Problem Set-1 _Solution

Q.1 The cost function for a firm is given by C(Q) =5 + Q

2
. If the firm sells output in a perfectly
competitive market and other firms in the industry sell output at a price of $20, what price should
the manager of this firm put on the product? What level of output should be produced to
maximize profits? How much profit will be earned?
Since it is perfectly competitive market, firm is a price taker and therefore the price = $20.
MC = 2Q; AR=MR=20.
Profit would be maximized when MR=MC
2Q = 20
Q = 10 ( Profit maximizing level of output)
Profit = TR TC
= (20X10) - (5+ 10X10) = 200 -105= $ 95.

Q.2 Suppose the cost function for a firm is given by C(Q )= 100 + Q
2
. If the firm sells output in a
perfectly competitive market and other firms in the industry sell output at a price of $10, what
level of output should the firm produce to maximize profits or minimize losses? What will be the
level of profits or losses if the firm makes the optimal decision?
Since it is perfectly competitive market, firm is a price taker and therefore the price = $10.
MC= 2Q ; AR=MR= 10
Profit would be maximized or loss would be minimized when MR=MC
2Q = 10
Q = 5 ( Profit maximizing level of output)
Profit = TR- TC
= (10X5) (100 + 5X5) = 50 125 = $- 75 (loss minimizing level of output)
Firm will continue the production because by shutting down the production firm will incur losses
which will be equal to its fixed costs ($100) while if it continues then there is only a loss of $75.


Q3. Suppose the inverse demand function for a monopolists product is given by P = 100 -2Q
and the cost function is given by C(Q) = 10 + 2Q. Determine the profit-maximizing price and
quantity and the maximum profits.
TR = PXQ = (100-2Q)Q = 100Q 2Q
2

MR = 100 4Q
MC = 2
Profit is maximized when MR=MC
100-4Q = 2
4Q = 98
Q= 24.5 (Profit maximizing level of output)
P = 100 2 X 24.5 = 100 49 = 51
Profits = TR TC
= 51X24.5 (10 +2X24.5) = 1249.5 59 = 1190.5

Q4. A firm sells its product in a perfectly competitive market where other firms charge a price of
$80 per unit. The firms total costs are C(Q)= 40 + 8Q+ 2Q
2
.
a. How much output should the firm produce in the short run?
MR= 80 ; MC = 8 + 4Q
MR= MC
80 = 8 + 4Q
4Q = 72
Q= 18
b. What price should the firm charge in the short run?
$80 because in this perfectly competitive market firms is a price taker.
c. What are the firms short-run profits?
Profits = TR TC
80 X 18 (40 + 8X18 + 2X18X18)
1440 (40+144+648) = 1440 832 = 608
d. What adjustments should be anticipated in the long run?
Prospective firms will get attracted to these super normal profits in this industry and therefore
they enter in this industry. Their entry increases the supply of homogenous product in the market
which consequently decreases the price of the product in this industry. Ultimately, entry of new
firms continues until price decreases up to a level at which no firm enjoys supernormal profits or
profits are reduced to normal profits.
Q5. You are the manager of a monopoly, and your demand and cost functions are given by P =
200 -2Q and C(Q) = 2000 + 3Q
2
, respectively.
a. What pricequantity combination maximizes your firms profits?
TR = PXQ = (200-2Q)Q = 200Q 2Q
2
MR = 200 4Q
TC = 2000+3Q
2

MC = 6Q
MR = MC
200- 4Q = 6Q
10Q = 200
Q = 20 (Profit maximizing level of output)
P = 200 2X20 = 200 40 = 160.

b. Calculate the maximum profits.

Profits = TR TC
160 X 20 ( 2000 + 3X 20X20) = 3200 3200 = 0 ( firm is earning only normal
profits)
c. Is demand elastic, inelastic, or unit elastic at the profit-maximizing
pricequantity combination?
PED = - 1/2 X 160/ 20 = -4 ( it is elastic)
c. What pricequantity combination maximizes revenue?
Revenue is maximized when TR is maximum which is only possible when MR=0.
MR= 200- 4Q = 0
Q = 50 ( revenue maximization level of output)
P = 200 2X 50 = 200 100 = 100
d. Calculate the maximum revenues.
The revenue is maximum when firm is producing 50 units and selling it at a price of 100
50 X 100 = 5000
e. Is demand elastic, inelastic, or unit elastic at the revenue-maximizing
pricequantity combination?
PED = -1/2 X 100/50 = - 1 (Unitary)

Q6. You are the manager of a monopolistically competitive firm, and your demand and cost
functions are given by Q = 20 2P and C(Q) = 104 14Q + Q
2
, respectively.
a. Find the inverse demand function for your firms product.
P = 10 0.5Q
b. Determine the profit-maximizing price and level of production.
TR= PXQ = (10 0.5Q)Q = 10Q 0.5Q
2

MR = 10 Q
TC = 104 14Q+Q
2
MC = -14+ 2Q
MR= MC
10 Q = -14 + 2Q
Q = 8
P = 10 0.5X8 = 6.
c. Calculate your firms maximum profits.
TR TC
6X 8 ( 104 -6X8 + 6X6) = 48 (104-48+36) = 96-140= -44 (loss)

d. What long-run adjustments should you expect? Explain.
The firm losses from operation ( -44) are less than its losses when there is shutdown of
production ( in this case, the losses would be equal to the fixed costs = -104). Since
losses from continuing the production is less than the losses from shut down, this firm
will prefer to continue in long run with some changes in its scale of production to get the
normal profits. Also, other firms which are unable to cover their average variable costs
will exit from the industry and their exit will create new market opportunities for this loss
making firm. Hence, the loss making firm would change its scale of production in such a
way that it gets normal profits in the long run.