Review Problems 1

1. Bunter was asked to solve the following problem:

Find the value of x between 0 and 2, inclusive, that maximizes f (x) = x2 .

Here is Bunter’s answer:

The derivative of f (x) with respect to x is 2x. I set 2x = 0 and solved for x. It came out
that x = 0, so the value of of x that maximizes f (x) in the given interval is x = 0.

Is Bunter correct?1
2. Bunter was asked to solve the following problem:

Find the value of x between 1 and 3, inclusive, that maximizes f (x) = x2 .

Here is Bunter’s answer:

The derivative of f (x) with respect to x is 2x. I set 2x = 0 and solved for x. It came out
that x = 0. However that value is not in the given interval. The value of x in the interval
closest to 0 is x = 1. This is the value of of x that maximizes f (x) in the given interval,
i.e., x = 1.

Is Bunter correct?
3. Bunter was asked to solve the following problem:
max x(1 − x) s.t. x ≤ 1
Here is Bunter’s answer:

The Lagrangean is
L(x, λ) = x(1 − x) + λ(1 − x).
∂L
= 1 − 2x − λ = 0
∂x
∂L
=1−x=0
∂λ
The second equation gives x = 1, so this is the value x that solves the problem.
1
His tight trousers against which boots and canes are constantly thudding, his astuteness in search of food, his
postal order which never turns up, have made him famous wherever the Union Jack waves.

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 Is Bunter correct?

4. Bunter was asked to solve the following problem:

max x(1 − x) s.t. x ≤ 0.25

Here is Bunter’s answer:

The Lagrangean is

L(x, λ) = x(1 − x) + λ(0.25 − x).

∂L
= 1 − 2x − λ = 0
∂x
∂L
= 0.25 − x = 0
∂λ
The second equation gives x = 0.25, so this is the value x that solves the problem.

Is Bunter correct?

5. Consider the table below that shows the incremental RP for various amounts of the product
SOMA.2

Quantity First Unit Second Unit Third Unit Fourth Unit

A’s RP 7 5 3 1
This table means that she values the first unit of SOMA at $7. She values her second
unit of SOMA at $5 and so on. Notice that her incremental RP’s are declining; she exhibits
diminishing marginal returns. You may assume that the RP for the fifth and higher units is
zero.
Suppose each unit of SOMA was being sold for $4. How many units would she buy?

6. Consider a SOMA producing monopolist with unit costs of production of $1 a unit. There
is only one customer, A, and her incremental RP for various amounts of SOMA are shown
in the table below:

Quantity First Unit Second Unit Third Unit Fourth Unit

A’s RP 9 7 5 3
You may assume that the RP for the fifth and higher units is zero. The table below lists
2
A possibly fictitious plant whose juice was used in India to produce an intoxicating drug. It appears in Huxley’s
Brave New World as a narcotic that is distributed by the State to produce social harmony.

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 possible per unit selling prices for SOMA. Fill in the demand (of A) at each of those prices
and the corresponding profits to the seller.

Price per Unit 1 2 3 4 5 6 7

A’s demand
Profit
What price will maximize the seller’s profits?
7. Suppose it costs a monopolist C(q) = q to produce q units. Suppose the demand for her
product at a unit price of p is D = 9 − p. Identify the profit maximizing price.
8. A monopolist faces the following demand relationship: D = 100 − 5p where D is demand
and p is the price per unit. The fixed costs of production are $20 and her cost of production
is a constant $10 a unit.
(a) Write down an expression for the monopolist’s profit as a function of the unit price p.
(b) What is her profit maximizing price?
(c) What is the profit maximizing level of output?
(d) What is the maximum amount of profit?
(e) What effect will a fixed tax of $20 have on the monopolist’s output and price?
(f) Suppose instead the monopolist must pay a tax of $2 on every unit produced. What is
her new profit maximizing price?

9. Suppose the selling price of SOMA is $12 a unit (and it can sell all that it produces at that
price) and the firms cost curve is C(x) = x2 + 16. Its marginal cost curve is 2x. Compute
the profit maximizing level of output.
(a) What is profit at this level of output?
(b) What happens to the profit maximizing level of output as its unit selling price increases
?

10. It costs a monopoly supplier of Soma q 2 + 16 to produce q units of Soma. If she charges a
price p per unit for Soma, the demand will be 100 − p. What price should she charge to
maximize profit? What quantity will she produce at this price? What is the elasticity of
demand this price?
11. It costs a monopoly supplier of SOMA 2q 2 to produce q units of Soma. If she charges a price
p per unit for Soma, the demand will be 100 − p. What price should she charge to maximize
profit? What quantity will she produce at this price?

12. Suppose demand, D, is related to unit price p by

D = 100 − p.
What is the elasticity of demand when the price p is $2.

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13. The monopoly supplier of SOMA has constant production costs of $1 a unit. It is currently
charging $2 a unit to its customers. At this price the elasticity of demand is 0.5. Is the
current selling price of $2 a unit profit maximizing?

14. Bunter was asked to solve the following problem:

A Soma producing monopolist has a production cost function, C(q) = 2q. Notice, the
marginal cost of each unit is $2 (constant returns to scale). The monopolist sells her product
into two distinct markets. In market 1, demand as a function of unit price is D1 (p) = 9 − p.
In market 2, demand as a function of unit price is D2 (p) = 4 − 2p. The monopolist can
choose to sell in none, one or both markets. If it chooses to sell in both markets, it must set
the same price both markets. What should the monopolist do to maximize profit?

Here is Bunter’s answer:

If p is the per unit price chosen by the monopolist, total profit will be
p(9 − p) + p(4 − 2p) − 2(9 − p) − 2(4 − 2p).
To find the value of p that maximizes this, differentiate and set to zero:
19
9 − 2p + 4 − 4p + p + 2 + 4 = 0 ⇒ 6p = 19 ⇒ p = .
6
As the second derivative of the profit function is negative, this must be the profit maximizing
price.

Is Bunter correct?
15. A monopolist sells her product into two distinct markets. In market 1, demand as a function
of unit price is D1 (p) = 9 − p. In market 2, demand as a function of unit price is D2 (p) =
4 − 2p. Total demand at price p per unit is D1 (p) + D2 (p). What is the total demand at a
price of p = 1.5 and p = 3?
16. A profit-maximizing monopolist faces the inverse demand function described by p = 50 − 4q.
The monopolist has no fixed cost and his marginal cost is 5 at all levels of output.

(a) Set up the monopolist’s problem and solve for his optimal price and quantity.
(b) A quantity tax of $2 per unit is imposed on the monopolist’s product by the government.
If the monopolist must pay the this tax, how does it affect the price for the product?
(c) A quantity tax of $2 per unit is imposed on the monopolist’s product by the government.
If the buyer must pay the this tax, how does it affect the price for the product?

17. Huxley Corp the monopoly supplier of SOMA sells to a market 10 miles away from the Soma
plant. The demand as a function of delivered price (p) in cents in that market is Demand
= 100 − p. Variable manufacturing costs are 20 cents a unit and transportation costs are 1
cent per unit per mile. Huxley is not obliged to serve all markets.

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 (a) Suppose Huxley corp adopts a uniform delivery price (UDP). That is Huxley pays the
transportation costs. What UDP price will maximize Huxley’s profit?
(b) Suppose Huxley adopts a Freight On Board Price (FOB). That is customers pay the
transportation costs. What FOB price (per unit) should Huxley Corp. quote to maxi-
mize its profit?

18. It costs a firm C(q) to produce q units of output. If C(q) = q 3 − q 2 what kind of returns to
scale does this technology exhibit for q ≥ 1/3?

19. Suppose that North Pole Enterprises makes ice sculptors in the North Pole and ships them to
the United States, where they are sold in a regulated ice-sculpture market for a fixed price of
125 dollars. The primary input in North Pole Enterprises production is ice. Unfortunately,
NPE doesn’t own any rich ice-producing land in the North Pole, and hence must purchase
ice from one of the many firms that produce ice.
Since NPE is the only demander of ice produced in the North Pole, it acts as a monopsonist
and sets a single price of ice. Call the price of ice i and say NPE sets i = r. If it does so, it
will be able to purchase r units of ice. NPE’s production function for sculptures is given by
√
F (x) = 4 x

where x is the amount of ice it uses.

(a) Set up NPE’s profit maximization problem.

(b) How much ice does NPE use and what is the price of ice?

20. Bruce’s inverse demand function for burgers is given by

p = 288/(q + 1)2 .

Bruce is currently consuming 11 burgers at a price of 2 dollars.

(a) How much money would Bruce be willing to pay to have this amount rather than no
burgers at all? What is his level of (net) consumer surplus?
(b) Now suppose the price of a burger rises from $2 to $8. What is Bruce’s change in
consumer surplus?

21. A profit-maximizing monopolist faces the following inverse demand curve: p = 60 − Q. The
monopoly’s costs are given by
1
C(Q) = Q2 .
2
(a) Suppose the monopolist can just charge a single price. What is the optimal monopoly
price and quantity?

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 (b) A quantity tax of t > 0 per unit is imposed on the monopolist’s product by the gov-
ernment. How does this tax affect the price for the product and the quantity of the
output? (Derive the profit maximizing quantity and price as a function of t.)

(c) If the government regulation authority requires the monopolist to charge a price equal
to the marginal cost of the last unit produced, what is the profit for this monopolist?

(d) Now suppose the government regulatory authority will chose the level of production
and the price of the output for the firm subject to the requirement that the firm earns
zero profit. If the regulator wished to maximize consumer surplus, which quantity will
it choose for the firm? What will the price be?

∂f ∂f ∂2f
22. Find the partial derivatives ,
∂x ∂y
and ∂x∂y
for f (x, y) = xy .

23. A monopoly employs capital and labor as the inputs, and the production function is f (K, L) =
min{K, L}. Denote the interest rate for capital as r, the wage rate as w.

(a) For a given target level q of output, sketch the curve of (K, L) combinations that will
generate q.3 Place K on the horizontal and L on the vertical.
(b) For a given cost C, sketch the the curve of (K, L) combinations that will cost C.4
(c) Denote by C(q) the minimum cost combination of K and L to generate an output of
q. What is C(q) as a function of w, r and q?
(d) Does C(q) have increasing, decreasing or constant returns to scale?
(e) For a given target level of output, would an increase in w result in the monopoly
consuming less L and more K?

24. A firm uses two inputs, called 1 and 2 to produce an output. Let xi denote the number of
units of input i used in the production process. The production function is given by
1/2
f (x1 , x2 ) = x1 [min{x2 , 4}]1/2 .

The unit prices of these inputs are given by w1 and w2 respectively.

Derive the firm’s cost function.
Hint: You first have to decide whether x2 = 4 or not.

25. A firm uses capital K and labor L to produce Soma. It has two possible technologies it
can use (and can switch costlessly between them). The first is defined by the production
q = f (K, L) = K + 2L. Call this technology F . The other, technology G, is defined by
the production function q = g(K, L) = 2K + L. Starting with a wage rate of w = 0 and
then increasing it, explain as a function of w, which of the two technologies the firm should
deploy. Assume the interest rate for capital is r = 1.
3
This is called an isoquant.
4
This is called an isocost curve.

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26. A monopolist uses three inputs to produce an output. The production function is given by
1/2
f (x1 , x2 , x3 ) = x1 [min{x2 , x3 }]1/2 .

Here xi is the quantity of input i. The prices of these inputs are given by w1 , w2 and w3
respectively.

(a) Write down an optimization problem whose solution would determine the minimum
cost combination of the xi ’s to generate an output q.
(b) Let x∗1 , x∗2 and x∗3 be an optimal solution to the optimization problem. Explain why
x∗2 = x∗3 .
(c) Solve the optimization problem to determine the minimum cost to produce q units as
function of w1 , w2 and w3 . Use the observation in part (2).
(d) The firm faces a demand curve of 100 − p where p is the unit price. What is the
monopolist’s profit maximizing price as function of w1 , w2 and w3 .

27. A monopoly employs capital and labor as the inputs, and the production function is f (K, L) =
1 1
2K 2 L 4 . Denote the interest rate for capital as r, the wage rate as w and the output price
as p.

(a) Write down the firm’s profit maximization problem.

(b) Solve for the optimal labor input (L∗ ), the optimal capital input (K ∗ ) and the optimal
profit level (π ∗ ) in terms of r, w and p. What fractions of total spending are allocated
to each input?
∂L∗ ∂K ∗ ∂L∗ ∂K ∗
(c) What are ∂w
and ∂w
? What are ∂p
and ∂p
? Discuss the signs of these objects.
1 1
(d) Now suppose the production function has changed to be f (K, L) = (2K 4 + L 4 )2 .
Calculate the optimal labor input (L∗ ), the optimal capital input (K ∗ ) and the optimal
profit level (π ∗ ) in terms of r, w and p.

28. Suppose a firm has production function q = f (L, K) = min(2L + K, L + 2K). Where K is
the quantity of capital and L the quantity of labor used. Draw the isoquants for this firm.
Derive the input demand functions for production of q unit of output, as a function of q, r
(the unit price of K), and w (the unit price of L).

29. Buber, a ride sharing service in Ruritania, matches riders with drivers interested in traveling
between Streslau and Hentzau. Buber posts a price per one-way ride. Riders and Drivers
observe the price and send a message to Buber if they are willing to either pay that much
for a ride or accept that much (less a commission) to provide a ride. Buber pockets the 20%
commission. For example, if Buber posts a price of $20, a rider who accepts will pay $20 for
a ride and the driver ferrying them will receive 0.8 × 20 = 16.
Buber knows the demand curve for rides, its D(p) = 100(1 − p), where p is the per ride
price. Potential drivers will only sign up if what they receives exceeds their opportunity cost
of doing something else as well as the marginal cost of ferrying someone one-way between

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 K

q
3

0 q q L
3

Figure 1: Isoquant for Question 3

the two cities. Buber has determined that if drivers are offered w per ride, 100w drivers will
volunteer to provide rides.
Buber is committed to ensuring that any rider willing to pay the posted price will be matched
with a driver. However, not every driver who announces they are willing to provide a ride
will be matched with a ride.

(a) What price should Buber post to maximize its revenue?

(b) At the price you identified in part (1), what is the total consumer surplus to riders?
(c) Suppose Buber were entirely benevolent and charged no commission. What price would
a benevolent Buber post if it wanted to maximize the surplus of riders?
(d) For this part only, suppose King Rudolf of Ruritania announces, in response to a cam-
paign by celebrities with more twitter followers than brain cells, that Buber must set a
price equal to the level identified in part (3). How should Buber adjust its commission
to maximize revenue under this new policy?
(e) The CEO of Buber believes that the 20% commission being charged to drivers does
not generate sufficient revenue. Instead he suggests charging the buyers a commission
instead of the drivers. Specifically, when Buber posts a price per ride of p, the driver
receives p but the buyer pays 1.2p. Would such a change generate more revenue for
Buber than in part (1).

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30. The Umbrella Corporation is the monopoly supplier of Adravil to Devlin-McGregor Pharma-
ceuticals. Devlin-McGregor combines Adravil with Havidol (sold by Cyberdine Industries)
to produce Provasic. Devlin-McGregor is the monopoly supplier of Provasic and faces a
demand curve of 100 − p, where p is the unit price of Provasic.
1 1
Devlin-McGregor’s production function is given by f (a, b) = a 2 b 2 where a is the number of
units of Adravil and b is the quantity of Havidol.
The Umbrella Corporation’s production costs for Adravil are a constant $1 a unit. The
Umbrella Corporation moves first and sets the price w per unit for Adravil that Devlin-
McGregor must pay. Cyberdine has promised Devlin-McGregor that it will supply Havidol
at a price equal to the price set by the Umbrella corporation. Devlin-McGregor in turn sets
the unit price p downstream to maximize its profit.

(a) What price should the Umbrella Corporation set for Adravil to maximize its profit? (5
points)
(b) Cyberdine now announces that it will charge twice whatever price the Umbrella corpo-
ration sets. Is this good or bad for the Umbrella Corporation? (1 point)

31. Consider a monopolist with zero marginal cost selling two products, 1 and 2. The inverse
demand for each product is listed below: Product 1’s inverse demand:

p1 = 1 − q1 − δq2

Product 2’s inverse demand:

p2 = δ(1 − q1 − q2 )
Here 0 < δ < 1. What quantities of each product should the monopolist produce to maximize
its profit?

32. Grow-Fast Inc. has a patent on a chemical product that is used as a key input in producing
farm and home agricultural fertilizer. Currently, Grow-Fast produces the product and sells
it to companies who manufacture the final products for the home and farm users. Grow-Fast
faces the following demand curves in each segment:

• (FARM) D = 30 − p
• (HOME) D = 20 − 2p

where D is demand and p is price per unit. Grow-Fast can produce the product at a constant
$2 a unit.

(a) Determine the profit maximizing price Grow-Fast should charge in the FARM market.
(b) Determine the profit maximizing price Grow-Fast should charge in the HOME market.
(c) If Grow-Fast attempted to charge different prices to the HOME and FARM segment,
what should it be concerned about?

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33. Grow-Fast Inc. has a patent on a chemical product that is used as a key input in producing
farm and home agricultural fertilizer. Currently, Grow-Fast produces the product and sells
it to companies who manufacture the final products for the home and farm users. Grow-Fast
faces the following demand curves in each segment:
• (FARM) D = 100 − p
• (HOME) D = 10 − p
where D is demand and p is price per unit. Grow-Fast can produce the product at a constant
$5 a unit.
(a) Determine the profit maximizing price Grow-Fast should charge in the FARM market.
(b) Determine the profit maximizing price Grow-Fast should charge in the HOME market.
(c) If Grow-Fast is forced to charge the same price in both markets, what price should it
charge to maximize profit?

34. Suppose you are the sole seller of a software application whose marginal cost is zero. Suppose
three segments of customers: 100 Power User customers willing to pay up to $10 for the good,
200 Regular customers willing to pay up to $5 for the good, and 300 Occasional customers
willing to pay up to $3 for the good.
(a) Suppose you cannot identify which segment a buyer belongs to, so you must charge the
same price to all customers. What is the revenue maximizing price?
(b) Suppose you could identify each of the segments, and prevent resale among them. If
you could charge different prices to different segments, what prices would you set to
maximize revenue?

35. Suppose you create a Premium version of your product, but you know you could disable
some of the features in order to create a Normal version of your product. Both versions have
zero marginal cost.
Suppose you have two groups of customers each interested in buying at most one version.
Thirty (30) Major Users are willing to pay up to $20 for the Premium version of your product
and $0 for the Normal version of your product. Seventy (70) Minor Users are willing to pay
up to $7 for the Premium version of your product and $5 for the Normal version of your
product. Each consumer will choose the product that gives her the highest surplus.
(a) If you offer only the Premium version of your product, what price should you charge in
order to maximize revenue?
(b) If you offer both versions of the product, what prices should you set to maximize
revenue.
(c) Now suppose that instead of valuing the Normal version at $0, the Major Users value
the Normal version at $12. Keep all other RPs the same as before. Show that at the
prices you chose in (b), Major Users would actually prefer to buy the Normal good
instead of the Premium good. Then show that if this happened, you would be better
off choosing the single-product strategy in (a).

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 (d) Consider keeping the Normal version at the same price as in (b), but lowering the
Premium price until the Major Users will be willing to buy the Premium good instead
of the Normal good. What pair of prices will you now be charging? What profits
will you make? Is this better or worse for the firm than the single-product strategy
described in (a)?

36. Mark has an RP for a word processor of $120 and an RP for a spreadsheet of $100. Noah’s
RP for a word processor is $100 and for a spreadsheet is $120.

(a) If you price each product individually, what prices should you set to maximize revenue?
(b) If you sell the two products as a bundle, what price should you set to maximize revenue.
(c) Could mixed bundling generate more revenue than either of the possibilities above?
(d) Suppose we add a third customer, Oscar, whose RP for a word processor is $150 and for
a spreadsheet is $10 (perhaps he’s a professional writer). What pricing scheme (selling
individually, pure bundling, mixed bundling) would maximize revenue?
(e) Suppose we now add a fourth customer, Peter, whose RP for a word processor is $20
and for a spreadsheet at $160 (perhaps he’s an accountant). Now what is the revenue
maximizing pricing strategy?

37. A monopolist sells two products (Soma and Mosa) to a market consisting of 3 consumers.
The RP of each consumer for each of the two products is shown in the table below:

Customer RP for SOMA RP for MOSA

A $4 $0
B 3 3
C 0 4

(a) If the monopolist sold Mosa and Soma individually, what will the revenue maximizing
price of each product be?
(b) If the monopolist sells Mosa and Soma together in a bundle (but never individually)
what is the revenue maximizing price of the bundle? Assume the RP for a bundle is
just the sum of the RPs of the components.
(c) If the monopolist offers the products individually or in a bundle, what should the
revenue maximizing price of each product and the bundle be?

38. Your firm produces two products, X and Y. Both products are produced at 0 marginal cost.
You face four customers whose RP’s for the product are shown below:

• Customer A: RP for X = 30, RP for Y = 90

• Customer B: RP for X = 40, RP for Y = 60
• Customer C: RP for X = 60, RP for Y = 40

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 • Customer D: RP for X = 90, RP for Y = 30
Consider the 3 alternative pricing strategies: (a) selling each product separately, (b) pure
bundling and (c) mixed bundling. For each strategy determine the profit maximizing price
to be charged and resulting profit. Which strategy yields highest profit?
39. You are in charge of regulating the monopoly electricity supplier in Ruritania. Demand for
electricity in Ruritania depends on both the price and the period of the day. The day can
be divided into two periods; peak and off-peak. Each period lasts 12 hours. The hourly
demand for electricity as a function of the per unit price in each period is given below:
Peak: D(p) = 100(1 − p)
Off-Peak: D(p) = 50(1 − p).
During the peak period, the hourly production costs are a constant $0.20 per unit per hour
while during the off-peak they are a constant $0.10 per unit per hour. Buyers who choose
not to purchase electricity, rely on wood, natural gas and the kindness of strangers.5
(a) As the regulator, what price should you set in each period to maximize consumer surplus
plus producer profit?
(b) As variable pricing may be unpopular, you also consider the possibility of setting the
same price in each period. In this case, what price should you pick to maximize con-
sumer surplus plus producer profit?
(c) The electricity supplier argues that you have ignored the costs incurred in ramping up
and down when one switches between periods. These costs can be substantial. So,
they suggest fixing the quantity of electricity supplied in each period at the same level
and letting the price adjust even if this requires a negative price (interpret this as a
subsidy). Would this be better or worse (as measured by total surplus) than the option
considered in (b)?

40. You are the monopoly supplier of Soma to a market consisting of two segments, heavy users
and light users. There are 1000 heavy users and 4000 light users. The demand curve for
Soma for a heavy user is DH = 240 − 2p, where p is the unit price. The demand curve for
Soma for a light user is DL = 100 − p, where p is the unit price. Your have constant marginal
cost of $20 a unit.
(a) If you were selling only to light users, what would your profit maximizing two-part tariff
be?
(b) If you were selling only to heavy users, what would your profit maximizing two-part
tariff be?
(c) If you were selling to both segments, what would the profit maximizing two-part tariff
be?

41. Devlin-McGregor is the monopoly supplier of Provasic into a market that consists of heavy
and light users. Half the market are heavy users and the other half are light users. The
demand curves (as a function of unit price) for a member of each segment are shown below.
5
Ruritanians are world famous for their hospitality and kindness.

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 • (HEAVY) DH (p) = 100 − p
• (LIGHT) DL (p) = 10 − p
Devlin-McGregor can produce each unit of Provasic for $5 a unit.
(a) Determine the profit maximizing two-part tariff Devlin-McGregor should charge in the
HEAVY users.
(b) Determine the profit maximizing two-part tariff Devlin-McGregor should charge in the
LIGHT users.
(c) If Devlin-McGregor is forced to use the same two-part tariff for both segments, what
should it be set at to maximize profit?
(d) The R&D department at Devlin-McGregor has developed a special monitor for users of
Provasic that measures their dosage levels and sends the user reminders to take their
meds. Each monitor costs 1 cent to produce. The CEO of Devlin-McGregor proposes
a new pricing strategy involving the monitor to get around the restriction in part (3).
Devlin McGregor should sell the monitor for a price of K, say. Anyone who purchases a
monitor is entitled to purchase Provasic for p per unit. Anyone who does not purchase
a monitor can buy Provasic but at a higher price, p0 > p per unit. What combination
of K, p and p0 will maximize profit under this scheme?

42. Firm A sells clothes in a mall on the east side of town and currently earns $100, 000 in profits.
Firm B, which sells clothes on the West side, currently earns $50,000. A is considering
building a second store on the West side that would cost it $20,000. B on the other hand is
considering a redesign of his one store on the West side to resemble A’s store, which would
cost it $10,000.
If A builds the new store and B does not redesign, A’s current profits go up by $30,000
while B’s will go down $30,000. If B redesigns and A does not build the new store, B’s
current profits will increase by $20,000 and A’s will go down $20,000. If A builds the new
store and B redesigns its store, their current profits decrease by $40,000 each from the
increased competition. These profit figures account for the costs of building and redesign
where appropriate.
(a) Write down the payoff matrix of the game where they must make their moves simulta-
neously. and determine all equilibrium outcomes.
(b) Suppose that A can make a credible commitment to building the new store before B
can decide (or commit) what to do, what should A do?

43. Consider an environment with 3 independent firms and 2 consumers. Firms 1 and 2 make a
browser while firm 3 makes an operating system. The browser of firms 1 (called browser 1)
and 2 (called browser 2) are compatible with the operating system sold by firm 3. Each of
the two consumers is interested in buying one operating system and one browser. Browser’s
without operating systems and operating systems without browsers have no value.
Consumer A has a RP of $3 for a combination of browser 1 and an operating system but
a RP of $1 for a combination of browser 2 and an operating system. Consumer B on the

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 other hand has a RP of $1 for a combination of browser 1 and the operating system and has
a RP of $3 for a combination of browser 2 and the operating system. Both consumers will
make purchase decisions so as to maximize consumer surplus and manufacturing costs for
all firms are 0.

(a) Consider the following combination of prices: firm 1 sell’s its browser for $ 2 per unit,
firm 2 sell’s its browser for $2 while firm 3 sell’s its operating system for $1. Show that
no firm acting alone has an incentive to deviate from the above prices if the other two
do not.
(b) Suppose that firm 3 costlessly acquires firm 1 and integrates browser 1 into its operating
system. Customers are still free to purchase browser 2 and use it with firm 3’s new
operating system. What is the highest price that firm 3 can charge (and still make a
profit) for the new operating system so as to drive firm 2 out of business (i.e. force firm
2’s price to be 0 or less)? Justify your answer.
(c) Consider the combined profits of firm’s 3 and 1 before the acquisition [under the price
regime described in (a)] and after [in the regime identified in (b)]. In which scenario
are they higher? Given an intuitive explanation for the difference.

44. There are two firms, A and B. Each makes a hard drive and a monitor. Label the hard drive
and monitor made by A as AH and AM respectively. Label the hard drive and monitor
made by firm B as BH and BM respectively. Manufacturing costs of all products are zero.
Buyers are interested in purchasing a system rather than individual components. That is,
they want to purchase a hard drive and a monitor. We can divide buyers into 3 equally sized
groups of size 2. So, there are 6 buyers altogether.
The groups are labeled AA, BB and AB. They differ in the value they place on different
hard drive and monitor combinations. These valuations are summarized in the table below:

Buyer Segment AH, AM BH, BM AH, BM AM, BH

AA $10 $5 $5 $5
BB $5 $10 $5 $5
AB $5 $5 $10 $0
So, the AA’s prefer a system that is made up entirely of A components and the BB’s prefer
one that is made up of B components only. The AB’s have a preference for systems that
combine a hard drive from A and a monitor from B. Given the price of a system, buyers will
buy the system that generates the largest surplus. For example if the price of an A system
is $8 while that of a B system is $2, the AA’s will buy the B system. In case of a tie, the
AA’s will buy a system from A, the BB’s will be buy from B.
There are two scenarios to consider. In scenario 1, the hard drive of A is incompatible with
the monitor of B and the hard drive of B is incompatible with the monitor of A. In this
scenario, the AB’s will split equally between the two sellers if the surplus on each system is
the same (and at least 0). That is one will buy a system from A and the other from B.
In scenario 2, each firm’s products are compatible with the other firms products.

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 (a) In scenario 1, is both firms pricing a system at $10 an equilibrium?
(b) In scenario 2, is both firms pricing each component at $5 an equilibrium?
(c) In scenario 1, incompatibility serves to segment the market in that Firm A’s products
are clearly different from Firm B’s products. Which scenario is more profitable for firm
A? Give an intuitive explanation.

45. In the Cournot model, competition between two firms is treated as a game. Their strategies
consist of simultaneous quantity choices. In terms of information each knows as much as the
other. Collusion is ruled out.
The inverse demand for Soma as a function of total quantity is 1 − q1 − q2 , where qi is the
quantity chosen by firm i = 1, 2. If the total amount produced is more than 1, the price will
be zero.6 Both firms have a cost function of C(x) = x2 , where x is the amount produced.
Compute the equilibrium quantities chosen by each firm.
46. Two firms, one makes a high quality product (H) and the other a low quality product (L).
Production costs are zero for both firms. Let h be the unit price of H and p the price of L.
There are two types of consumers, ‘choosy’ and ‘cheap’ each interested in buying at most
one unit from either H or L. Cheap consumers are indifferent to quality and shop only on
price. The firm with lowest price (in the cheap market) makes sales of 1 − s where s is the
lowest price, to the cheap market, with sales split evenly if the two firms charge the same
price.
Amongst the choosy consumers, demand for H’s product is given by 1 − h + p while the
demand for L’s product is h − p.

(a) If H and L sell only to the choosy market and choose prices simultaneously, what price
will each charge in equilibrium?
(b) Now suppose H sells only to the choosy market while L sells to both markets and does
so at the same price. What happens to equilibrium prices?
(c) At these prices (the ones in (b)) does H have an incentive to enter the cheap market
and undercut L? Assume that H must charge the same price in the cheap market as it
does in the choosy one.
(d) Does the answer to the previous question change if H can charge different prices to the
different markets?

47. There are two companies (LEFT and RIGHT) located 1 mile apart. Between LEFT and
RIGHT are one thousand customers, evenly/uniformly distributed.7 Each of these customers
wants exactly one unit of SOMA and has a RP of $3 for either companies product. Each
firm has 0 marginal costs of production. Shipping costs (for both sellers and buyers) are $1
a mile.
6
If you like, imagine the total demand in the market is 1 unit. If more than 1 unit is produced, supply exceeds
demand and so price is 0.
7
This means the number of customers in any segment between 0 and 1 is proportional to the length of that
segment. For example, the number of customers between 0 and 0.25, will be 0.25 × 1000.

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 (a) Suppose the two companies adopt the FOB rule. What price or prices will emerge in
the market? How much money will LEFT and RIGHT make?
(b) Next suppose the two companies adopt the UDP rule. What price or prices will emerge
in the market now? How much money will LEFT and RIGHT make? Assume that
under equal UDP prices, customers flip a fair coin to decide where to go.
(c) Next suppose LEFT and RIGHT merge to form one company. The merged entity
retains the two locations at which LEFT and RIGHT previously operated. Suppose
the merged company adopts the FOB rule (at both locations). What price will it quote?
How much money will it make?
(d) As in c above, but the merged firm uses the UDP rule.

48. There are two stores that sell the same product. One is a discount store and let p represent
its unit price. The other is a non-discount or high price store, let h represent its unit price.
Assume throughout that p ≤ h. Marginal costs for both stores are zero.
Buyers do not know which store is which unless they pay a search cost. However, they are
aware of the average store price, i.e., each buyer knows the value of p+h
2
before searching.
For every number s between 0 and 1 (including the endpoints) there is a buyer with search
cost s. That is, each number in [0, 1] represents a buyer and vice-versa. The fraction of
buyers with a search cost of at most w ∈ [0, 1] will be w.
Buyers with a high s value are high time-value buyers, whose cost of searching for the lowest
price is high. Buyers with low s are low time-value customers for whom the cost of searching
and shopping is low. The cost of searching for a buyer of type s is Cs where C ≥ 2 is a
parameter that measures the actual cost of searching.
If a buyer does engage in search, they will buy from the discount store; as it always has the
lower price. A buyer of type s will search if
p+h
p + Cs ≤ .
2
That is, the cost of searching plus purchasing is less than the cost of buying at random.
So, the largest value of s a buyer can have and still search is h−p
2C
. Therefore the fraction of
h−p
buyers who search at prices p and h is 2C .
Half of all buyers who do not search will purchase at the high priced store and the other half
will purchase at the discount store.

(a) For given prices p and h, what fraction of buyers will choose the discount store?
(b) For given prices p and h, what fraction of buyers will choose the high priced store?
(c) Derive the reaction function of the discount store.
(d) Derive the reaction function of the non-discount store.
(e) What are equilibrium prices as a function of C.
(f) What fraction of buyers search in equilibrium?

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 (g) As the cost of searching, C, increases what happens to the fraction of buyers who
conduct a search.
(h) Give an intuitive explanation for your answer.

49. Cyberdine and the Umbrella Corporation each produce a smart diaper for zero marginal
cost.8 Both companies sell their diapers to Wal-Mart which in turn sets the price of each
brand downstream. Wal-Mart is a monopolist in the downstream market. The diapers
are substitutes for each other and the downstream demand for each is summarized in the
following pair of demand curves:

Dc = 100 − pc + 0.5pu

Du = 100 − pu + 0.5pc
The first is the demand for Cyberdine’s diapers as a function of Cyberdine’s unit price (pc )
and Umbrella’s unit price (pu ). Similarly with the second demand curve.

(a) Cyberdine and Umbrella move first and simultaneously by setting a wholesale price
to Wal-Mart. Let wc be Cyberdine’s wholesale price to Wal-Mart. Let wu be the
Umbrella’s Corporation’s wholesale price to Wal-Mart. Wal-Mart moves second and
chooses the downstream prices pc , pu to maximize its profit. Compute the profit maxi-
mizing choice of pc and pu as a function of wc and wu .
(b) Compute the quantity that Wal-Mart orders from each of Cyberdine and Umbrella.
(c) Determine Cyberdine’s and the Umbrella Corporation’s reaction function.
(d) What prices do Cyberdine and Umbrella charge in equilibrium?
(e) The CEO’s of both Cyberdine and Umbrella have both heard of double marginalization.
They each decide to bypass Wal-Mart and sell directly downstream. Does this make
them better or worse off than before?
(f) Suppose instead Wal-Mart had the power to dictate the wholesale price to Cyberdine
and Umbrella. In other words, Wal-Mart makes credible take-it-or-leave-it offers to
each. In this scenario would Cyberdine and Umbrella be better off bypassing Wal-
Mart?

50. For many years Devlin-McGregor had the monopoly over the sale of Provasic in its home
country, Ruritania. The patent has now now expired. Omni-Corp based in Detroit has
entered the Provasic market in Ruritania. Devlin-McGregor and Omni-Corp now compete
in Ruritania in Cournot style. That is, each chooses a quantity and the market sets the
price. The inverse demand curve for Provasic in Ruritania is 100 − q, where q is the total
quantity available.
Omni-Corp and Devlin-McGregor face different costs driven by the labor markets in their
respective locations. Massive unemployment in Detroit means that Omni-Corp can secure
8
These diapers contain a sensor that measures moisture and sends an alert to a smart phone informing the
parental unit that the diaper must be changed. It saves having to sniff the diaper.

Page 18
 as much labor as it wants for $1 per unit of labor. Omni-Corp converts 1 unit of labor
into 1 unit of Provasic. In Ruritania, however, workers have many opportunities. If Devlin-
McGregor offers a wage of w per unit of labor, it can count on a supply of w2 units of labor.
Devlin-McGregor also converts one unit of labor into one unit of Provasic.

(a) What will be the equilibrium quantities of Provasic supplied into Ruritania?
(b) What will be the wage per unit of labor that Devlin-McGregor will pay in equilibrium?
(c) Shocked at the disparity in wages between Detroit and Ruritania, the Champagne
Socialists institute a sales tax of 10% on Provasic supplied by Omni-Corp. In other
words, Omni-Corp must pay to the Government of Ruritania 10% of the revenues that
it earns. It is argued that such a sales tax will save Ruritanian jobs being exported
overseas. Will the effect of the sales tax be to increase the amount of labor that Devlin-
McGregor consumes?
(d) What is the effect on consumer surplus of the introduction of the tax?

51. Suppose f (x) is continuous, monotonically increasing, and concave; and g(x) is continuous,
monotonic, and concave. Additionally, the domain of f is the same as the range of g. Define
a new function h(x) = f ◦ g(x): h is the composition of f and g, i.e. h(x) = f (g(x)).

(a) Suppose f (x), g(x), and h(x) are all twice differentiable. Is h(x) monotonic, concave?
Use the first and second derivatives to justify your answer.
(b) Suppose neither f (x) nor g(x) is differentiable. Is h(x) monotonic, concave? Prove or
give a counterexample.
(c) Suppose the assumption “f (x) is monotonically increasing”is weakened to “f (x) is
monotonic”, everything else held fixed. Is h(x) concave? Prove or give a counterexam-
ple.

52. Fiona has preferences, , that are complete and transitive. Suppose there are four bundles
x1 , x2 , x3 , and x4 , with the property that

(a) x1  x2 ,
(b) x3 v x4 , and
(c) x3  x1 .

How do Fiona’s preferences rank x2 and x4 ?

53. (a) Give an example of preferences which are not transitive.

(b) Find an example of preference which are not strictly monotonic.

54. Show that the following three utility functions all represent the same preferences. (These
preferences are an example of Cobb-Douglas preferences.)
2 1
(a) u1 (x1 , x2 ) = x13 x23

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 (b) u2 (x1 , x2 ) = 3x21 x2 + 2
(c) u3 (x1 , x2 ) = 4 log x1 + 2 log x2 − 12
√
55. Show that the utility functions u1 (x1 , x2 ) = x1 x2 and u2 (x1 , x2 ) = .6 log x1 + .4 log x2
represent different preferences over x1 and x2 . The easiest way to do this is to find two
bundles that are indifferent according to u1 but not indifferent according to u2 , or that have
preferences reversed.

56. Bunter consumes hamburgers and french fries. He is particular about his food, and only
enjoys hamburgers (good 1) if each hamburger is paired with exactly two cartons of french
fries (good 2) each. More generally, each unit of hamburger must be paired with 2 units of
french fries. Denote by xi the number of units of good i consumed for i = 1, 2. Which of the
following utility functions represent Bunter’s preferences?

(a) U (x1 , x2 ) = min{2x1 , x2 }

(b) U (x1 , x2 ) = x1 + 2x2
(c) U (x1 , x2 ) = min{x1 , 2x2 }
√
(d) U (x1 , x2 ) = 40x1 + 20x2

57. Bunter consumes positive amounts of goods 1 and 2. He thinks that 3 units of good 1 is
always a perfect substitute for 1 unit of good 2. Which of the following utility functions
represent Bunter’s preferences?

(a) U (x1 , x2 ) = min{x1 , 3x2 }.

(b) U (x1 , x2 ) = 9x21 + 6x1 x2 + x22 .
√
(c) U (x1 , x2 ) = 5x1 + 15x2 + 100.
(d) U (x1 , x2 ) = x1 + 3x2 + 500.

58. Bunter requires a minimum level of consumption to derive any utility: U (x1 , x2 ) = 0 if
x1 + x2 ≤ 5 and U (x1 , x2 ) = x1 + x2 if x1 + x2 > 5. Draw Bunter’s indifference curves.
Consider two bundles (x1 , x2 ) and (y1 , y2 ). Suppose x1 > y1 and x2 > y2 . Is it always the
case that Bunter strictly prefers x to y?

59. For each of the following utility functions, (i) calculate the marginal utility for each good,
(ii) calculate the marginal rate of substitution.
1 3
(a) U (x1 , x2 ) = 2x14 x24
(b) U (x1 , x2 ) = 2x1 + 5x2
(c) U (x1 , x2 ) = min{2x1 , 5x2 }
(d) U (x1 , x2 ) = (axα1 + (1 − a)xα2 )1/α where α 6= 0 and α < 1 and a ∈ (0, 1).

Page 20
 Figure 2: Exercise 3 - Indifference curves

60. Assume α ∈ (0, 1) and p, I > 0. Solve the following:

max α ln x1 + (1 − α) ln x2
x1 ,x2

s.t. x1 + px2 = I
x1 , x2 ≥ 0

61. Assume α ∈ (0, 1). Solve the following:

max αx1 + (1 − α)x2

x1 ,x2

s.t. 2x1 + x2 = 10
x1 , x2 ≥ 0

62. Assume α ∈ (0, 1) and p, I > 0. Solve the following:

max min{x1 , αx2 }

x1 ,x2

s.t. x1 x2 = I
x1 , x2 ≥ 0

Page 21
63. Suppose Bunter earns income I = 100 and can purchase either burritos (good 1), for a price
of $5 each, or pizza (good 2), for a price of $8 each. Assume that the quantity of burritos
purchased are represented on the x-axis while the quantity of pizza purchased is represented
on the y-axis.
(a) Draw Bunter’s budget line. Label the values of the x and y-intercepts.
(b) What is the slope of the budget line.
(c) Can Bunter afford to buy 10 pizzas and 8 burritos? How about 10 pizzas and 3 burritos?
Draw these points on the graph from part (a).
(d) Now suppose that the government decides to tax pizza at a rate of $2 each. How does
this impact the budget line (i.e. the slope and intercepts)? Draw the new budget line
on the same graph from part (a).
(e) How large an increase in income would Bunter need to be able to buy every bundle
that she could afford before the tax?
(f) What if the tax doesn’t apply for the first 2 pizzas Bunter buys? How does this impact
the budget line (i.e. the slope and intercepts)? Draw the new budget line on the same
graph from part (a).

Figure 3: Budget line

64. Bunter has Cobb-Douglas preferences represented by utility function

1/3 2/3
U (x1 , x2 ) = x1 x2 .
and faces prices and income p1 , p2 , I.

Page 22
 Figure 4: variation in price

(a) Find his optimal consumption bundles in terms of prices and income, x∗1 (p1 , p2 , I) and
x∗2 (p1 , p2 , I).

(b) Now suppose his preferences are represented by utility function

1/3 2/3
U (x1 , x2 ) = 2(x1 x2 )2 .

Find his optimal consumption bundles in terms of prices and income, x∗1 (p1 , p2 , I) and
x∗2 (p1 , p2 , I).
(c) Compare your answers to part (a) and part (b). What is the relationship between
these two utility functions? What is the relationship between the two sets of demand
functions you derived?

65. Bunter buys T-shirts (the amount of which is represented by x1 ) and jeans (the number of
which is represented by x2 ), and has a constant elasticity of substitution utility function,
3/4 3/4
U (x1 , x2 ) = (x1 + x2 )4/3

given prices and income p1 , p2 , I.

(a) Find his utility maximizing bundle in terms of prices and income, x∗1 (p1 , p2 , I) and
x∗2 (p1 , p2 , I).
(b) If the price of a T-shirt is p1 = 10, the price of a pair of jeans is p2 = 50, and Bunter
earns 500, how many T-shirts and pairs of jeans does Bunter buy?

Page 23
 (c) How about if prices remain the same, p1 = 10 and p2 = 50, but his income doubles to
I 0 = 1000?
(d) More generally, given arbitrary prices p1 and p2 , how does the number of T-shirts and
jeans that Bunter purchases change when income doubles?

Budget share: consider the share of income that Bunter spends on T-shirts. We can
represent this as:
p1 x1 /I
Take a minute to interpret this expression: p1 x1 represents the total amount that Bunter
spends on T-shirts; dividing by I expresses this expenditure as a fraction of his total
budget. For example, if he spends half of his income on T-shirts, so that p1 x1 = 0.5Y ,
then this expression simplifies to p1 x1 /I = 0.5I/I = 0.5.
(e) Write an expression for the share of income that Bunter spends on each good at his
optimal bundle, given the demand functions you derived in part (a).
(f) How does the share of income that Bunter spends on each good change when his income
doubles, holding constant prices at p1 , p2 ?

66. Bunter has perfect substitute preferences between Wawa hoagies (denote the quantity of
Wawa hoagies by x1 ) and food truck hoagies (denote the quantity of food truck hoagies
by x2 ). Food truck hoagies are three times as big, so his marginal utility from food truck
hoagies is three times her marginal utility from Wawa hoagies which implies the following
utility function:
U (x1 , x2 ) = x1 + 3x2
He faces prices p1 , p2 and income I.

(a) Find his optimal consumption bundle in terms of prices and income, x∗1 (p1 , p2 , I) and
x∗2 (p1 , p2 , I).
(b) If food truck hoagies are four times more expensive than Wawa hoagies, p1 = 1 and
p2 = 4, and Bunter earns I = 100, how many food truck hoagies and Wawa hoagies
does he buy?
(c) Now suppose food truck hoagies are twice as expensive as Wawa hoagies, p1 = 1 and
p2 = 2 (income remains I = 100). How many food truck hoagies and Wawa hoagies
does he buy?
(d) More generally, given arbitrary income and prices p1 , p2 , Y , how does the optimal num-
ber of Wawa hoagies change with respect to p1 (i.e. calculate ∂x∗1 /∂p1 ). How about
with respect to p2 (i.e. calculate the cross-partial ∂x∗1 /∂p2 ).

67. Repeat question 66 with a perfect compliments utility function,

U (x1 , x2 ) = min{x1 , 3x2 }.

Page 24
68. A consumer’s utility for a quantity x1 of product 1 and x2 for product 2 is given by the
function u(x1 , x2 ) = b1 ln(x1 + a1 ) + b2 ln(x2 + a2 ), with ai ≥ 0 and b1 + b2 = 1. This is called
a Stone-Geary utility. Product 1 is sold by firm 1 for price p1 per unit and and product 2 is
sold by firm 2 at a price of p2 per unit. The consumer has an income of I. Production costs
for each of the firms is $ 1 per unit.
For the following parts, let’s focus on a specific rather than the general case: assume a1 =
a2 = 1 and b1 = b2 = 0.5. The solutions to the general case shall be similar to the ones we
solve below.
(a) Is the consumer’s utility function quasi-concave?
(b) What is the consumers demand for product 1 as a function of I, p1 and p2 ?
(c) What is the consumers demand for product 2 as a function of I, p1 and p2 ?
(d) Are the two products substitutes for each other?
(e) Suppose the firms simultaneously choose their prices. Then, the consumer chooses a
utility maximizing bundle. What price will each firm choose in equilibrium? You can
determine this by calculating each firms reaction function.

69. Bunter’s utility function over leisure and consumption of food is U (c, r) = c − (40 − 2r)2 ,
where r is the amount of leisure he has per day and c is the nunber of units of food she
consumes. He has 16 hours a day to divide between work and leisure. He has an income of
$15 a day from non-labor sources. The price of consumption is $1 per unit.
(a) How many hours does he choose to work at a wage rate of $80 per hour?
(b) How many hours does he choose to work at a wage rate of $20 per hour?
70. Bunter consumes bagel (good 1) and coffee (good 2), and has a utility function u(x1 , x2 ) =
x1 x32 where x1 is the amount of bagel consumed and x2 is the amount of coffee consumed.
(a) Let x1 (p1 , p2 , I) and x2 (p1 , p2 , I) be Bunter’s utility maximizing demand for bagel and
coffee given prices p1 , p2 and income I. Derive an expression for x1 and x2 in terms of
p1 , p2 and I.
(b) Bunter’s income is I = $40, and the prices for the two goods are p1 = $1, p2 = $5.
What is his optimal consumption bundle? Denote it e1 .
(c) Bagel price rises to p01 = $2, what is Bunter’s optimal consumption bundle after the
price change? Denote it e2 .
(d) Find an income level Y ∗ and a bundle e∗ which satisfy both of the following conditions:
i. e∗ is the utility maximizing bundle with income Y ∗ under the new prices p01 = $2
and p2 = $5.
ii. e∗ gives the same utility as e1 .
(e) A change from e1 to e∗ can be viewed as a move along the old indifference curve until
the slope corresponds to the ratio of new prices. We call the change from e1 to e∗ the
substitution effect.
Calculate the substitution effect. How do you interpret your answer?

Page 25
 (f) A change from e∗ to e2 can be viewed as a parallel shift of a fictitious budget line (with
new prices) until it coincides with the new budget line. We call the change from e∗ to
e2 the income effect.
Calculate the income effect. How do you interpret your answer?

71. In this question we will analyze the Walrasian equilibrium of a 2 person economy. Wooster,
has 1 unit of time to allocate between two activities: working and relaxation. Working
generates income that allows Wooster to purchase food. Let xe denote the quantity of food
consumed measured in pounds and xr the quantity of relaxation consumed measured in units
of time.9 Wooster’s utility from consuming (xe , xr ) is

u(xe , xr ) = ln xe + ln xr .

The food that Wooster consumes is produced by a factory owned by Gradgrind. The pro-
duction of food requires labor (which is measured in units of time). x units of labor will
produce f (x) = αx pounds of food, where 0 < α < 1 and f is Gradgrind’s production
function. Gradgrind wishes to maximize profit.
Let pe be the unit price of food and w the wage paid per unit of time (recall labor is measured
in units of time).

(a) What kinds of returns to scale does Gradgrind’s technology exhibit?

(b) For fixed pe and w, what is the profit maximizing level of food Gradgrind should supply
as a function of pe and w?
(c) For fixed pe and w, what is the utility maximizing level of xe (as a function of pe and
w) that Wooster should choose?
(d) For fixed pe and w, what is the utility maximizing level of xr (as a function of pe and
w) that Wooster should choose?
(e) Is there a value for pe and w at which the supply of food is equal to the demand for
food? You may take wages w as the numeraire and set it to 1.

72. In this question we will examine a 2 person economy without a Walrasian equilibrium.
Bertram Wooster, has 1 unit of time to allocate between two activities: working and re-
laxation. Working generates income that allows Wooster to purchase food. Let xe denote
the quantity of food consumed measured in pounds and xr the quantity of relaxation con-
sumed measured in units of time.10 Wooster’s utility from consuming (xe , xr ) is

u(xe , xr ) = ln xe + ln xr .

The food that Wooster consumes is produced by a factory owned by Thomas Gradgrind. The
production of food requires labor (which is measured in units of time). x units of labor will
produce f (x) = x1/2 pounds of food, where f is Gradgrind’s production function. Gradgrind
wishes to maximize profit.
9
Consuming food incurs no time at all.
10
Consuming food incurs no time at all.

Page 26
 Let pe be the unit price of food and w the wage paid per unit of time (recall labor is measured
in units of time).

(a) For fixed pe and w, what is the profit maximizing level of food Gradgrind should supply
as a function of pe and w?
(b) For fixed pe and w, what is the utility maximizing level of xe (as a function of pe and
w) that Wooster should choose?
(c) For fixed pe and w, what is the utility maximizing level of xr (as a function of pe and
w) that Wooster should choose?
(d) Is there a value for pe and w at which the supply of food is equal to the demand for
food?

73. In this question we will analyze the Walrasian equilibrium of a 2 person economy. Wooster,
has 1 unit of time to allocate between two activities: working and relaxation. Working
generates income that allows Wooster to purchase food. Let xe denote the quantity of food
consumed measured in pounds and xr the quantity of relaxation consumed measured in units
of time.11 Wooster’s utility from consuming (xe , xr ) is

u(xe , xr ) = ln xe + ln xr .

Finknottle also has 1 unit of of time to allocate between two activities: working and re-
laxation. Working generates income that allows Finknottle to purchase food. Finknottle’s
preferences are identical to Wooster’s.
The food that Wooster consumes is produced by a factory that is half owned by Wooster and
the other half by Finknottle. 12 The production of food requires labor (which is measured
in units of time). x units of labor will produce f (x) = x1/2 pounds of food, where f is the
factory’s production function. The factory operates so as to maximize profit.
Let pe be the unit price of food and w the wage paid per unit of time (recall labor is measured
in units of time).

(a) What kinds of returns to scale does the food production technology exhibit?
(b) For fixed pe and w, what is the profit maximizing level of food the factory should supply
as a function of pe and w?
(c) For fixed pe and w, what is the maximum profit earned by the factory as a function of
pe and w?
(d) For fixed pe and w, what is the utility maximizing level of xe (as a function of pe and
w) that Wooster should choose?
(e) For fixed pe and w, what is the utility maximizing level of xr (as a function of pe and
w) that Wooster should choose?
(f) What are the utility maximizing levels of xe and xr for Finknottle?
11
Consuming food incurs no time at all.
12
This means each gets half of the profits generated by the factory.

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 (g) Is there a value for pe and w at which the supply of food is equal to the demand for
food? Take w = 1.

74. In this question we will analyze the competitive equilibrium of a 2 person economy. Wooster,
has 1 unit of time to allocate between two activities: working and relaxation. Working
generates income that allows Wooster to purchase food. Let xe denote the quantity of food
consumed measured in pounds and xr the quantity of relaxation consumed measured in units
of time.13 Wooster’s utility from consuming (xe , xr ) is
u(xe , xr ) = ln xe + ln xr .
The food that Wooster consumes is produced by a factory that is half owned by Gradgrind.
The other half is owned by Wooster.14 The production of food requires labor (which is
measured in units of time). x units of labor will produce f (x) = x − 0.5x2 pounds of food,
for 0 ≤ x ≤ 1 where f is Gradgrind’s production function. Gradgrind has the right to
manage the factory and he operates so as to maximize profit.
Let pe be the unit price of food and w the wage paid per unit of time (recall labor is measured
in units of time).
(a) What kinds of returns to scale does Gradgrind’s technology exhibit?
(b) For fixed pe and w, what is the profit maximizing level of food Gradgrind should supply
as a function of pe and w?
(c) For fixed pe and w, what is the maximum profit earned by the Gradgrind firm as a
function of pe and w?
(d) For fixed pe and w, what is the utility maximizing level of xe (as a function of pe and
w) that Wooster should choose?
(e) For fixed pe and w, what is the utility maximizing level of xr (as a function of pe and
w) that Wooster should choose?
(f) Is there a value for pe and w at which the supply of food is equal to the demand for
food?

75. Consider an economy with two people, Bunter and Quelch. There is an ordinary, private
good x in the economy, and a public good y. Each person has an amount T of time (and is
endowed with nothing else). Bunter and Quelch can each split his time between producing
the private good and producing the public good, and then can consume the private good
they have produced and can consume all of the (nonexcludable and nonrival) public good
produced by both people. One unit of time can produce either one unit of the private good
or one unit of the public good.
Suppose person i consumes xi units of the private good and produces yi units of the public
good. The total quantity of the public good will be y = y1 + y2 . Each person i has utility
√
function u(xi , y) = 2 xi + α(y1 + y2 ), where xi is the quantity of the private good consumed
and y the total amount of the public good present. Assume that α12 ≤ T .15
13
Consuming food incurs no time at all.
14
This means that Wooster gets half of the profits generated by the factory.
15
It will be instructive to compare this question with question 3 on sample midterm 3.

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 (a) Each person simultaneously decides what quantity of the private good to produce (and
consume) and how much of the public good to provide. What is the Nash equilibrium
outcome of this game?
(b) Find a pareto optimal allocation in which Bunter and Quelch behave identically.

76. Consider an economy with two people, Bunter and Quelch and and two goods. Each is
endowed with 10 units of each good. If xi is the quantity of good i consumed by Bunter, his
utility will be uB (x1 , x2 ) = x1 x22 . If yi is the quantity of good i consumed by Quelch, then
Quelch’s utility will be uQ (y1 , y2 ) = y12 y2 .

(a) Find the Walrasian equilibrium for this economy. (Let good 1 be the numeraire.)
(b) Now suppose that Quelch’s endowment decreases to only 5 units of each good. Con-
tinuing to let good 1 be the numeraire, what is the new equilibrium price of good
2?
(c) In light of your answer to part (b), which goods do we expect to command relatively high
prices—those that are relatively important to rich people, or those that are relatively
important to poor people?

77. Consider an economy with two people, Bunter and Quelch and and two goods. If xi is the
quantity of good i consumed by Bunter, his utility will be uB (x1 , x2 ) = x1 x22 . If yi is the
quantity of good i consumed by Quelch, then Quelch’s utility will be uQ (y1 , y2 ) = y12 y2 .
Assume that Bunter is endowed with one unit of good 1 (and no good 2) and Quelch with
one unit of good 2 (and no good 1).

(a) Find the Walrasian equilibrium for this economy. (Let good 1 be the numeraire.)
(b) Now suppose that Quelch’s endowment of good 2 doubles, to two units. In the new
Walrasian equilibrium is Bunter better off?
(c) Now suppose instead that Bunter’s endowment of good 1 doubles, to two units. In the
new Walrasian equilibrium what is Bunter’s utility? How does this compare to your
answer to (2).
(d) Think of Bunter and Quelch as countries rather than individuals, and interpret an
increase in endowment as a resource discovery, such as the discovery of oil or natural
gas. Use your answer to discuss the circumstances under which you would you rather
have such a discovery in your own country, and those in which you would rather have
it in another country.

78. Consider the utility function u(x1 , x2 ) = (x1 − 10)x2 . Interpret x1 as the money spent on
health and x2 as money spent on other goods. Let the budget constraint be x1 + x2 = I.

(a) The government is considering a health care plan. In one proposal, the government
gives each individual an amount S (for subsidy). The intention is presumably that
people use this money to purchase health care, but no such restrictions are imposed;
people are free to spend S however they want. What is the effect on purchases of good
2?

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 (b) Suppose instead the government subsidizes the purchase price of health care, by paying
proportion t of what the individual pays for health care. Hence, the individual’s price
is (1 − t) per unit of health care and the cost to the government of this plan is tx1 ,
where x1 is the dollar amount of health care the person consumes. Suppose the subsidy
t is chosen so that this program costs the government the same as the direct transfer
program described in (1). Assuming (as usual) that the individual maximizes utility in
both cases, which program will result in a higher utility for the individual.

79. Suppose a honey farm is located next to an apple orchard. If H is the quantity of honey
produced, it will cost the honey farm c(H) which is given by:

H2
cH (H) = .
100
The production of honey imposes an externality on the apple farm and this is reflected in
the apple farm’s cost function. If A is the quantity of apples produced and the honey farm
produced H units if honey, the cost to the apple farm is denoted cA (A, H) where

A2
cA (A, H) = − H.
100
Suppose the price of honey is $2 and the price of apples is $3. At these prices assume that
each farm can sell as many units of what it produces.

(a) What is the choice of H that the honey farm will choose to maximize its own profit?
(b) Given the choice made by the honey farm, what is the choice of A that will maximize
the apple farm’s profits?
(c) Suppose that the honey and apple firms merged.
What would be the profit-maximizing output of honey and apples for the combined
firm?
(d) If the firms stayed separate, what per unit honey subsidy would induce the same output
of apples and honey as that generated by the merged farm.

80. There are N firms each with a cost function of C(q) = q 2 where q is output. Suppose the
market demand is 100 − p where p is the per unit price.

(a) Suppose each firm is told that it can sell any amount it produces for a price p∗ per unit.
What is the profit maximizing quantity that each firm will choose?
(b) What is the total output of all firms as a function of N and p∗ ?
(c) What is the price p∗ as a function of N at which the market clears, i.e., total supply
equals demand?
(d) What is the profit of each firm at the price you determined above?
(e) Now suppose the Government charges a license fee of $25 to each firm that operates.
If no firm can exit or enter, what will the market clearing price be?

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(f) Suppose now firms can costlessly enter and exit this industry. In the long run, it is
argued in many introductory economic courses, that the number of firms in this market,
and hence the market price, will adjust to ensure that each firm earns zero profit. This
is called a long run equilibrium. What will the long run equilibrium value of N be in
the absence of the fixed fee of $25?
(g) Suppose now firms can costlessly enter and exit this industry. In the long run, the
number of firms in this market, and hence the market price, will adjust to ensure that
each firm earns zero profit. What will the long run equilibrium value of N be in the
presence of the fixed fee of $25?
(h) What is the effect on consumer surplus (under the long run equilibrium) of the intro-
duction of the license fee?
(i) To illustrate an important assumption underlying the long-run equilibrium argument,
suppose there are only two firms. Each firm must pay a fixed fee of $25 before it can
enter. Each firm has two actions: enter or not. Upon entry, prices and demand are
determined as described above. Construct a payoff table that records the profits of each
firm for each combination of decisions.

Firm 1/ Firm 2 Entry No Entry

Entry
No Entry $0, $0
Is both firms entering a Nash equilibrium?

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