1a. The competitive price equals marginal cost, so P = 20.

To find demand, substitute the price into the demand curve and solve: 20 = 740 – 2
Q, Q = 360 Which means 360,000 widgets. To find profits, note that π = (P – AC) Q = (20 – 20) 360 = 0 Accounting profits would be higher since
accounting costs do not include all relevant opportunity costs, most notably the opportunity cost of equity capital.

b.Find the monopoly output by setting MR = MC. Since the marginal revenue curve has the same intercept and twice the slope of the demand
curve (written in inverse form), the equation to determine the optimal output is: MR = 740 – 4 Q = 20. 2 Solving for Q gives Q = 180, which
means 180,000 widgets. We then solve for the price by substituting the quantity into the demand curve: P = 740 -2 · 180 = 380 We can then
find profits as: π = (P – AC) Q = (380 – 20) 180 = 64,800, which means $64.8 million.

c.The game matrix is: where the first number is the payoff for firm 1 and the second number is the payoff for firm 2 (both measured in
thousands of dollars). The entries in bold represent best responses. The Nash equilibrium is the cell with
two entries in bold. Both firms produce 120 and both earn $28,800 (thousands). At the equilibrium,
total market output is 120 + 120 = 240, and the price is determined by: P = 740 – 2 · (120 + 120) = 740 –
2 · 240 = 260.

2. Given: Q = 8.4 - 0.7 pe; C = Q (0.37 pc + 10-8 pk + .51), 0.51 are all fixed. Q. Suppose the market price of corn is $4.19/bushel and the annual
lease price for a 100 million gallon per year ethanol production plant is $16 million. What are the planned average and marginal cost? Use the
term in parentheses in the cost function combined with the given input prices to get the planned average and marginal cost: MCP = ACP = 0.37
· $4.19 + 10-8 · 16 · 106 + .51 = $2.22.

Q. If all ethanol plants have the same constant returns to scale cost function and the market for ethanol is highly competitive. What is the long
run market equilibrium price and market output? Given these assumptions, the supply curve is a horizontal line at $2.22 and, therefore, the
long run competitive price is $2.22. To get the output, substitute this price into the demand curve to get: Q = 8.4 – 0.7 · 2.22 = 6.85 (billion
gallons)

Q. Suppose that the amount of capacity needed to produce the output you found in b. was in place. If the price of corn rises
to $6.00 per bushel, what 5 would you project for the market price of ethanol, industry output, and economic profits in the
short run? The short run supply curve has a horizontal portion at unit (both average and marginal) variable cost. The vertical
portion is at an output of 6.85. With the increase in the price of corn, the horizontal portion shifts up to: 0.37 · $6.00 +.51 =
$2.73. As this is above $2.22, the price at which demand equals industry capacity, the price must rise to $2.73. The quantity
supplied is, then, Q = 8.4 – 0.7 · 2.73 = 6.49 (billion gallons). Profits are: π = (P – AVC)Q – S, Since P = AVC, the industry loses
its sunk costs. The sunk costs are $16 million per 100 million gallons of capacity. With 6.85 billion gallons of capacity, the
sunk costs are 68.5 x $16 million = $1.096 billion. As a result, industry profits are -$1,096 billion. (Note that the losses are
the sunk costs for the entire industry capacity and not just for the quantity produced in the short run.)

Q.In 2011, the average price of ethanol was $2.18 and the price of corn was $6.00/bushel. Recall that the cost function
above reflects Biofuel Energy Corporation’s (BEC) costs. Given these market prices, what advice would you give BEC about
how much to produce in the short run? As we saw above, average variable cost is $2.73 when the price of corn is $6. As this
exceeds the market price, BEC should shut down.

To solve for the optimal contract, we go through three steps. Step 1 – Determine the efficient level of effort. The efficient
level of effort is high. The incremental benefit to Jim of high effort compared with medium effort is $50,000 (since he gets
$15,000 for each of his 10 concerts rather than $10,000). The incremental cost to Michael of high effort compared with
medium effort is $30,000 - $10,000 = $20,000. Step 2 – Determine the sharing percentage. The sharing percentage is the
ratio of Michael’s incremental cost for the efficient level of effort to Jim’s incremental benefit. This is: ($30,000 -
$10,000)/($150,000 - $100,000) = $20,000/$50,000 = 0.4 (or 40%). Step 3 – Determine the fixed component Michael’s total
cost if he gives the high level of effort is $40,000 + $30,000 = $70,000. From his sharing percentage, he will get 0.4 x
$150,000 = $60,000. As a result, the fixed component needed to induce Michael to accept the contract is: $70,000 - $60,000
= $10,000.
Q1. To maximize their joint profits, their combined output should equal the monopoly output of 24, which would entail both
producing 12

Q. Recall that by planning stage (or long run) marginal cost, we generally mean average incremental cost over the smallest practical increment.
Based on the information above, what is the planning stage average incremental cost of natural gas when a driller drills an additional well? (5
points) 0.40 + 0.60 + $1 million/500,000 = $3 per MMBTU

Q. What are the realized (or short run) average and marginal costs for a well that has already been drilled? (5 points) Average cost is total cost
over a specific time period divided by the output in that period. The well is a sunk (no pun intended) cost, and the amount of the cost over a
period is the lease value. Thus, ACSR = $1 million/Q + $1 MCSr = $1 up to an output of 500,000 MMBTU.

Q. The long run equilibrium price is $3. The quantity is determined as: Qng=100 - 15 ·3 + 0.5 ·80 = 95 billion MMBTU Since each well produces
½ million MMBTU, 190,000 wells will be needed. (No, these numbers are not realistic.)

Q. Suppose the industry is in the equilibrium you found in part c. Suppose the price of oil drops from $80/barrel to
$40/barrel. What happens to the competitive price and output in the short run. What will industry profits be? Explain using
words and/or supply and demand graphs. (5 points) The reduction in the price of oil will cause demand for natural gas to
drop. The lowest the price would ever go in response to such a reduction in demand would be to short run MC, or $1. If the
priced did drop to $1, demand would be: Qng=100 - 15 ·1 + 0.5 ·40 = 105 billion MMBTU However, with industry capacity at
only95 billion MMBTU, the price cannot drop that low. Instead, solve for PNG: Png = 8 – 1/15 Qng = 8 – 95/15 = $1.67
Profits will be ($1.67 - $3) 95 billion = -$126.67 billion

Q. If the $40 per barrel of oil persisted (and all other conditions remained the same), how would the market adjust in the
long run? Explain using words and/or supply and demand graphs. (5 points) Industry capacity would shrink (as it wore out
and firms decided not to replace it) until the price returned to $3. Demand would be: Qng=100 - 15 ·3 + 0.5 ·40 = 75 billion
MMBTU.