ECON 301, Professor Hogendorn

Problem Set 6

1. Luxray. Luxray Inc. is a firm with cost function T C (y) = y 2 + 10.

This firm is a perfectly competitive price-taker in a market where
p = 100.

(a) Write down Luxray’s average cost function, average variable

cost function, and marginal cost function. Why does Luxray
produce y ∗ = 50 in short-run equilibrium?
(b) Find Luxray’s net profit at y ∗ = 50. Write it down three ways
and verify that they are all equal: (i) total revenue minus to-
tal cost, (ii) net profit margin times quantity, (iii) operating
profit margin times quantity, minus fixed costs.
(c) Suppose that the cost functions we have been working with
are the long-run cost functions. However, firms may enter or
exit this market freely in the long run. Should Luxray man-
agement expect to produce more or less than 50 units as the
industry moves toward long-run equilibrium? Explain using
a graph.

2. OilProducers. Suppose there are two oil-producing regions in the

world, and in each one there are perfectly competitive producers.
The fixed cost is F and the long-run average variable costs are

LAVC(y) = y

For an oil shale deposit, F=$3,000. In Saudi Arabia, the capital cost
is so much lower, we might as well just set F=0. (Note that given
their high fixed costs, the oil shale wells may not enter the market
depending on the price.)

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 (a) Show cost-curve diagram for a Saudi oil well and an oil shale
well. Draw the LAC (i.e. long-run average total cost) curve,
the LMC (long-run marginal cost curve), and show a price of
$95 per barrel of oil. What is the optimal output for each type
of well?

(b) Suppose there were N wells of each type. What is the market
supply curve for oil (holding the number of wells fixed)?

(c) Suppose new wells can enter the market, but only by using
oil shale. What is the long-run market supply curve for oil?

3. Growing. Along with the fracking boom has led to a increased de-
mand for drilling supply equipment. Suppose Stewart Manufac-
turing Co. (perhaps owned by a distant cousin of Wesleyan physics
professor Brian Stewart) is one of many perfectly competitive firms
in the drilling supply industry. It has a production function that
uses labor and steel and an upward-sloping marginal cost curve.
Both labor and steel are variable factors in the short run.

(a) Market demand for drilling supply equipment rises. Draw a

graph of the overall equipment market and separately draw a
graph of Stewart’s firm-level demand and cost curves. Show
how, in the short run, the increase in market demand affects
prices and quantities on both graphs.

(b) Though market demand for oil equipment rose, Stewart buys
labor and steel in much larger markets where wages and the
price of steel remain unchanged. Draw a graph showing Stew-
art’s isoquants and isocost lines. Show the situation before
and after the increase in market demand (again in the short
run, but remember both factors are variable).

4. Coke. Suppose that all around the world, there are small towns in
which the price elasticity of demand for Coca-cola is constant at

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 -1.2. Each of these towns is served by a monopoly Coke distribu-
tor. However, the technology for distributing Coke varies widely:
huge bottling plants and 18-wheeler truck delivery in the USA, lo-
cal bottlers and van delivery in Japan, delivery by pack mule to
isolated parts of Bolivia, etc.

(a) What is the Lerner Index on Coke in these markets?

(b) Let the production function be f (K ) = βK 2 , where β is a pa-
rameter that varies from place to place, and let the price of
capital be 20. How does the price of Coke vary with β? (This is
pretty tricky. Note that there is a constant elasticity demand,
check review problem Minus2.)

Review problems only, not to turn in:

5. 12firms. There is a firm with production function

q = f (L, K ) = L 1/2 + K 1/2

This firm is initially stuck in the short run with K = 16 which can-
not be changed. The wage is w = 3 and the price of capital is r = 4.

(a) Find the short run marginal cost curve and the short-run
supply curve.
(b) If there are 12 firms, and if market demand is q(p) = 96 − p,
what is the short-run market equilibrium price?
(c) What is the short-run average total cost? Is this firm making
a loss, breaking even, or making a super-normal profit? Illus-
trate on a two-panel graph, one panel showing the market,
the other showing the cost curves of an individual firm.

6. Consulting. Technology can improve labor productivity. One might

be concerned that this could be bad for workers since fewer would

3
be needed to produce the same output. Displaced workers might
have to move to another industry. To think about this, suppose
an industry has the production function f (L) = αL 0.5 . The condi-
¡ ¢2
tional factor demand is thus L(y) = α1 y 2 . Let w L = 1 throughout
this whole problem (i.e. overall labor market equilibrium is unaf-
fected by the changes in the industry we examine here). Suppose
there is a fixed cost to start a firm which is F = 2500. The cost func-
tion is thus µ ¶2
1
c(y) = y 2 + 2500
α
Note that this is both the short-run and the long-run cost func-
tion; the only difference is that in the long run a firm can exit or
enter the industry.
Suppose that demand in the industry is given by X (p) = 60000p ² .
Elasticity ² can take on two values: -0.5 and -1.5. Answer the fol-
lowing for each of these values:

(a) Suppose that initially α = 100 and the industry is in long-

run perfectly competitive equilibrium. How many firms are
there? What is the total number of workers?
(b) Suppose that improved technology causes a change to α =
160. In the short run (i.e. with the number of firms fixed)
what is the new total number of workers?
(c) In the long run, the number of firms will adjust to the new
situation. What is the new number of firms and the new total
number of workers?
(d) Describe in words what an individual worker would experi-
ence during parts (a)-(c). For example, your description might
read “First I noticed that my firm hired a few new people.
Later, some of our competitors went out of business. Most
of the people who worked for those firms came to work at
my firm and our remaining competitors, but a few had to get

4
 jobs in another industry.” Remember to do this for both val-
ues of elasticity, and discuss which elasticity is preferable for
the workers.

7. Minus2. Suppose the demand curve for a good is:

x(p) = 1000p−2

There is a monopoly which produces this good, and it has con-

stant marginal cost of $2 per unit.

(a) What is the monopoly optimal price, quantity, and profit?

(b) What is the deadweight loss of this monopoly?

Answers to Review Problems:

5. 12firms_a.

(a) Since q = L 1/2 + 4, the short-run conditional factor demand

for labor is
L1/2 = q − 4 ⇒ L(q) = (q − 4)2

Short run total cost T C (q) = wL(q)+r K = 3(q −4)2 +64. Then
marginal cost is

dTC(q)
MC(q) = = 6(q − 4) = 6q − 24
dq

A perfectly competitive firm sets MC=p, so its supply is

p + 24 1
p = 6q − 24 ⇒ q = ⇒ s(p) = 4 + p
6 6

(b) With 12 firms, market supply equals market demand is

12s(p) = q(p) ⇒ 48 + 2p = 96 − p ⇒ p∗ = 16

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 (c) At p = 16, each individual firm produces s(16) = 6.67. Short
run average cost is

TC(q) 3(q − 42 ) 64
AC(q) = = +
q q q

so AC(6.67) = 3.2 + 9.6 = 12.8. Since this is lower than the price
of 16, the firm makes a profit.
Market Individual Firm
p $
S
MC(q)
AC(q)
14 14 D
12.8

D
Q 6.67 q

6. Consulting_a.

(a) The average and marginal cost curves in this case are:
2500
AC (y) = + 0.0001y MC (y) = 0.0002y
y

Thus, the minimum average cost is 2500

y +0.0001y = 0.0002y ⇒
y LR = 5000. At this output, the amount of labor employed by
each firm is L(5000) = 2500.
The marginal cost of this output level is MC (5000) = 1, and
since perfectly competitive firms set price equal to marginal
cost, we have p LR = 1. This is the long run supply curve.
Equating supply to demand, we find the demand at p = 1,
which is 60000 · 1² = 60000.
The number of firms in the market must therefore be N =
60000
5000
= 12. Since each firm employs 2500 workers, total em-
ployment is 30000.

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(b) Now that α = 160, the conditional factor demand is L(y) =
0.00004y 2 and the total cost function is c(y) = 0.00004y 2 +
2500. Thus, the new marginal cost curve and the short-run
firm supply curve is:

MC (y) = 0.00008y s(p) = 12500p

Since the number of firms cannot change in the short run,

there are still 12 of them, so the market supply curve is just
12s(p), and setting supply equal to demand gives us:

60000p ² = 12 · 12500p
p ²−1 = 2.5
1
p = 2.5 ²−1

p = (0.54, 0.69) when ² = (−0.5, −1.5)

X (p) = (81650, 104683) when ² = (−0.5, −1.5)
y = (6804, 8724) when ² = (−0.5, −1.5)
L(y) = (1852, 3044) when ² = (−0.5, −1.5)
N L(y) = (22224, 36528) when ² = (−0.5, −1.5)

(c) With α = 160, the average and marginal cost curves are:
2500
AC (y) = + 0.00004y MC (y) = 0.00008y
y

Thus, the minimum average cost is 2500

y +0.00004y = 0.00008y ⇒
y LR = 7906. At this output, the amount of labor employed by
each firm is L(7906) = 2500. (Note this is the same as before,
which occurs because we have only changed the coefficient
on the production function.)
The marginal cost of this output level is MC (7906) = 0.632,
and since perfectly competitive firms set price equal to marginal
cost, we have p LR = 0.632. This is the long run supply curve.

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 Equating supply to demand, we find:

p = (0.632, 0.632) when ² = (−0.5, −1.5)

X (p) = (75473, 119420) when ² = (−0.5, −1.5)
N = (9.54, 15.1) when ² = (−0.5, −1.5)
L(y) = (2500, 2500) when ² = (−0.5, −1.5)
N L(y) = (23866, 37750) when ² = (−0.5, −1.5)

(d) Case of ² = −0.5: I never should have taken the job at Sprint.
Everything was fine until stupid researchers at Bell Labs and
Nortel introduced the new technology. There was overcapac-
ity everywhere, and Sprint laid off about 25% of its workforce.
After a while, Global Crossing, Williams, and Worldcom filed
for bankruptcy. But now that there’s been some consolida-
tion, Sprint is doing a little better, and it looks like the laid-off
workers will be rehired. My friends at Global Crossing are out
of luck though – there won’t be any telecoms jobs for them.
Case of ² = −1.5: When I started at Nortel, it seemed like a
sleepy firm, but then this great new technology came along.
Nortel grew really fast, and we hired all kinds of new peo-
ple. Fortunately, I saw that the good times couldn’t last, so
I cashed in my stock options and moved to a startup. It’s a
good thing, because Nortel laid off most of the people it hired.
My new firm’s hanging in there, but it’s not like before.
Clearly, the ² = −1.5 is preferable, but note that even then
there were some layoffs in this model.

7. Minus2_a.

(a) This is easy because we have a constant elasticity demand

curve with ² = −2 and a constant marginal cost of $2. Thus,
the Lerner Index form of the monopoly’s first order condition

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 tells us that
p −2 1
=− ⇒ p∗ = 4
p −2
The demand curve tells us that x(4) = 1000 × 4−2 = 62.5. The
constant MC is the same as the AC, so there is a profit of $2
per unit, or a total profit of 125.

(b) At p ∗ = MC = 2, the monopoly quantity is

x(2) = 1000 × 2−2 = 250

The deadweight loss is the area between the price of 2 and 4,

but not including the monopoly profit:
Z 4
1000p −2 d p − 125 = −1000 × 4−1 + 1000 × 2−1 − 125 = $125
2

This is represented by areas A and B in the following figure:

$

4
A B
2