BUS 312

Managerial Economics
Problem Set 5
Spring 2020

Problem 1: Suppose that an industry is characterized as follows:

TC = 100+ 2Q2 Firm total cost function

MC = 4Q Firm marginal cost function
P = 90 - 2Q Industry demand curve
MR = 90 - 4Q Industry marginal revenue curve .

a. If there is only one firm in the industry, find the monopoly price, quantity, and level of
profit.

Answer: If there is only one firm in the industry, then the firm will act like a monopolist
and produce at the point where marginal revenue is equal to marginal cost, MR=MC:

90 − 4Q = 4Q
Q = 11.25

For a quantity of 11.25, the firm will charge a price P = 90 − 2Q. Since Q is equal to 11.25 then
price will be equal to
P = 90 − 2(11.25)
= $67.50
Profit is equal to the difference between total revenue (TR) and total cost (TC). TR=PxQ and
TC = 100+2Q2 If we substitute P= $67.50 and Q = 11.25 into these equations, we obtain:

TR=$67.50(11.25)
TC=100 + 2(11.25)2

Then TR-TC=PxQ − C =$67.50(11.25) − [100 + 2(11.25)2] = $406.25. Hence profit is equal to

$406.25.

b. Find the price, quantity, and level of profit if the industry is competitive.

Answer: If the industry is competitive, price will equal marginal cost. Therefore P=MC will
hold. P=90 − 2Q and C = 4Q. Hence at equilibrium

90 − 2Q = 4Q
Q = 15

At a quantity of 15, price is equal to P = 90 − 2(15) = $60. The industry’s profit is = $60(15)
− [100 + 2(15)2] = $350.
 Problem 2: Suppose a profit-maximizing monopolist is producing 800 units of output and is
charging a price of $40 per unit.

a. If the elasticity of demand for the product is -2, find the marginal cost of the last unit
produced.

Answer: The monopolist’s pricing rule as a function of the elasticity of demand is:

(𝑃 − 𝑀𝐶) 1
=−
𝑃 𝐸𝑑

Where 𝐸𝑑 is elasticity of demand. Alternatively,

1
𝑃 (1 + ) = 𝑀𝐶
𝐸𝑑

Substitute −2 for the elasticity and 40 for price, and then solve for MC = $20.

b. What is the firm’s percentage markup of price over marginal cost?

Answer: (P − MC)/P = (40 − 20)/40 = 0.5, so the markup is 50% of the price.

c. Suppose that the average cost of the last unit produced is $15 and the firm’s fixed cost is
$2000. Find the firm’s profit.

Answer: Total revenue (TR) is price times quantity. P= $40 and Q=800 Hence:

TR= $40(800) = $32,000.

Total Cost (TC) is equal to average cost (AVC) times quantity, AVC=$15 and Q=800. Hence:

TC= $15(800) = $12,000.

Profit is therefore TR-TC = $32,000 − 12,000 = $20,000.

(Fixed cost is already included in average cost, so we do not use the $2000 fixed cost figure
separately.)

Problem 3: A monopolist faces the demand curve P = 11 - Q, where P is measured in dollars

per unit and Q in thousands of units. The monopolist has a constant average cost of $6 per
unit.
a. Draw the average and marginal revenue curves and the average and marginal cost
curves. What are the monopolist’s profit-maximizing price and quantity? What is the resulting
profit? Calculate the firm’s degree of monopoly power using the Lerner index.
Answer: Total Revenue (TR) = PxQ and P=11-Q. Hence TR = (11-Q)Q = 11Q-𝑄2 .
Average revenue=TR/Q hence average revenue is equal to demand curve which is P = 11 − Q.

marginal revenue function is the derivative of TR with respect to Q. Hence

MR= −Q

Because average cost is constant, marginal cost is constant and equal to average cost, so

MC = 6.

To find the profit-maximizing level of output, set marginal revenue equal to marginal cost:

11 − 2Q = 6, or Q = 2.5

That is, the profit-maximizing quantity equals 2500 units.

Substitute the profit maximizing quantity into the demand equation to determine the price:

P = 11 − 2.5 = $8.50.

Profits are equal to total revenue minus total cost,

 =TR − TC = PQ − (AC)(Q), or

 = (8.50)(2.5) − (6)(2.5) = 6.25, or $6250.

The degree of monopoly power according to the Lerner Index is:

𝑃 − 𝑀𝐶 8.5 − 6
= = 0.294
𝑃 8.5

b. A government regulatory agency sets a price ceiling of $7 per unit. What quantity will
be produced, and what will the firm’s profit be? What happens to the degree of monopoly
power?

Answer: To determine the effect of the price ceiling on the quantity produced, substitute the
ceiling price into
the demand equation.

7 = 11 − Q, or Q = 4.

Therefore, the firm will choose to produce 4000 units rather than the 2500 units without the price
ceiling. Also, the monopolist will choose to sell its product at the $7 price ceiling because $7 is
the
highest price that it can charge, and this price is still greater than constant marginal cost of $6,
resulting in positive monopoly profit.
 Profits are equal to total revenue minus total cost:

 = 7(4000) − 6(4000) = $4000.

The degree of monopoly power falls to

𝑃 − 𝑀𝐶 7 − 6
= = 0.143
𝑃 7

Problem 4: A firm faces the following average revenue (demand) curve: P = 120 - 0.02Q
where Q is weekly production and P is price, measured in dollars per unit. The firm’s cost
function is given by C = 60Q + 25,000. Assume that the firm maximizes profits.
a. What is the level of production, price, and total profit per week?

The profit-maximizing output is found by setting marginal revenue equal to marginal cost. Given
a linear demand curve in inverse form, P = 120 − 0.02Q we know that the marginal revenue curve
has the same intercept and twice the slope of the demand curve.

Thus, the marginal revenue curve for the firm is

MR = 120 − 0.04Q.

Marginal cost is the slope of the total cost curve. The slope of TC = 60Q + 25,000 is 60, so MC is
constant and equal to 60.

Setting MR = MC to determine the profit-maximizing quantity:

120 − 0.04Q = 60, or

Q = 1500.

Substituting the profit-maximizing quantity into the inverse demand function to determine the
price:

P = 120 − (0.02)(1500) = 90 cents.

Profit equals total revenue minus total cost:

 = (90)(1500) − (25,000 + (60)(1500)), so

 = 20,000 cents per week, or $200 per week.

b. If the government decides to levy a tax of 14 dollars per unit on this product, what will be the
new level of production, price, and profit?

Answer: Suppose initially that consumers must pay the tax to the government. Since the total
price (including the tax) that consumers would be willing to pay remains unchanged, we know
that the demand function is
 P* + t = 120 − 0.02Q, or
P* = 120 − 0.02Q − t,

where P* is the price received by the suppliers and t is the tax per unit. Because the tax increases
the price consumers pay for each unit, total revenue for the monopolist decreases by tQ. You can
see this most easily by expressing R = P*Q, which means tQ is subtracted from revenue.

Marginal revenue, the revenue on each additional unit, decreases by t:

MR = 120 − 0.04Q − t
where t = 14 cents. To determine the profit-maximizing level of output with the tax, equate
marginal revenue with marginal cost:

120 − 0.04Q − 14 = 60, or

Q = 1150 units.
Substituting Q into the demand function to determine price:

P* = 120 − (0.02)(1150) − 14 = 83 cents.

Profit is total revenue minus total cost:

= (83)(1150) − [(60)(1150) + 25,000] = 1450 cents, or
$14.50 per week.
Note: The price facing the consumer after the imposition of the tax is 83 + 14 = 97 cents.
Compared to the 90-cent price before the tax is imposed, consumers and the monopolist each pay
7 cents of the tax. If the monopolist had to pay the tax instead of the consumer, we would arrive
at the same result. The monopolist’s cost function would then be

TC = 60Q + 25,000 + tQ = (60 + t)Q + 25,000.

The slope of the cost function is (60 + t), so MC = 60 + t. We set this MC equal to the marginal
revenue function from part a:

120 − 0.04Q = 60 + 14, or

Q = 1150.

Thus, it does not matter who sends the tax payment to the government. The burden of the tax is
shared by consumers and the monopolist in exactly the same way.