Chapter 4

The Consumer

Exercise 4.1 You observe a consumer in two situations: with an income of

$100 he buys 5 units of good 1 at a price of $10 per unit and 10 units of good 2
at a price of $5 per unit. With an income of $175 he buys 3 units of good 1 at
a price of $15 per unit and 13 units of good 2 at a price of $10 per unit. Do the
actions of this consumer conform to the basic axioms of consumer behaviour?

x2

x′′ = (3,13)

x′ = (5,10)

p1 / p 2 = 2 p1 / p2 = 1.5

x1

Figure 4.1: WARP violated

Outline Answer
At the original price ratio p1 =p2 = 2 the choice is x0 = (5; 10); but at those
prices the and with that budget the consumer could have a¤orded x00 = (3; 13):
x0 is revealed-preferred to x00 . But at the new price ratio p1 =p2 = 1:5 x00 is
chosen, although x0 is still a¤ordable: x00 is revealed-preferred to x0 . This
violates WARP –see Figure 4.1.

41
Microeconomics CHAPTER 4. THE CONSUMER

Exercise 4.2 Draw the indi¤ erence curves for the following four types of pref-
erences:

Type A : log x1 + [1 ] log x2

Type B : x1 + x2
2 2
Type C : [x1 ] + [x2 ]
Type D : min f x1 ; x2 g

where x1 ; x2 denote respectively consumption of goods 1 and 2 and ; ; ; are

strictly positive parameters with < 1. What is the consumer’s cost function
in each case?

x2 x2

A B

x1 x1
x2 x2

C D

x1 x1

Figure 4.2: Indi¤erence curves: four cases

Use the fact that expenditure minimisation for the household and cost-
minimisation for the …rm are essentially the same problem. The indi¤erence
curves in Figure 4.2 are identical to the isoquants depicted in Exercises 2.4, 2.5.
So, substituting the notation in Exercise 2.4 and 2.5we get:
h i1
p1 p2
Case A: C(p; ) = C(p; ) = e 1 .

Case B: C(p; ) = min(p1 = ; p2 )

p p
Case C: C(p; ) = min(p1 = ; p2 )
p1
Case D: C(p; ) = + p2 .

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Microeconomics

Exercise 4.3 Suppose a person has the Cobb-Douglas utility function

n
X
ai log(xi )
i=1

where xi is the quantity Pnconsumed of good i, and a1 ; :::; an are non-negative

parameters such that j=1 aj = 1. If he has a given income y, and faces
prices p1 ; :::; pn , …nd the ordinary demand functions. What is special about the
expenditure on each commodity under this set of preferences?

Outline Answer
The relevant Lagrangean is
n
" n
#
X X
i log xi + y pi xi (4.1)
i=1 i=1

The …rst-order conditions yield:

i
xi = ; i = 1; 2; :::; n: (4.2)
pi
n
X
y = pi xi (4.3)
i=1
Pn
From the n + 1 equations (4.2,4.3) we get at the optimum: y = i=1 i= =
1= . So the demand functions are
iy
xi = ; i = 1; 2; :::; n: (4.4)
pi
and expenditure on each commodity i is

ei := pi xi = i y; (4.5)

–a constant proportion of income.

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Microeconomics CHAPTER 4. THE CONSUMER

Exercise 4.4 The elasticity of demand for domestic heating oil is 0:5, and
for gasoline is 1:5. The price of both sorts of fuel is 60c/ per litre: included
in this price is an excise tax of 48c/ per litre. The government wants to reduce
energy consumption in the economy and to increase its tax revenue. Can it do
this (a) by taxing domestic heating oil? (b) by taxing gasoline?

Outline Answer
Let p be the untaxed price, and the excise tax. Government revenue
is T = x, and the purchase price is p + . Clearly an increase in would
reduce consumption, and =[ + p] = 0:8: The e¤ect on tax revenue is given by
@T =@ = x + @x=@ = x[1 + 0:8"]. If (a) " = 0:5 then this is positive. If (b)
" = 1:5 then it is negative.

Exercise 4.5 De…ne the uncompensated and compensated price elasticities as

pj @Di (p;y) pj @H i (p; )

"ij := ; "ij :=
xi @pj xi @pj

and the income elasticity

y @Di (p;y)
"iy := :
xi @y
Show how the Slutsky equation can be expressed in terms of these elasticities
and the expenditure share of each commodity in the total budget.

Use the fact that each demand function Di is homogeneous of degree zero
in all prices and income. Then, using the standard lemma for homogenous
functions, we have for each i = 1; :::; n :
n
X @Di (p; y) @Di (p; y)
pj +y = 0 Di (p; y)
j=1
@pj @y
= 0

which implies
n
X
"ij + "iy = 0:
j=1

Moreover we can rewrite the Slutsky equation as

"ij = "ij vj "iy

p j xj
where vj = is the expenditure share of commodity j.
y

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Microeconomics

Exercise 4.6 You are planning a study of consumer demand. You have a data
set which gives the expenditure of individual consumers on each of n goods. It
is suggested to you that an appropriate model for consumer expenditure is the
Linear Expenditure System:
2 3
Xn
ei = i pi + i 4y pj j 5
j=1

where pi is the price of good i, ei is the consumer’s expenditure on good i, y

is the consumer’
Pn s income, and 1 ; :::; n , 1 ; :::; n are non-negative parameters
such that j=1 j = 1.

1. Find the e¤ ect on xi , the demand for good i, of a change in the consumer’s
income and of an (uncompensated) change in any price pj .

2. Find the substitution e¤ ect of a change in price pj on the demand for good
i.

3. Explain how you could check that this demand system is consistent with
utility-maximisation and suggest the type of utility function which would
yield the demand functions implied by the above formula for consumer
expenditure. [Hint: compare this with Exercise 4.3]

Outline Answer

1. We have 2 3
n
X
i 4y
xi = i + pj j 5 (4.6)
pi j=1

Notice that ( 1 ; :::; n ) play

Pnthe role of “subsistence minima”of the n com-
modities, and so y0 := j=1 pj j can be considered as the subsistence
minimum expenditure, and the remaining budget y y0 as “discretionary
expenditure”; i is then the proportion of discretionary expenditure spent
on discretionary purchases of commodity i: pi [xi i ] = [y y0 ]. Com-
pare this with (4.5). From (4.6) we have:

@xi i
= (4.7)
@y pi
@xi i j
= if j 6= i (4.8)
@pj pi
" Pn #
@xi i y j=1 pj j
= i + (4.9)
@pi pi pi

2. Apply Slutsky equation using (4.7) and (4.8) to establish

dxi i xj j
= , if j 6= i (4.10)
dpj =con tant pi

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Microeconomics CHAPTER 4. THE CONSUMER

3. Check that demand function (4.6) is homogeneous of degree 0 in prices

and income, and that the sum of the right-hand side of the equation in the
question adds up to total income. Check that cross-substitution e¤ects are
symmetric, and that own-price substitution e¤ects are negative. Using the
analogy with part (b) we can see that the demand system is similar, but
with the commodity origin shifted from 0 to the point ( 1 ; :::; n );so we
expect the indi¤erence curves from which the demand system was derived
will look like Cobb-Douglas contours with the origin shifted to the point
( 1 ; :::; n ). The utility function will then be
n
X
i log(xi i) : (4.11)
i=1

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Microeconomics

Exercise 4.7 Suppose a consumer has a two-period utility function of the form
labelled type A in Exercise 4.2. where xi is the amount of consumption in period
i. The consumer’s resources consist just of inherited assets A in period 1, which
is partly spent on consumption in period 1 and the remainder invested in an
asset paying a rate of interest r.

1. Interpret the parameter in this case.

2. Obtain the optimal allocation of (x1 ; x2 )

3. Explain how consumption varies with A, r and .

4. Comment on your results and examine the “income” and “substitution”

e¤ ects of the interest rate on consumption.

Outline Answer

1. The parameter captures the consumer’s “impatience”: the higher is

the more steeply sloped will be the indi¤erence curves in Figure 4.3. Note
1
that 1+r is the price of consumption in period 2 relative to the price of
consumption in period 1; so the lifetime budget constraint, expressed in
terms of period-1 prices, is:
x2
x1 + A (4.12)
1+r
and so the Lagrangean is:

x2
log x1 + [1 ] log x2 + A x1 (4.13)
1+r

2. We can be sure an interior maximum will exist (examine the indi¤erence

curve in Figure 4.3). First-order conditions are

=
x1
1 1
=
x2 1+r
x
x1 + 2 = A
1+r
1
From these we …nd = A and therefore optimum consumption in each
period is:

x1 = A (4.14)
x2 = [1 + r] [1 ]A (4.15)

So we can see that the smaller is (the lower is the level of impatience), or
the larger is r (the rate of interest), the more consumption will be “tilted”
toward period 2.

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Microeconomics CHAPTER 4. THE CONSUMER

x2

x*

1+r

x1
A

Figure 4.3: Equilibrium in 2-period case

3. The e¤ect of an increase in assets is:

@x1
= (4.16)
@A
@x2
= [1 + r] [1 ] (4.17)
@A
leaving the proportion spent on consumption in each period unaltered.
The e¤ect of an increase in the interest rate is:
@x1
= 0 (4.18)
@r
@x2
= [1 ]A (4.19)
@r

4. To …nd the substitution e¤ect we need to use the Slutsky equation. In a

conventional 2-commodity model this would be given by

@x1 dx1 @x1

= x2 (4.20)
@p2 dp2 =constant @y

Taking 1=[1 + r] as the “price” p2 of consumption in period 2, with

A =lifetime budget y and price of period-1 consumption de…ned as 1.
Noting that in this case dp2 = 1=[1 + r]2 dr we can rewrite (4.20) as

@x1 dx1 x2 @x1

= + (4.21)
@r dr =constant [1 + r]2 @A

Rearranging this, the substitution e¤ect for good 1 of an increase in r may

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Microeconomics

then be found (using 4.16 and 4.18) as:

dx1 @x1 x2 @x1

=
dr =constant @r [1 + r]2 @A
x2
= <0 (4.22)
[1 + r]2

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Microeconomics CHAPTER 4. THE CONSUMER

Exercise 4.8 Suppose a consumer is rationed in his consumption of commodity

1, so that his consumption is constrained thus x1 a. Discuss the properties
of the demand functions for commodities 2; :::; n of a consumer for whom the
rationing constraint is binding.

Outline Answer
Use the standard analysis on the short-run for the …rm (see Chapter 2) to
get insight on the economics of the consumer under rationing. In the case of the
…rm has to cope with the side-constraint z3 = z3 in the short run; the consumer
has to cope with the rationing constraint x1 a: if the constraint is slack then
it is irrelevant (the consumer does not use all his ration); if it is binding, then
the problem is just like that of the …rm. The solution is at x0 in Figure 4.4

x2

x′

x1
a

Figure 4.4: Ration

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Microeconomics

Exercise 4.9 A person has preferences represented by the utility function

n
X
U (x) = log xi
i=1

where xi is the quantity consumed of good i and n > 3.

1. Assuming that the person has a …xed money income y and can buy com-
modity i at price pi …nd the ordinary and compensated demand elasticities
for good 1 with respect to pj , j = 1; :::; n.
2. Suppose the consumer is legally precommitted to buying an amount An
of commodity n where pn An < y. Assuming that there are no additional
constraints on the choices of the other goods …nd the ordinary and com-
pensated elasticities for good 1 with respect to pj , j = 1; :::n. Compare
your answer to part 1.
3. Suppose the consumer is now legally precommitted to buying
Pn an amount Ak
of commodity k, k = n r; :::; n where 0 < r < n 2 and k=n r pk Ak < y.
Use the above argument to explain what will happen to the elasticity of good
1 with respect to pj as r increases. Comment on the result.

Outline Answer

1. For the speci…ed utility function it is clear that the indi¤erence curves do
not touch the axes for any …nite xi , so we cannot have a corner solution.
The budget constraint is
Xn
pi xi y:
i=1

The problem of maximising utility subject to the budget constraint is

equivalent to maximising the Lagrangean
n
" n
#
X X
log xi + y pi xi :
i=1 i=1

The FOC are

1
pi = 0; i = 1; :::; n (4.23)
xi
and the (binding) budget constraint. From (4.23) we get
n
X
n pi xi = 0: (4.24)
i=1

and so, using the budget constraint, we …nd = n=y. Substituting the
value of into (4.23) we …nd:

(a) The ordinary demand function for good i is

y
xi = (4.25)
npi

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Microeconomics CHAPTER 4. THE CONSUMER

The
Pn indirect utility function V is given by = V (p; y) = U (x ) =
i=1 log xi . So, from (4.25) we have:

yn
= log (4.26)
nn p1 p2 p3 :::pn
Inverting the relation (4.26) the cost function C is given by
1 1
y = C(p; ) = [nn p1 p2 p3 :::pn e ] n = n [p1 p2 p3 :::pn e ] n (4.27)

Di¤erentiating (4.27) the compensated demand for good 1 is

1 n 1
x1 = p1 n [p2 p3 p4 :::pn e ] n (4.28)

(b) From (4.25) we have the elasticities

@ log x1
= 1;
@ log p1 y=const
@ log x1
= 0; j = 2; :::; n:
@ log pj y=const

(c) From (4.28) we have the compensated elasticities

@ log x1 1 n
= < 0;
@ log p1 =const n
@ log x1 1
= > 0; j = 2; :::; n
@ log pj =const n

2. The problem now is equivalent to maximising

n
X1
log xi + log An
i=1

subject to
n
X1
pi xi y0 ;
i=1

where y 0 := y pn An . Reusing the method above, the ordinary and

compensated demand functions are, respectively,
y0 y pn An
x1 = = (4.29)
[n 1] p1 [n 1] p1
2 n 1
x1 = p1n 1
[p2 p3 p4 :::pn 1e ]n 1
(4.30)

(a) So now, from (4.29) we have

@ log x1
= 1;
@ log p1 y=const
@ log x1
= 0; j = 2; :::; n 1:
@ log pj y=const

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Microeconomics

(as before) but

@ log x1 pn An
= <0
@ log pn y=const y0
The reason for this last result is that if the person is forced to buy the
…xed amount An then changing pn is equivalent to a simple income
e¤ect (think about what happens to y 0 ).
(b) From (4.28) we have
@ log x1 2 n
= < 0;
@ log p1 =const n 1
@ log x1 1
= ; j = 2; :::; n 1:
@ log pj =const n 1
@ log x1
= 0:
@ log pn =const

3. The problem is just a generalisation of part 2. The person is maximising

m
X
log xi + log A0
i=1
Pm Qn
subject toP i=1 pi xi y 0 , where m := n r 1, A0 := k=n r Ak and
0 n
y := y k=n r pk Ak . Ordinary and compensated demands are
Pn
y0 y k=n r pk Ak
x1 = = (4.31)
mp1 mp1
1 m 1
x1 = p1 m [p2 p3 p4 :::pm e ] m (4.32)
and so we have .
@ log x1 1 m
= < 0; (4.33)
@ log p1 =const m
@ log x1 1
= > 0; j = 2; :::; m: (4.34)
@ log pj =const m
@ log x1
= 0; k = n r; :::; n: (4.35)
@ log pk =const

Given that m = n r 1 it is clear that as r increases the elasticity (4.33)

decreases in absolute value and (4.34) increases. We also have
@ log x1 p k Ak
= < 0; k = n r; :::; n
@ log pk y=const y0

The model can be used to illustrate in part the comparative statics of some-
one who is subject to a quota ration xi Ai where the rationing constraint
is assumed to be binding in the case of goods n r to n. However, it is not
rich enough to allow us to determine which commodities are consumed at a
conventional equilibrium with MRS =price ratio, like (4.29), and which will be
constrained by the ration. Parts 2 and 3 show clearly how the compensated
demand becomes “steeper” (less elastic with respect to its own price) the more
external constraints are imposed –as in the “short-run” problem of the …rm.

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Microeconomics CHAPTER 4. THE CONSUMER

Exercise 4.10 Show that if the utility function is homothetic, then ICV = IEV

Outline Answer
Let x0 be optimal for p0 at 0
and x1 be optimal for p1 at 0
:

x2

αx1

x1
αx0
x0 υ1

υ0 x1
0

Figure 4.5: Homothetic preferences

Because of homotheticity, x0 must be optimal for p0 at 1

and x1 be
optimal for p1 at 1 : see Figure 4.5.
Hence X
C(p0 ; 0 ) = p0i x0i ;
X
C(p0 ; 1 ) = p0i x0i ;
X
C(p1 ; 0 ) = p1i x1i ;
X
C(p1 ; 1 ) = p1i x1i
So in this special case we have
P 1 1
p x
ICV = P 0i 0i
p i xi
P 1 1
p x
IEV = P i0 i0
p i xi
and the result follows.

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Microeconomics

Exercise 4.11 Suppose an individual has Cobb-Douglas preferences given by

those in Exercise 4.3.

1. Write down the consumer’s cost function and demand functions.

2. The republic of San Serrife is about to join the European Union. As a
consequence the price of milk will rise to eight times its pre-entry value. but
the price of wine will fall by …fty per cent. Use the compensating variation
to evaluate the impact on consumers’ welfare of these price changes.
3. San Serrife economists have estimated consumer demand in the republic
and have concluded that it is closely approximated by the demand system
derived in part 1. They further estimate that the people of San Serrife
spend more than three times as much on wine as on milk. They conclude
that entry to the European Union is in the interests of San Serrife. Are
they right?

Outline Answer

1. Using the results from previous exercises we immediately get

1 2 n
p1 p2 pn
C(p; ) = ::: :
1 2 n

This is su¢ cient. However, it may be useful to see the proof from …rst
principles. The relevant Lagrangean is
n
" n
#
X X
pi xi + i log xi (4.36)
i=1 i=1

The …rst-order conditions are:

i
xi = ; i = 1; 2; :::; n: (4.37)
pi
n
X
= i log xi (4.38)
i=1

From the n equations (4.37) we get at the optimum:

Pn Xn
pi xi
= Pi=1n = pi xi = y (4.39)
i=1 i i=1
Pn
where y is the budget, or minimised cost and i=1 i = 1. From (4.38)
we get, using (4.37):
n
X n
X n
X
= i log i + log i i log pi (4.40)
i=1 i=1 i=1
Pn
Using (4.39) and writing i=1 i log i = log A, equation (4.40) gives:

y = Ae p1 1 p2 2 :::pnn = C(p; ): (4.41)

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Microeconomics CHAPTER 4. THE CONSUMER

This is the required cost function. The demand functions are known from
Exercise 4.2 or are obtained immediately from (4.37) and (4.39):
iy
xi = ; i = 1; 2; :::; n: (4.42)
pi

2. Let p denote the original price vector, p ^ the price vector after entry.
Observe that p^milk = 8pmilk ; p^wine = 12 pwine . So, using (4.41):

C(^
p; ) = Ae p^1 1 p^2 2 :::^
pnn = Ae p1 1 p2 2 :::pnn b = bC(p; ): (4.43)

where
1
b := [8] [ ] wine = 23 milk wine
milk
(4.44)
2
Using the de…nition in the notes the compensating variation is therefore

CV(p ! p
^ ) := C(p; ) C(^
p; ) = [1 b] C(p; ) (4.45)

Clearly, the consumer will bene…t from p ! p ^ if CV(p ! p ^ ) > 0: the cost
of living – interpreted as the cost of hitting the original level of utility –
goes down. This condition is satis…ed if, and only if, b < 1.
3. Notice that, from (4.42), i = pi xi =y – the budget share of commodity
i. So, since we are told that wine > 3 milk it is clear that b < 1. The
economists are right!

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Microeconomics

Exercise 4.12 In a two-commodity world a consumer’s preferences are repre-

sented by the utility function
1
U (x1 ; x2 ) = x12 + x2

where (x1 ; x2 ) represent the quantities consumed of the two goods and is a
non-negative parameter.

1. If the consumer’s income y is …xed in money terms …nd the demand

functions for both goods, the cost (expenditure) function and the indirect
utility function.

2. Show that, if both commodities are consumed in positive amounts, the

compensating variation for a change in the price of good 1 p1 ! p01 is
given by
2 2
p2 1 1
:
4 p01 p1

3. In this case, why is the compensating variation equal to the equivalent

variation and consumer’s surplus?

Outline Answer
x2

x1

Figure 4.6: Possible corner solution

First sketch the utility function. Note that the indi¤erence curves touch
the axes – it is possible that one or other commodity is not consumed at the
optimum – See Figure 4.6. In this case it is easiest to substitute directly from
the budget constraint (binding at the optimum)

p1 x1 + p2 x2 = y

into the utility function. The consumer will then choose x1 to maximise
1 y p 1 x1
x12 +
p2

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Microeconomics CHAPTER 4. THE CONSUMER

The FOC is 1 p1
[x1 ] 2
=0
2 p2
which suggests that demands are
2 h i2 3
1 p2
x1 D (p1 ; p2 ; y)
= =4 2p1 5
x2 D2 (p1 ; p2 ; y) y 2 p2
p2 4 p1

But this neglects the possibility that we may be at a corner. Note that a strictly
positive amount of good 2 requires
2
p22
p1 > p1 :=
4 y
So demand functions are given by
8 h i2
>
< 2pp12 if p1 > p1
x1 = D1 (p1 ; p2 ; y) = (4.46)
>
: y
p1 otherwise
8 y 2 p
< p2 4 p1
2
if p1 > p1
x2 = D2 (p1 ; p2 ; y) = (4.47)
:
0 otherwise
Also, if p1 > p1 , maximised utility is

V (p1 ; p2 ; y) = U (x1 ; x2 )
2 2
p2 y p2
= +
2p1 p2 4p1
2
p2 y
= + (4.48)
4p1 p2
q
y
Otherwise V (p1 ; p2 ; y) = p1 : Also note ( for the case p1 > p1 ) that (4.48)
implies:
2
p2 x1
V1 (p1 ; p2 ; y) = = <0
4p21 p2
2
y x2
V2 (p1 ; p2 ; y) = = <0
4p1 p22 p2
1
Vy (p1 ; p2 ; y) = >0
p2
so that we immediately see that Roy’s identity holds. To …nd the cost function
write = V (p; y) and solve for y in terms of p and . This gives
2
p2 C(p; )
= +
4p1 p2
2 2
p2
C(p; ) = p2 (4.49)
4p1

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Microeconomics

for the case p1 > p1 and

h i2
C(p; ) = p1

otherwise.

2 Using the de…nition of the compensating variation

2
p2 y
V (p1 ; p2 ; y) = +
4p1 p2
2
p2 y CV
V (p01 ; p2 ; y CV) = +
4p01 p2
2 2
p2 1 1
CV(p ! p0 ) = (4.50)
4 p01 p1
As an alternative method use the consumer’s cost function (4.49). Clearly
we have:
2 2 2 2
p2 p2
C(p; ) C(p0 ; ) = 0
4p1 4p1

3 In this case the income e¤ect on commodity 1 is zero if p1 > p1 – see

equation (4.46). In the special case of zero income e¤ects CV=EV=CS

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Microeconomics CHAPTER 4. THE CONSUMER

Exercise 4.13 Take the model of Exercise 4.12. Commodity 1 is produced by

a monopolist with …xed cost C0 and constant marginal cost of production c.
Assume that the price of commodity 2 is …xed at 1 and that c > 2 =4y.

1. Is the …rm a “natural monopoly”?

2. If there are N identical consumers in the market …nd the monopolist’s
demand curve and hence the monopolist’s equilibrium output and price p1 .
3. Use the solution to Exercise 4.12 to show the aggregate loss of welfare
L(p1 ) of all consumers’ having to accept a price p1 > c rather than being
able to buy good 1 at marginal cost c. Evaluate this loss at the monopolist’s
equilibrium price.
4. The government decides to regulate the monopoly. Suppose the government
pays the monopolist a performance bonus B conditional on the price it
charges where
B = K L(p1 )
and K is a constant. Express this bonus in terms of output. Find the
monopolist’s new optimum output and price p1 . Brie‡y comment on the
solution.

Outline Answer

1. It is easy to see that the cost function is subadditive and therefore the
…rm is a natural monopoly.
2. Because consumers are identical we can just multiply the demand of one
consumer by N to get the market aggregates. We use this throughout the
answer.
If p2 is normalized to 1 then, given that there are N identical consumers
the market demand curve is given by
2
q = N x1 = N
2p1
which on rearranging gives
s
N
p1 = (4.51)
2 q
p
This gives the average revenue curve. So total revenue is 2 N q. Given
the structure of costs speci…ed in the question the monopolist’s pro…ts are
p
p1 q [C0 + cq] = N q C0 cq (4.52)
2
Di¤erentiating (4.52) we …nd the FOC characterising the monopolist’s
optimum as s
N
c= (4.53)
4 q

c Frank Cowell 2006 60

Microeconomics

where the expression on the right-hand side of (4.53) is marginal revenue.

Using (4.53) we …nd that the monopolist’s equilibrium output is given by
h i2
q =N
4c
Using (4.51) the price charged will be
s
N
p1 = 2
2 N [ =4c]
in other words
p1 = 2c (4.54)
Maximised pro…ts are
h i2 h i2
p1 q cq C0 = 2cN cN C0
4c 4c
2
N
= C0
16c
3. Using (4.50) and multiplying by N , the (absolute) loss of welfare of each
consumer of having to buy at price p1 rather than at marginal cost c is
given by
N 2 1 1
L(p1 ) = N CV = (4.55)
4 c p1
Using (4.54) to evaluate (4.55)
N 2 1 1
L(p1 ) =
4 c 2c
2
N
= >0
8c
4. Pro…ts, including the performance bonus, are now
p
p1 q C0 cq + B = N q C0 cq + B (4.56)
2
where, from the de…nition in the question and (4.55)
B = K L(p1 )
N 2 1 1
= K (4.57)
4 c p1
Given (4.51) we …nd that (4.57) can be written as
2
r
N 2 q 1
B(q) = +K
4 N c
p 2
N
= Nq +K (4.58)
2 4c
and so, substituting from (4.58) into (4.56) we get
p 2
N
p1 q C0 cq + B = Nq cq + K C0 (4.59)
4c

c Frank Cowell 2006 61

Microeconomics CHAPTER 4. THE CONSUMER

The FOC for maximising (4.59)

s
N
=c
2 q

and so
h i2
q = N >q
2c
p1 = c < p1

Of course this is just the solution “price equal to marginal cost.”The bonus
scheme has made the monopolist simulate the outcome of a competitive
industry.

c Frank Cowell 2006 62