produces zero output, he
can rent or sell his fixed assets and therefore avoid all his fixed costs?
4. The bolt-making industry currently consists of 20 producers, all of whom operate
with the identical short-run total cost curve STC(Q) = 16 + Q2, where Q is the
annual output of a firm. The corresponding short-run marginal cost curve is
SMC(Q) = 2Q. The market demand curve for bolts is D(P) = 110 P, where P is
the market price.
a) Assuming that all of each firms $16 fixed cost is sunk, what is a firms short-run
supply curve?

b) What is the short-run market supply curve?

c) Determine the short-run equilibrium price and quantity in this industry.
5. Newsprint (the paper used for newspapers) is produced in a perfectly competitive
market. Each identical firm has a total variable cost TVC(Q) = 40Q + 0.5Q2, with
an associated marginal cost curve SMC(Q) = 40 + Q. A firms fixed cost is entirely
nonsunk and equal to 50.
a) Calculate the price below which the firm will not produce any output in the short
run.
b) Assume that there are 12 identical firms in this industry. Currently, the market
demand for newsprint is D(P) = 360 2P, where D(P) is the quantity consumed in the
market when the price is P. What is the short-run equilibrium price?
6. The oil drilling industry consists of 60 producers, all of whom have an identical
short-run total cost curve, STC(Q) = 64 + 2Q2, where Q is the monthly output of a
firm and $64 is the monthly fixed cost. The corresponding short-run marginal cost
curve is SMC(Q) = 4Q. Assume that $32 of the firms monthly $64 fixed cost can
be avoided if the firm produces zero output in a month. The market demand curve
for oil drilling services is D(P) = 400 5P, where D(P) is monthly demand at
price P. Find the market supply curve in this market, and determine the short-run
equilibrium price.
7. There are currently 10 identical firms in the perfectly competitive gadget
manufacturing industry. Each firm operates in the short run with a total fixed cost
of F and total variable cost of 2Q2, where Q is the number of gadgets produced by
each firm. The marginal cost for each firm is MC = 4Q. Each firm also has non
sunk fixed costs of 128. Each firm would just break even (earn zero economic
profit) if the market price were 40. (Note: The equilibrium price is not necessarily
40 when there are 10 firms in the market.)
The market demand for gadgets is QM = 180 2.5P, where QM is the amount
purchased in the entire market.
a) How large are the total fixed costs for each firm? Explain.
b) What would be the shutdown price for each firm? Explain.
c) Draw a graph of the short-run supply schedule for this firm. Label it clearly.
d) What is the equilibrium price when there are 10 firms currently in the market?
e) With the cost structure assumed for each firm in this problem, how many firms
would be in the market at an equilibrium in which every firms economic profits are
zero?
8. A perfectly competitive industry consists of two types of firms: 100 firms of type
A and 30 firms of type B. Each type A firm has a short-run supply curve sA(P) =
2P. Each type B firm has a short-run supply curve sB(P) = 10P. The market
demand curve is D(P) = 5000 500P. What is the short-run equilibrium price in
this market? At this price, how much does each type A firm produce, and how
much does each type B firm produce?

9. Gadgets are produced and sold in a competitive market. When there is no tax, the
equilibrium price is $20 per gadget. The own-price elasticity of demand for
gadgets is 0.5. If an excise tax of $4 leads to an increase in the price of gadgets
to $24, what must be true about the own-price elasticity of supply for gadgets?

10. In a perfectly competitive market, the market demand curve is given by Qd = 200
5Pd, and the market supply curve is given by Qd = 35Ps.
a) Find the equilibrium market price and quantity demanded and supplied in the
absence of price controls.
b) Suppose a price ceiling of $2 per unit is imposed. What is the quantity supplied
with a price ceiling of this magnitude? What is the size of the shortage created by the
price ceiling?
c) Find the consumer surplus and producer surplus in the absence of a price ceiling.
What is the net economic benefit in the absence of the price ceiling?
d) Find the consumer surplus and producer surplus under the price ceiling. Assume
that rationing of the scarce good is as efficient as possible. What is the net economic
benefit in this case? Does the price ceiling result in a deadweight loss? If so, how
much is it?
e) Find the consumer surplus and producer surplus under the price ceiling, assuming
that the rationing of the scarce good is as inefficient as possible. What is the net
economic benefit in this case? Does the price ceiling result in a deadweight loss? If
so, how much is it?

11. Suppose the market for corn in Pulmonia is competitive. No imports and exports
are possible. The demand curve is Qd = 10 Pd, where, Qd is the quantity
demanded (in millions of bushels) when the price consumers pay is Pd. The supply
curve is

where Qs is the quantity supplied (in millions of bushels) when the price producers receive is
Ps.
a) What are the equilibrium price and quantity?
b) At the equilibrium in part (a), what is consumer surplus? producer surplus? deadweight
loss? Show all of these graphically.
c) Suppose the government imposes an excise tax of $2 per unit to raise government
revenues. What will the new equilibrium quantity be? What price will buyers pay? What
price will sellers receive?
d) At the equilibrium in part (c), what is consumer surplus? producer surplus? the impact on
the government budget (here a positive number, the government tax receipts)? deadweight
loss? Show all of these graphically.

e) Suppose the government has a change of heart about the importance of corn revenues to
the happiness of the Pulmonian farmers. The tax is removed, and a subsidy of $1 per unit is
granted to corn producers. What will the equilibrium quantity be? What price will the buyer
pay? What amount (including the subsidy) will corn farmers receive?
f) At the equilibrium in part (e), what is consumer surplus? producer surplus? What will be
the total cost to the government? deadweight loss? Show all of these graphically.
g) Verify that for your answers to parts (b), (d), and (f) the following sum is always the same:
consumer surplus + producer surplus + budgetary impact + deadweight loss. Why is the sum
equal in all three cases?

12. In a perfectly competitive market, the market demand and market supply curves are given
by Qd = 1000 10Pd and Qd = 30Ps. Suppose the government provides a subsidy of $20 per
unit to all sellers in the market.
a) Find the equilibrium quantity demanded and supplied; find the equilibrium market price
paid by buyers;
find the equilibrium after-subsidy price received by firms.
b) Find the consumer surplus and producer surplus in the absence of the subsidy. What is the
net economic benefit in the absence of a subsidy?
c) Find the consumer surplus and producer surplus in the presence of the subsidy. What is the
impact of the subsidy on the government budget? What is the net economic benefit under the
subsidy program?
d) Does the subsidy result in a deadweight loss? If so, how much is it?

13. In a perfectly competitive market, the market demand curve is Qd = 10 Pd, and the
market supply curve is Qs = 1.5Ps.
a) Verify that the market equilibrium price and quantity in the absence of government
intervention are Pd = Ps = 4 and Qd = Qs = 6.
b) Consider two possible government interventions: (1) A price ceiling of $1 per unit; (2) a
subsidy of $5 per unit paid to producers. Verify that the equilibrium market price paid by
consumers under the subsidy equals $1, the same as the price ceiling. Are the quantities
supplied and demanded the same under each government intervention?
c) How will consumer surplus differ in these different government interventions?
d) For which form of intervention will we expect the product to be purchased by consumers
with the highest willingness to pay?
e) Which government intervention results in the lower deadweight loss and why?

14. Consider an industry in which chief executive officers (CEOs) run firms. There are two
types of CEOs: exceptional and average. There is a fixed supply of 100 exceptional CEOs
and an unlimited supply of average CEOs. Any individual capable of being a CEO in this
industry is willing to work for a salary of $144,000 per year. The long-run total cost of a firm
that hires an exceptional CEO at this salary is

where Q is annual output in thousands of units and total cost is expressed in thousands of
dollars per year. The corresponding long-run marginal cost curve is MCE(Q) = Q, where
marginal cost is expressed as dollars per unit. The long-run total cost for a firm that hires an
average CEO for $144,000 per year is TCA(Q) = 144 + Q2. The corresponding marginal cost
curve is MCA(Q) = 2Q. The market demand curve in this market is D(P) = 7200 100P,
where P is the market price and D(P) is the market quantity, expressed in thousands of units
per year.
a) What is the minimum efficient scale for a firm run by an average CEO? What is the
minimum level of long-run average cost for such a firm?
b) What is the long-run equilibrium price in this industry, assuming that it consists of firms
with both exceptional and average CEOs?
c) At this price, how much output will a firm with an average CEO produce? How much
output will a firm with an exceptional CEO produce?
d) At this price, how much output will be demanded?
e) Using your answers to parts (c) and (d), determine how many firms with average CEOs
will be in this industry at a long-run equilibrium.
f ) What is the economic rent attributable to an exceptional CEO?
g) If firms with exceptional CEOs hire them at the reservation wage of $144,000 per year,
how much economic profit do these firms make?
h) Assuming that firms bid against each other for the services of exceptional CEOs, what
would you expect their salaries to be in a long-run competitive equilibrium?