Intermediate Microeconomics

Recitation Material

NOT TO BE SUBMITTED

Exercise 1
A monopolist has an inverse demand curve given by p(y) = 12 − y and a cost curve
given by c(y) = y 2 .
(1) What will be its profit-maximizing level of output?
(2) Suppose the government decides to put a tax on this monopolist so that for each
unit it sells it has to pay the government $2. What will be its output under this
form of taxation?
(3) Suppose now that the government puts a lump sum tax of $10 on the profits of
the monopolist. What will be its output?
Answer:

(1) First order condition implies

d
(12 − y)y − y 2 = 12 − 4y = 0 ⇔ y = 3
dy
The profit is 27 − 9 = 18.
(2) With the tax the FOC changes to

d
(12 − y)y − y 2 − 2y = 10 − 4y = 0 ⇔ y = 2.5
dy

(3) The FOC changes to

d
(12 − y)y − y 2 − 10 = 12 − 4y = 0 ⇔ y = 3
dy
And the profit is 8.

Exercise 2
In a graph, use black ink to draw the inverse demand curve, p1 (y) = 200 − y.
(1) If the monopolist has zero costs, where on this curve will it choose to operate?
(2) Now draw another demand curve that passes through the profit- maximizing
point and is flatter than the original demand curve. Use a red pen to mark the part
of this new demand curve on which the mo nopolist would choose to operate. (Hint:
Remember the idea of revealed preference?)
(3) The monopolist would have (larger, smaller) profits at the new demand curve
than it had at the original demand curve.

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Answer:
(1) The revenue is maximized at y such that

200 − 2y = 0 ⇔ y = 100

(2) and (3)

Exercise 3
An airport is located next to a large tract of land owned by a housing developer. The
developer would like to build houses on this land, but noise from the airport reduces
the value of the land. The more planes that fly, the lower is the amount of profits that
the developer makes. Let X be the number of planes that fly per day and let Y be the
number of houses that the developer builds. The airport’s total profits are 48X − X 2 ,
and the developer’s total profits are 60Y − Y 2 − XY . Let us consider the outcome
under various assumptions about institutional rules and about bargaining between the
airport and the developer.
(1) “Free to Choose with No Bargaining”: Suppose that no bargains can be struck
between the airport and the developer and that each can decide on its own level
of activity. No matter how many houses the developer builds, what is the number
of planes per day that maximizes profits for the airport? Given that the airport
is landing this (profit maximizing) number of planes, what is the number of houses
that maximizes the developer’s profits? What will be the total profits of the airport?
What will be the total profits of the developer? What is the sum of their individual
profits?
(2) “Strict Prohibition”: Suppose that a local ordinance makes it illegal to land
planes at the airport because they impose an externality on the developer. Then no
planes will fly. How many houses will the developer build? What will be her total
profits?
(3) ”Lawyer’s Paradise”: Suppose that a law is passed that makes the airport liable
for all damages to the developer’s property values. Since the developer’s profits are
60Y − Y 2 − XY and his profits would be 60Y − Y 2 if no planes were flown, the total
amount of damages awarded to the developer will be XY . Therefore if the airport
flies X planes and the developer builds Y houses, then the airport’s profits after it
has paid damages will be 48X − X 2 − XY . The developer’s profits including the
amount he receives in payment of damages will be 60Y −Y 2 −XY +XY = 60Y −Y 2 .
How many houses will the developer choose to build to maximize his net profits, no
matter how many planes are flown? How many planes will the airport choose to land

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 to maximize its profits, net of damages? What will the total profits of the developer
be? What will the total profits of the airport be? What will the sum of their profits
be?

Exercise 4
This problem continues the story of the airport and the developer from the previous
problem.
(1) “Merger”: Suppose that the housing developer purchases the airport. What is
the profit function for the new joint entity? To maximize joint profits, how many
houses should it build? How many planes should the joint entity allow to land. What
is the combined profit now? Explain why each of the institutional rules proposed
in the previous problem fails to achieve an efficient outcome and hence has lower
combined profits.
(2) “Dealing”: Suppose that the airport and the developer remain independent. If
the original situation was one of ”free to choose,” could the developer increase his
net profits by bribing the airport to cut back one flight per day if the developer has
to pay for all of the airport’s lost profits? The developer decides to get the airport
to reduce its flights by paying for all lost profits coming from the reduction of flights.
To maximize his own net profits, how many flights per day should he pay the airport
to eliminate?

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Exercise 5
In El Carburetor, California, population 1,001, there is not much to do except drive
your car around town. Everybody in town is just like everybody else. While everybody
likes to drive, everybody complains about the congestion, noise, and pollution caused
by traffic. A typical resident’s utility function is U (m, d, h) = m + 16d − d2 − 6h/1, 000,
where m is the resident’s daily consumption of Big Macs, d is the number of hours
per day that he, himself, drives, and h is the total amount of driving (measured in
person-hours per day) done by all other 1,000 residents of El Carburetor. The price of
Big Macs is $1 each. Every person in El Carburetor has an income of $40 per day. To
keep calculations simple, suppose it costs nothing to drive a car.
(a) If an individual believes that the amount of driving he does won’t affect the
amount that others drive, how many hours per day will he choose to drive? (Hint:
What value of d maximizes U (m, d, h)?)
Answer: 8
(b) If everybody chooses his best d, then what is the total amount h of driving by
other 1000 persons?
Answer: 8000
(c) What will be the utility of each resident?
Answer: 56
(d) If everybody drives 6 hours a day, what will be the utility level of a typical
resident of El Carburetor?
Answer: 64
(e) Suppose that the residents decided to pass a law restricting the total number of
hours that anyone is allowed to drive. How much driving should everyone be allowed
if the objective is to maximize the utility of the typical resident? (Hint: Rewrite the
utility function, substituting 1, 000d for h, and maximize with respect to d.)
Answer: 5
(f) The same objective could be achieved with a tax on driving. How much would
the tax have to be per hour of driving? (Hint: This price would have to equal an
individuals marginal rate of substitution between driving and Big Macs when he is
driving the right amount.)
Answer: 6

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