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SPRING 2015

Intermediate

MICROECONOMICS

ECON 302

Dr. Jose J. Vazquez

University of illinois

at Urbana-Champaign

CHAPTER 1: DEMAND THEORY ............................................................................................... 5

I. Overview ............................................................................................................................................................................. 7
II. Consumer Happiness = Indifference Curves ....................................................................................................... 7
Assumptions About Consumer Theory.................................................................................................................................9
III. The Budget (Income) Constraint.......................................................................................................................... 10
A Change in Income ................................................................................................................................................................... 11
A Change in Prices...................................................................................................................................................................... 12
IV. Consumer Choice ........................................................................................................................................................ 12
A Change in Consumer Preferences ................................................................................................................................... 13
A Change in Income ................................................................................................................................................................... 13
A Change in Prices...................................................................................................................................................................... 14
V. Consumer Choice using the calculus approach ............................................................................................... 15
The Concept of Utility ............................................................................................................................................................... 15
Introducing Calculus................................................................................................................................................................. 16
Example .......................................................................................................................................................................................... 17
A Numerical Example ............................................................................................................................................................... 20
The Cobb-Douglas Utility Function .................................................................................................................................... 21
The Marginal Rate of Substitution ..................................................................................................................................... 21
The Utility-Maximizing Problem ......................................................................................................................................... 22
VI. Income and Substitution Effects .......................................................................................................................... 25

CHAPTER 2: FIRM THEORY ................................................................................................... 29

I.

The Cobb-Douglas Production Function .............................................................................................................. 31

The Marginal Rate of Technical Substitution (MRTS) .............................................................................................. 31
A Numerical Example ............................................................................................................................................................... 33
II. Cost Minimization Using the Cobb-Douglas Production Function........................................................... 34
The Isocost Approach ............................................................................................................................................................... 34
III. Cost Curves .................................................................................................................................................................... 38
Average Costs. .............................................................................................................................................................................. 38
Variable Costs .............................................................................................................................................................................. 38
Average Costs ............................................................................................................................................................................... 39
Marginal Costs. ............................................................................................................................................................................ 39
Calculating Costs Using the Cobb-Douglas Function ................................................................................................. 39

CHAPTER III: MATH REVIEW ................................................................................................. 43

I.

Calculus Review.............................................................................................................................................................. 45
How to find a derivative .......................................................................................................................................................... 46
Derivatives of Sums and Differences. ................................................................................................................................ 47
Derivatives of Products............................................................................................................................................................ 48
Partial Differentiation ............................................................................................................................................................. 49
Using derivatives to solve maximization and minimization problems ............................................................. 50

PART II: CLASSROOM PROBLEMS ......................................................................................... 53

LAB 1: What are we going to do here? ............................................................................................................................. 55
Lab 2: The Tools of Microeconomics ................................................................................................................................. 57
Lab 3: Consumer Choice (Part I) ......................................................................................................................................... 61
LAB 4: Consumer Choice (Part II) ....................................................................................................................................... 65
LAB 5: Income and Substitution Effects ........................................................................................................................... 69

LAB 6: Elasticity .......................................................................................................................................................................... 73

LAB 7: Taxes: An Initial Analysis ......................................................................................................................................... 77
LAB 8: The firm technological problem ........................................................................................................................... 79
LAB 9: Minimizing Costs for the Firm ............................................................................................................................... 83
LAB 10: Cost Curves................................................................................................................................................................... 85
LAB 11: Maximizing Profit ..................................................................................................................................................... 91
LAB 12: The Model of Perfect Competition..................................................................................................................... 95
LAB 13: Welfare .......................................................................................................................................................................... 97
LAB 14: Monopoly ................................................................................................................................................................... 101
LAB 15: Game Theory ............................................................................................................................................................ 107

PART I
THEORY
HANDOUTS

CHAPTER 1:
DEMAND THEORY

I.

Overview

In this part of the course we are going to try to answer the following question:

How does a consumer maximizes happiness given its his/her limited resources?

As you can see, this question has two parts: 1) consumer happiness (satisfaction), and 2) limited
resources. The first has to do with the consumer values and preferences, and the second one has
to do mostly with the consumers income. Therefore, before we can answer our main question,
we need to investigate these two parts in detail.
II.

Consumer Happiness = Indifference Curves

Economists used a model called: Indifference Curves to represent consumer happiness (satisfaction). An
indifference curve represents the preference of ONE consumer in the traditional X and Y plane. Each
indifference curve map represents the case for just ONE consumer, and the consumer chooses between
TWO goods; usually represented by X (horizontal axis) and Y (vertical axis). Therefore, one point in the
diagram represents a bundle of these two goods the consumer can consume.
Figure 1.1: A consumer bundle.

An indifference curve is a curve connecting all the bundles that give the consumer equal satisfaction.
Take a look at Figure 1.2. For instance, suppose that consumer bundles A, B, and C give the consumer
the same satisfaction. When this consumer consumes 5 units of each good, he/she is willing to consumer
3 more units of X by giving up 3 units of Y. At the same time, he or she is willing to consume 5 more
units of Y by giving up 4 units of X.
Therefore, a consumer will be indifferent between consuming any of these bundles. If we draw a curve
passing through all these points, we will have an indifference curve for this consumer.
Figure 1.2: An indifference curve.

The marginal rate of substitution (MRS) is the rate at which the consumer trades one good for the other
while remaining indifferent. For instance, in the figure above the marginal rate of substitution when the
consumer moves from point A to point B is -3/3 since the consumer gave away 3 Y in exchange for 3 X
to remain at the same level of satisfaction. As you can see, the marginal rate of substitution is basically
the slope of the indifference curve.

Assumptions About Consumer Theory

As we try to develop this model, we are going to have to make some assumptions about our indifference
curves, in order to get a shape that allows to apply the model to different problems. Here are the first two:
1. The consumer satisfaction for one good ALWAYS diminishes as he or she consumes more of that
good. This means that indifference curves always have a negative slope; or that the MRS is always
negative. Can you tell why?

2. The consumer always gets more satisfaction by consuming more. This means indifference curves to
the right of the origin ALWAYS give the consumer more satisfaction. Look at Figure 1.3 below. If
the consumer is able to consume 8 units of X, while still consuming 5 units of Y, then this consumer
MUST be happier since he or she is consuming more than before. Therefore, since this new bundle, 8
and 5, gives the consumer more satisfaction, he or she can not be on the same indifference curve as
before, but on a higher one. The opposite would apply if the consumer lost some of both goods at the
same time.
Figure 1.3: Two indifference curves.

3. The consumer is consistent when ranking different bundles. This means indifference curves cannot
cross. For instance, look at Figure 1.4 below.
The fact that both of these curves pass through the coordinate 1,10 suggest this consumer is indifferent
between consuming 5 units of each good, and consuming 5 Y and 8 X. BUT THIS CANT BE, since we
had just established the consumer always like more. So, this consumer MUST prefer 5Y and 8X.

Figure 1.4: Two indifference curves.

4. The consumer always wants at least one of each good. This means indifference curves will never
touch the axes.
When indifference curves meet all of the four assumptions described above, then we say we have wellbehaved indifference curves. Unless we say otherwise, we are always going to assume indifference
curves are well-behaved.

III.

The Budget (Income) Constraint

The budget constraint depends on two things: consumers income and the price of the two goods. The
simplest assumption we can make about this constraint is that the consumer spends all of his or her
income consuming the two goods. We can represent this assumption in the following equation:

PxX + PyY = M
Px = price of good X
Py = price of good Y
M = Income
X = quantity of good X
Y = quantity of good Y.
So what this equation says is that the consumer uses all of his/her income (M) to buy X and Y. The
money this consumer spends on X is PxX; while the money this consumer spends on Y is PyY.
In order to put this equation in the typical X, Y, we need to solve the equation for Y. This would give us
the equation for the budget line, BL.
Y = M/Py (Px/Py)X

10

The first part of this equation is the y-intercept, and the second one is the slope of the budget line. Take a
look at Figure 1.5 to see what Im taking about. The intercept of the line, M/Py, represents all the units of
good Y this consumer will buy if he or she spends all of her income in good Y. The slope of the curve is
equal to the ratio of the price, -Px/Py. Also, notice that the line is downward sloping, reflecting the fact
that in order to buy more one good the consumer must give up some of the other good.

Figure 1.5: Two indifference curves.

A Change in Income
When the income, M, of the consumer changes both intercepts will change. If income increases the curve
shift to the right, and if income falls the curve shift to the left.
Figure 1.6: An increase in Income (M).

11

A Change in Prices
When the ratio of prices, Px/Py, change the slope of the curve also changes.
Figure 1.7: An increase in the price of X (Px).

IV.

Consumer Choice

The trick to solve the consumer problem graphically is to combine the indifference curve with
the budget line in one diagram. For instance, look at figure 1.8 below. At point B, this consumer
is not doing to most it can with its income, since she could afford a higher indifference curve.
Point C, however, is the best this consumer can do with the income she has. Any move to a
higher indifference curve would require more income.
Figure 1.8: The point of maximizing satisfaction

Notice that at the maximizing point the slopes of both curves, indifference curve and budget line,
are the same. Since the slope of the indifference curve is the MRS, and the slope of the budget
line is the ratio of the price, Px/Py, we could use the following equation to identify the point at
which the consumer maximizes satisfaction:
MRS = Px/Py
12

A Change in Consumer Preferences

A chance in consumer preferences changes the maximizing point by changing the shape of the
indifference curves. An increase in the value the consumer perceives for good X makes the indifference
curves steeper, while an increase in the value the consumer gets from Y flattens it.
Figure 1.9: An increase in the value of good X and maximizing consumption

A Change in Income
A chance in income changes the maximizing point because it changes the budget line. For instance, an
increase in income allows the consumer to afford a higher indifference curve by shifting the budget line to
the right.
Figure 1.10: A decrease in income and maximizing consumption.

13

A Change in Prices
A change in any of the prices changes the maximizing point by changing the slope of the budget
line. For instance, an increase in the price of X makes the budget line steeper, hence forces the
consumer to find a new maximizing point. A change in prices changes consumption in two
ways: 1) reducing the total income available to buy both goods; and 2) forcing the consumer to
substitute one good for the other in order to get more for her money.
Figure 1.11: An increase in the price of X, Px, and maximizing consumption.

14

V.

Consumer Choice using the calculus approach

The Concept of Utility

Utility = satisfaction = unit of measurement for indifference curves.
Consumers derive utility from consuming different combinations of goods. For instance:
(1)

U = (Beers, Food, Books, Etc)

And if we combined goods we can have

(2)

U = ( Beers, Dollars)

where dollars is what we called a composite good since it captures combinations of more than
1 good. So the utility function with two variables can be used to describe the consumers
problem of choosing among a combination of many goods; not just two.
More generally, a utility function like the one above can be stated as
U = (X,Y)
Where X are Y are two different goods or composites of goods (i.e. Y can be called other
goods and measured in dollars).
Given this generalized utility function, we can defined the Marginal Utility of X, MUX, as the
additional utility one gets from an 1 additional of X holding all other goods constant. In other
words, MUX measures the rate of change in utility (U) associated with a small change in the
amount of good X holding good Y constant. More formally:
MUX = U / X
MUY = U / Y
Therefore, for the utility function of the form U = (X,Y) the change in total utility is given by the
following equation:
(3)

U = MUX X + MUY Y

Now, as we know from class along that along an indifference there is no change in utility since
that is precisely what the word indifferent implies. This means that along the indifference
curve U = 0. So replacing that into equation (3) above we have
(4)

MUX X + MUY Y = 0
MUX X = - MUY Y
15

And since we also know that the slope of an indifference curves is equal to (X/Y), we can
solve for that slope by dividing equation (4) above first by X and then by MUY to end up with:
(5)

MUX / MUY = - Y/ X

If you remember from class, the right hand side of this equation is the marginal rate of
substitution, MRS. Therefore,
(6)

MRS = - Y/ X

And replacing that into equation (5) above,

(7)

MUX / MUY = MRS

Now, we know from class that the utility-maximization condition is the following:
(8)

MRS = PX/PY

For a consumer to maximize his/her utility he/she must consume a combination of goods so that
his/her marginal rate of substitution between the two goods is equal to the ratio of the prices of
those two goods. So, if we put equations (7) and (8) together we end up with the following
utility-maximizing condition:
(9)

MUX/MUY = PX/PY

Which says that for a consumer to maximize his/her utility between two gods he/she must
consume at the point where the ratio of the marginal utilities between the two goods is equal to
the ratio of the prices. We explained the economic interpretation of this result in class so make
sure you are clear about it since it is a very important economic concept (translation: this will be
in the exam!!).
So far, all this stuff I have explained so far is in your textbook. The following is not.
Introducing Calculus
Again, suppose you have the following utility function:
(10)

U = (X,Y) = XY

If you draw indifference curves for this utility function you will get contour lines like the ones
we developed during our second of class (you should try it). Now, in the previous section we
defined the marginal utility of X, MUX, as the extra utility gained from increasing X by 1 unit,
holding Y constant. If you remember from the math review, this is nothing else than the partial
16

derivative of U with respect to X (in fact, in economics, the word marginal usually refers to
a derivative!!!) Formally, then, for the utility function above

MU X

MU Y

U
Y
X

U
X
X

Note: make sure to check the math review for the rules of how to find partial derivatives.
Now, if we replace that into equations (6) and (9) respectively we have,

(11)

U / X
MRS
U / Y

or
(12)

U / X PX

U / Y PY

And this is our utility-maximizing condition using calculus. So using the tools of calculus it is
now possible to find the specific quantities of the two goods a person will consumed, as long as
we have a utility function (which describes the consumers preferences) and a budget constraint
(which describes the consumers budget). In other words, the problem a consumer faces is
nothing else than a typical mathematical problem of maximizing a particular function (in this
case a utility function) subject to constraints (in this case the budget constraint). This is a much
better way than dealing with those annoying diagrams!!!!

Example

Suppose a consumer problem was the following:

Max

U = (X,Y) = XY

subject to

PYY + PXX = M

using the usual definitions for all the variables (X and Y are two goods, M is income, and PX and
PY are the prices of X and Y respectively)..
17

There are several ways to solve this maximization problem. The easiest one is to use the utilitymaximizing condition we derived earlier; lets called that Method 1.
Method 1
We know the utility maximizing condition is given by equation (12):

U / X PX

U / Y PY
First, we find out the marginal utilities by calculating the partial derivatives.

MU X

MU Y

U
Y
X

U
X
X

And replacing this into (12) we have

Y/X = PX / PY
Now we know the budget constraint can be solve for Y to have
Y = M/PY (PX/PY)X
So now we have two equations and two unknowns.
Y/X = PX / PY
Y = M/PY (PX/PY)X
Which means we can substitute our budget constraint into our maximizing equation and solve for
the two unknowns. After the algebra we will end up with the following1:
1

This is the complete derivation. Substituting the budget constraint into the utility-maximization equation give up
[M/PY (PX/PY)X] / X = PX / PY

Cross multiplying we have,

[M/PY (PX/PY)X] PY = PXX

18

(13)
(14)

X = M / 2PX
Y = M / 2PY

These are the equations for the demand for X and Y respectively.
Method 2
A second way of solving the initial problem is to simply solve the budget constraint for Y in
terms of X and then substitute the result wherever Y appears in the utility function. Utility then
becomes a function of X alone, and we can maximize it by taking its first derivative with respect
to X and equating that to zero. The value of X that solves that equation is the optimal value of
X, which can then be substituted back into the budget constraint to find the optimal value of Y.
Lets do it; remember our problem was the following:
Max

U = (X,Y) = XY

subject to

PYY + PXX = M

We can solve the budget constraint for Y and then substitute that into the utility function to end
up with
U = X [M/PY (PX/PY)X] = XM/PY X2PX/PY
Now we take the derivate of that equation with respect to X and make it equal to zero (remember
from your math review this is the first order condition to find a maximum)
dU / dX = M/PY 2XPX/PY = 0
Which after a little algebra solves into
X = M / 2PX
Y = M/2PY
Fortunately the same as result as the one we found using the first method.

Canceling the PY in the left hand side we end up with

M - P XX = P XX
Moving the X terms to the same side we end up with the equations (13) and (14).

19

The last way to solve the utility-maximization problem is the so-called Lagrange method.
Nevertheless, although quite useful for sensitivity analysis, this method can get kind of messy
and I believe might be too cumbersome at this point. So dont worry about that.

A Numerical Example
Now lets try to solve a utility maximization problem using some values for the variable. Im
going to use Method 2 to solve it.
Suppose that
U(X,Y) = XY,
with M = 40, PX = 4, and PY = 2. The budget constraint is then
4X +2Y = 40, which solves for
Y = 20 2X.
Substituting this expression back into the utility function, we have
U(XY) = X(20 2X) = 20X X2.
Taking the first derivative of U with respect to X and equation the result to zero, we have

dU
20 2X 0
dX
which solves for X = 5. Plugging this value of X back into the budget constraint, we discover
that the optimal value of Y is 10. So the optimal bundle is (5,10). For this optimal values of X
and Y, the consumer will obtain (5)(10) = 50 units of utility. If you try to solve this using the
Method 1the answer should be the same (try it out).
A More Difficult Problem.
Now, use either of the two methods described above to solve the following utility maximization
problem.
Max U = XC YD
Subject to PYY + PXX = M
Derive the demand equations for X and Y.
20

The Cobb-Douglas Utility Function

Probably the most famous function in economics is the so called: Cobb-Douglas utility function
(or its equivalent the Cobb-Douglas production function). It bear the name of the two people
who suggested it first: Paul Douglas, an economist at the University of Chicago who later
became a US Senator, and Charles Cobb, a mathematician at Amherst College. They originally
used it to study production behavior in the US.
As we will see during the course, this equation has many useful properties; we will use it a lot in
this class. So make sure you familiarize yourself with it as much as you can.
Here Im going to use it to solve the utility-maximizing problem we have been discussing in
class. Once you solve it in this general form, you will be able to apply the result to any utility
function that has the same form. This will reduce your work tremendously during homeworks
and exams.
The traditional Cobb-Douglas utility function has the following form:
U (X,Y) = XcYd
where c and d are positive numbers that describe the preferences of the consumer. Its first
usefulness is that if you choose different values for c and d you will find that this equation
generates different type of curves with the traditional convex shape we have been studying. So
try it out. Graph the contour lines for this equation with a = , b = and see what type of
contour lines you get. Then do the same with a = 1/5, b = 4/5 and see what you get. They
should look like the nice convex indifference curves we have been studying in class.
The Marginal Rate of Substitution
Alright, so lets get busy here. Lets start using the function. First, lets find out what will be the
MRS for this function. We know that the MRS is the ratio of the Marginal Utilities and that we
can calculate them by taking the partial derivatives. More formally:
MRS

MU X
MU Y

U
cX c 1Y d
X
U
MU Y
dX cY d 1
Y
MU x

21

And replacing the equations for the marginal utilities into our equation for the MRS we have
U
cX c 1Y d cY

X
(1)
MRS

U dX cY d 1 dX
Y
Note that the MRS only depends on the ratio of the two parameters and the quantity of the two
goods in this case2.
The Utility-Maximizing Problem
First, remember our problem is the following:
U=(X,Y)=XcY d

max
subject to

PX X PYY M

In class, I gave you to ways of solving this problem. Method 1 required us to use the utilitymaximizing condition we have derived in class. So lets use that one first.
Remember that our utility-maximizing rule says that when the consumer is maximizing his/her
utility subject to his/her budget constraint, the MRS will be equal to the ratio of the prices. More
formally:
(2)

MRS

PX
PY

So, now that we know the MRS we can use our utility-maximizing rule to solve the utilitymaximizing problem. So combining equations (1) and (2) we have:

A little help with the algebra. To solve for the MRS you have to use the rules of exponents. Namely the following
two rules:
Xa/Xb = X a-c and X-1 = 1/X

Using these two rules its now clear to see how I derived the algebra in the MRS equation. Here is the complete
derivation of the right hand sides:

cX c 1Y d cX c 1cY d (d 1) cX 1Y 1) cY

dX cY d 1
d
d
dX
22

MRS
(3)

cY
dX
cY PX

dX PY

And now we have the following two equations:

cY PX

dX PY

PX X PYY M
These are two equations in two unknowns that can be solve for the optimal choice of X and Y.
As we have been doing in class, first we solve the budget constraint for Y

PX X PYY M

M PX
X

PY PY

and then substitute that into the utility-maximizing equation (equation 3 above):
c(

M PX
X)

PY PY
P
X
dX
PY

And if we cross-multiply we have:

cM cPX X dXPX

Bringing the X terms to one side we have:

cM dXPX cPX X

cM X (dPX cPX )

And dividing by the terms in the parenthesis (in order to solve for X) we have:

c
dPX cPX

Finally, rearranging the variables in the left-hand side we have:

23

(4)

c
M

c d PX

Voila!! We have found the demand equation for X for any type of Cobb-Douglas utility
function.!!! If you substitute this result back into the budget constraint you will get
(5)

d
M

c d PY

Which is the demand equation for Y.

Now, as practice, you should try to solve the initial problem using Method 2 and confirm you get
the same solutions.
Furthermore, to see that this works, try it out with a few different forms of the function. For
instance, try to solve the following utility function:
U X Y

Using both the Methods we discussed in class and then the demand equations we derived. You
will see you get exactly the same results.
Again, the Cobb-Douglas function is very important. Go through this derivation a few times to
make sure you understand it. At the very least, if you dont want to do this, memorize the
demand equations for X and Y we just derived (although I think this is a very questionable
strategy).

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VI.

Income and Substitution Effects

Suppose your consumption for two goods is given by the typical Cobb-Douglas utility function: U = XY.
Furthermore, suppose PX = $2.00, PY = $1.00 and M = $200. Given all this, to maximize utility you will
have to consume 50 units of X and 100 units of Y. Now, what would happen to this consumption bundle
if the price of X is reduced to $0.50?
Well, it makes sense to think that when the price of X is lower than before, and you have the same
income, you are going to decide to consume more X. In fact, if you solve the problem again you will
quickly see that this is in fact the case. With the new price of X (PX2) consumption of X is now 200 (X2).
Thats pretty easy! Nevertheless, a more difficult question is to figure out why are you consuming more
X?
This sounds like a really stupid question, right? Obviously, you are consuming more X because X is
cheaper. Yes, but, really, why are you consuming more X? If you think about this a little more, you will
realize that there are two reasons why you decide to consume more X when the price of X goes down.
First, your purchasing power is now larger than before. In other words, if you continue to consume
the same quantities you were consuming before after the reduction in price of X, you will have some
money leftover. That would not be rational! So you are obviously deciding to consume more X simply
because you have more money. This is called: the income effect of the change in the price of X.
But, as it turns out, even if your purchasing power had remained the same, you would still consume more
X (and less Y). Why? Well, mainly because now you are getting a better deal for your buck by
consuming X. Given this, since you are rational, you are going to shift your consumption towards more
X and less Y. This is called: the substitution effect of a change in the price of X (it makes sense to call it
the substitution effect since thats exactly what youre doing: substituting X for Y). Therefore, the total
change in the consumption of X as a result of the price change was the following:
Total Change in Consumption of X from Reduction in Price of X (X) = Change due Substitution Effect
(XS) + Change due to Income Effect (XI)
or
X = XS + XI
And we had already found that that this was equal to
X = X2 X1 = 150
Hence,
X = XS + XI = 150
And now the real question is: how much is the increased in consumption of X due to the substitution
effect and how much is due to the income effect? Lets take the substitution effect first. In order to
measure this effect, we need to get rid of the income effect (XI) in the equation above. In other words, we
need to know how much more X you consume when the price of X changes and your purchasing power
remains constant. Well, the easiest way to do this is simply to take away the extra money you get when
the price of X is reduce and see how much X you would consume after that. Lets do this. Calculate how
much it would cost you to consume the original bundle with the lower price of X.

25

This is going to be equal to:

X1*PX2 + Y1*PY = M2
(50)($0.50) + (100)($1.00) = $125

So, when the price of X goes down, you only need $125.00 to consume what you were consuming
originally. Therefore, the extra income you make is $75 (M2 M1). Now, ask yourself, how much X and
Y you would consume with an income of $175.00? Any increase in the consumption of X must be due
simply to the fact that X is now a better deal (Substitution Effect). Lets find out.
Max U = XY
s.t. Y3 = $125 - $0.50X3 Y = (M2/PY) (PX2/PY)X
The solution to this problem gives: X3 = 125 ; Y3 = 62.5. Also notice that utility is larger than it was
before; U3 = 7,812.5 (compare to U1 = 5,000). This means that you will consume 75 additional units of X
(X3 X1) simply because you get a better deal for your buck with X after the price of X goes down. This
is the Substitution Effect! More formally:
Substitution Effect = XS = X3(PX2,M2) X1 (PX1,M1) = 125 50 = 75.
And the Income Effect? Well, the income effect must be the leftover from the Total Effect equation.
Again,
X = XS + XI = 150
XS = 75
XI = 75.
Notice that this is also equal to:
XI = X2 (PX2, M) X3 (PX2,M2) = 200 125 = 75
The notation above is useful since it clearly shows what we are doing: the change in X with the same
price (PX2) and different income (M2 vs. M1).
In other words, when the price of X goes down from $2.00 to $0.50 you consume 75 additional units of X
because you are getting a better deal for your buck by consuming X and 75 additional units because your
purchasing power is larger.
And what was the point of all this? Well, well see eventually.
Here is the graphical solution.

26

200

125
100
U3

62.5

U2
U1
50

200

100 125

XS =75

250

400

XI =75

X =150

27

CHAPTER 2: FIRM
THEORY

29

I.

The Cobb-Douglas Production Function

As promised, now that we are moving into the Theory of the Firm we are going to continue to
use the now famous Cobb-Douglas function. This time, we are going to use it to model the
technological problem facing any firm: how to combine labor and capital to produce certain
output.
When we talked about the consumer in the previous section we saw that the traditional CobbDouglas utility function had the following form:
U (X,Y) = XcYd
where c and d were positive numbers that described the preferences of the consumer. Well, as it
turns out, to Cobb-Douglas Production Function is exactly the same, but this time we dont care
about goods X and Y, but about Labor (L) and Capital (K). And we dont care about utility
anymore (thank god) but about the output, Q, the firm produces. So, a Cobb-Douglas Production
function looks more like this:
Q (L,K) = LcKd

Since all the properties of the function remain the same its interpretation in production theory is
very similar to its counterpart interpretation in consumer theory. Lets start with the equivalent
to the Marginal Rate of Substitution in producer theory: the Marginal Rate of Technical
Substitution.
The Marginal Rate of Technical Substitution (MRTS)
We know that the MRTS is the ratio of the Marginal Products and that we can calculate them by
taking the partial derivatives. More formally:
MRTS

MPL
MPK

U
cLc 1K d
L
U
MPK
dLc K d 1
K
MPL

And replacing the equations for the marginal products into our equation for the MRTS we have

31

(2)

Q
cLc 1K d cK
MRTS L c d 1
Q dL K
dL
K

Note that the MRTS only depends on the ratio of the two parameters and the quantity of the two
inputs in this case.
Now, as it applies to production, the function is even more useful. Consider the MP L

MPL

Q
Q
cLc 1K d c
L
L

This says that the Marginal Product of Labor depends not only on all the other inputs used (i.e.
K) but also on the Average Product of Labor (Q/L). And the same applies to capital. Dont
believe me, look at this:

MPK

Q
Q
dK d 1Lc d
K
K

Furthermore, the exponents c and d have very interesting economic interpretations. Both of them
tell you by what percentage output goes up if labor (or capital) go up by 1 percent. Dont believe
me, here is the derivation of that.
Q
Q
c
L
L
Q L
c
L Q

Is the left-hand side of this equation familiar? Yes!! That is the famous (or infamous depending
on how you did on the exam) elasticity equation from demand theory. But this time we replaced
P for L. So, this equation is the output elasticity of labor and it tells you the percentage change
in output to a percentage change in labor. The same applies to capital.
Q
Q
d
K
K
Q K
d
K Q

So, by how much output would go up if I increase both L and K by 1 percent? You got it, it
would increase by a percentage equal to c + d.
32

A Numerical Example
Suppose you thought the production in US was given by the following production function:
Q = AL0.70K0.30
where Q = units of output, L = units of labor, K = units of capital and A is a constant (it usually
represents the level of technological progress of a country). This is a very similar formulation to
the one suggested originally by Cobb and Douglas to describe production in the US at the time of
their research.
1. What is the MPL and MPK given this equation?
Q
0.70AL0.30K 0.30
L
Q
MPL 0.70
L
Q
MPK
0.30AL0.70K 0.70
K
Q
MPK 0.30
K
MPL

2. What are the output elasticities of Labor and Capital respectively?

Q
L
Q
L
Q
L
Q
L
Q
L

0.70AL0.30 K 0.30
0.70

Q
L

L
0.70 output elasticity of labor
Q
0.30AL0.70 K 0.70

K
0.30 output elasticity of capital
Q

This means that if Labor goes up by 1 percent, output would go up by 0.70 percent. And if
capital goes up by 1 percent, then output would go by 0.30 percent. Therefore, if both capital
and labor go up by 1 percent, then output would go up by 1 percent. This means this production
function exhibits constant returns to scale.
33

II.

Cost Minimization Using the Cobb-Douglas Production Function

The Isocost Approach

So now that we understand how the production of the firm lets introduce costs into our problem.
The main costs of production will be the prices of the two inputs we have been using: Labor and
Capital. The price of Labor is the wage (w), and the price of Capital is the rent (r ). Therefore,
assuming these are all the costs of production, the total costs function for the firm will be the
following:
5.1

TC = wL + rK

which says: the total costs of production will equal to the price of labor (the wage) times the
amount of labor we use (i.e. workers) plus the price of capital (the rent) times the amount of
capital we use (i.e. machines).
Now, we know that so far we have been doing the analysis of the firm using a xy-diagram where
Labor is on the x-axis and capital is on the y-axis. Figure 1 below shows this diagram, along
with isoquant we developed in our previous section. Remember an isoquant gives you all the
combinations of Labor and Capital you will need to produce a particular output. The Isoquants
are the equivalent to the Indifference curves we used in Consumer Theory.
So, going back to our total cost function above, we can represent this equation in the xy-diagram
of Figure 1 simply by solving this equation for K (Capital) since that is what we have in the yaxis. If we did that, we would have the following:
TC = wL + rK
5.2

TC w
L
r
r

Hence, the various combinations of capital and labor that can be purchased, given w, r, and TC
can be represented by a straight line like the one shown in Figure 2. As customary, the first term
TC
on the right-hand side of this equation is the vertical intercept,
, while the ratio of the prices
r
w
of labor and capital is the slope,
.
r
Given this definitions, it seems clear that the higher the Total Costs are, TC, the higher the yintercept and the hence the whole Isocost curve will shift to the right. For instance, if you look at
figure 2 youll notice that the Isocost2 is to the right of Isocost 1 since TC2 are higher than TC1.
And, since both curves have the same slope, then the ratio of w/r must have remained constant.
In the same way, if the ratio of the price of labor and capital change, then the slope of the Isocost
will change.
34

Figure 1: The Isoquants

Capital (K)

Q2
Q1

Labor (L)

Figure 2: The Isocost

Capital (K)

Slope = w / r

Isocost2 for TC2 (TC2 > TC1)

Isocost1 for TC1
Labor (L)

Figure 3 shows the process of minimizing costs for the firm graphically. The firm faces a
technological constraint since it can only use a certain amount Capital and Labor to produce a
particular output. This constraint is the same you were facing each round when we played the
calculator game in class. The technological constraint for the firm is given by its Isoquant. Each
Isoquant is the most output the firm can produce with the limited amount of Capital and Labor it
has. The firm wants to produce this output by spending the least, or minimizing costs.
35

Therefore, the producer will try to find the lowest possible Isocost line that allows the firm to
produce that output. It should be clear that this Isocost will be the one that touches the Isoquant
at the point of tangency between the two curves. At that point, the slope of both curves is the
same. And since we already had an equation for the slopes of both curves, the tangency point,
given these equations is the following:
MRTS

w
r
MPL
MRTS
MPK
MPL w

MPK
r

The last of these equations is the minimizing costs condition for the firm. It is a very important
equation, so please memorize it right now!!!!
Figure 3: Minimizing Costs for the Firm

Capital (K)

Minimizing Costs Point (MRTS = w/r = MPL / MPK )

Isoquant (slope = MRTS = MPL/MPK )

Isocost (slope = w/r )

Labor (L)

So, if youre thinking: man, this looks a lot like the stuff from consumer theory, youre right
on the money. The process of cost-minimization for the firm is exactly the same (but in reverse)
to the process of maximizing utility for the consumer. In consumer theory, the consumer is
trying to maximize utility (Indifference Curves) given a certain income constraint (Budget Line).
So the consumer started with a set budget constraint and tries to move along this budget
constraint to find the highest indifference curve. In producer theory, the producer is trying to
minimize certain cost (Isocost) given certain technological constraint (Isoquant). So the Isoquant
is your constraint and the Isocost is the objective function. The producer starts with a set
36

Isoquant (technological constraint) and tries to move along the Isoquant until it finds the lowest
possible Isocost.

37

III.

Cost Curves

The last topic we need to present in this section of costs are the costs curves. I leave this topic to the end
because although the math might be new, the concepts are well covered in your Principles classes. So
you should be very familiar with them.
The best way for the firm to understand how efficient its production is at any time is for the firm to
evaluate its operation costs in a per-unit analysis. In particular, there are two types of costs any
manager needs to pay special attention: 1) the average total costs of the firm, and 2) the marginal costs.
Although they are much related these two measures give the manager a complete different picture about
the level of efficiency of the firm. Lets take Average Costs first.

Average Costs.
In essence, average costs are nothing else than the per-unit costs of the firm at any level of output. In
the language of math, they are calculated in the following way:

5.3

ATC

TC
Q

where TC stands for Total Costs and Q stands for output. But, economists like to complicate things, so
they like to split those ATC into two different costs: average fixed costs (AFC) and average variable costs
(AVC). Actually, what is consider a Fixed Costs and what is consider a Variable Costs will largely
depend on the time period the firm is evaluating. And I have to admit that this time we have to cut
economists some slack because as it turns out it makes a lot of sense to separate the firms costs in that
way. Let me explain.
Fixed Costs
You see, every business will have to incur in some costs that are completely unrelated to the level of
output. For instance, if you own a Burritos stand around campus, every month you will have to pay a
bunch of costs regardless of how many burritos you sell that month. For instance, at the end of the
month, your rent, your water, your lease for the ovens, etc need to be paid. And like I said, you need to
pay them even if you dont sell any burritos. Furthermore, most of those costs are tied up in contracts that
usually last longer than a month. For instance, in order to use the locale for your burrito stand, you might
have had to enter in a one-year rent contract. This means that over the period of that year, you will have
to pay that rent regardless of how well (or bad) you do at selling burritos. Therefore, during that year, the
cost of paying the rent is FIXED. The same applies to those other costs. So, to summarize, any cost that
is not related to the quantity of your output is consider fixed, and hence we are going to call them Fixed
Costs.

Variable Costs
At the same time, some of your costs are definitely going to change depending on your output (i.e. how
many burritos you sell). For instance, how much you spend paying your employees obviously depends
on how many employees you have. At the same time, the more employees you have the larger your

38

output. So, labor costs usually change depending on your output. Can you think of any other of these
types of costs?
So, since these costs change with output, we are going to call them: Variable Costs.

Average Costs
So then Total Costs will be divided into Fixed Costs and Variable Costs. Therefore, Average Total Costs
will be divided between Average Fixed Costs and Average Variable Costs. And all of them are calculated
in the same per-unit basis using the following formulas:
5.4
5.5
5.6

AFC

FC
Q
VC
AVC
Q

ATC AFC AVC

TC
Q

Marginal Costs.
Not only does a manager or owner need to know the per-unit cost of operating his/her business, but more
importantly he/she need to know how these costs change every time your output change. In fact, as we
will demonstrate in class, this measure of costs is actually the most important of all. We define the
Marginal Costs as: the change in your Total Costs every time you increase your output by one (or by a
very small amount). As Im sure you guessed, since we are talking about a marginal measure, we are
probably going to calculate it with a derivate. And you will have a chance to do this in a second. But
first, here is the formal definition of marginal costs, MC:
5.7

MC

VTC
VQ

which is equivalent to the word definition above.

Calculating Costs Using the Cobb-Douglas Function

O.k. so lets apply these equations for the Cobb-Douglas equation you have come to love so much. Here it
is again:

Q ALcK d
Can we find out all the measures described above for a firm with this production-function? Remember,
since we are assuming some costs will in fact be fixed, the easiest would be to assume capital is in fact

39

this Fixed input and any costs related to capital will in fact be Fixed Costs. Therefore, using K0 for the
fixed level of capital, the production function above with a fixed input is:

Q ALcK0d
Again, where K0 is some fixed level of capital. O.k. now, here are the derivations of each of these costs
for this equation. No wait!!! Before you look at the derivations, why dont you try to deriving those
costs yourself and then compare what you get with my derivations? This could an invaluable exercise for
you to prepare for the exam. In order to help you out, Im not going to develop the derivation until the
next page. Remember, these are the costs you need to derive using the equation above:

AFC

FC
Q
VC
AVC
Q
TC
ATC
Q
VTC
MC
VQ

Q ALcK0d

How did it go? That bad, huh? Well, here you go:

The first thing we know is the Total Cost equation:

TC wL rK0
But, since capital is fixed at K0, theres only one value of L for different values of Q. So the first thing we
need to do is solve the production function for L in terms of Q.

Q ALcK 0d
Q
Lc
AK 0d
L

Qc
1

A K0
c

d
c

And now that we found L, we can plug that back into the Total Cost equation:

TC wL rK 0
TC w

Qc
1

A c K0
40

d
c

rK 0

And now we are ready to find all the costs measures.

TC wL rK 0
TC w

Qc
d
c

rK 0

A K0
FC rK 0 (those cost that don't change with Q)
FC rK 0
AFC

Q
Q
c

VC w

Qc
1

A c K0
AVC

d
c

wQ c
1

A c K0 c

(the costs that change with Q)

wQ c
1

A c K0 c
1

rK wQ c
ATC AFC AVC 0 1 d
Q
A c K0 c

TC
1 wQ c
1
VTC
MC

AVC

d
1
c c c c
Q
VQ
1

A K0

41

CHAPTER III:
MATH REVIEW

43

I.

Calculus Review

Suppose you have the following utility function:

U (x,y) = xy
We know that the marginal utility of x is given by:
(1.1)

MU x

U change in U

x
change in x

So, if a 2 unit increase in x results in a 1 unit increase in U, the MUx is about .

Now, this value will be constant only if the relationship between X and Y is a straight line, and
we know that for well behave indifference curves thats not the case. Therefore, in order to
calculate the slope of the utility function, and hence the marginal utilities, at different points of
the indifference curves we need to resort to the derivative of that curve. What follows is a very
brief summary of the concept of the derivative.
The Derivative
The derivative of a function Y = f (X) is
(1.2)

Y
d (Y )
lim
x 0 X
dX

Therefore, the derivative represents how much y changes as you change x by a small margin.
More formally, the derivative of Y with respect to X is defined as the limit of Y/X as X
approaches zero.
To understand what is meant by a limit, consider the function (X 2). What is the limit of this
function as X approaches 2? Clearly, as X gets closer and closer to 2, (X 2) gets closer and
closer to zero. On the other hand, what is the limit of this function as X approaches 0? Clearly
as X gets closer and closer to zero (X 2) gets closer and closer to -2.
Graphically, the derivate of Y with respect to X equals the slope of the curve showing Y (on the
vertical axis) as a function of X (on the horizontal axis).
Suppose that we wanted to find the value of the derivative of Y with respect to X when X equals
X5 on the graph below. A rough measure would be the value of X/Y when a movement is
made from point A to point C:

Y 7 Y5
X7 X5
45

M
C
Y7

Y6
A
Y5

X5

X6

X7

Or the slope of the AC line. A better measure would be the value of Y/X when a movement
is made between A and B (shorter distance). What we want is the value of Y/X when X is at
small as possible. Clearly in the limit, as X approaches zero, the ratio Y/X is equal to the
slope of the line M, which is drawn tangent to the curve at point A.
How to find a derivative
Derivative of constants: If Y = a (where a is a constant),
(1.3)

dY
0
dX

Example: Suppose Y = 6. Since the value of Y does not change as X varies, dY/dX must be
equal to zero. To see how this can be shown graphically, recall from the previous section the
dY/dX equals the slope of the curve showing Y as a function of X. As evident from the equation
above figure 2, this slope equals zero; this means that dY/dX must equal zero.
Derivative of Power Functions
A power function can be expressed as

Y aX b
where a and b are constants. If the relationship between X and Y is of this kind, the derivative of
Y with respect to X equals b times a multiplied by X raised to the (b -1) power:
46

dY
baX b 1
dX

(1.4)
Example Suppose that
Y = 3X
Applying equation 1.4 we find that

dY
1 3 X 0 3
dX
Since a = 3 and b =1. If you do a graph of this result it would make perfect sense, since the
slope of its line will be 3, regardless of the value of X.
Example. Suppose that
Y 2X 2

Applying equation 1.4 we find that

dY
2 2 X 1 4X
dX
Since a = 2 and b = 2.
Derivatives of Sums and Differences.
Suppose that U and W are two variables, each of which depends on X. That is,

U g (X )

and W h (X )

The functional relationship between U and X is denoted by g, and that between W and X is
denoted by h. Suppose further that
Y U W

Inn other words, Y is the sum of U and W. If so, the derivative of Y with respect to X is equal to
the sum of the derivatives of the individual terms:

(1.5)

dY dU dW

dX dX dX
47

Example. Consider the case in which U = g(X) = 3X3 and W = h(X) = 4X2. If Y = U + W =
3X3 + 4X2,

dY
9X 2 8X
dX
To see why, recall from equation 1.5 that

dY dU dW

dX dX dX
Applying equation 1.4

dU
9X 2 and
dX

dW
8X
dX

The same rules apply for the derivatives of differences.

Derivatives of Products.

The derivative of the product of two terms is equal to the sum of the first term multiplied by the
derivative of the second, plus the second term time the derivative of the first. Consequently, if Y
= UW,
(1.6)

dY
dW
dU
U
W
dX
dX
dX

Example. If Y = 6X(3 X2), we can let U = 6X and W = 3 X2; then

dY
dW
dU
6X
(3 X 2 )
dX
dX
dX
2
6X (2X ) 9(3 X )(6)
12X 2 18 6X 2
18 18X 2

The first term, 6X is multiplied by the derivative of the second term, -2X, and the result is added
to the second term, 3 X2, times the derivative of the first, 6.
Derivative of Quotients
48

If Y = U/W, the derivative of Y with respect to X equals

(1.7)

dY

dX

dU
dW
U
dX
dX
W2

In other words, the derivative of the quotient of two terms equals the denominator times the
derivative of the numerator minus the numerator times the derivative of the denominator all
divided by the square of the denominator.
Example. (On your own). Calculate the derivative of the following expression

5X 3
Y
3 4X

Partial Differentiation
In most of our cases, we are going to deal with functions of not one, but two variables.
Therefore, we will have to resort to the partial derivative.
Consider the following function
(1.8)

U f (X ,Y )

To find the value of each o the independent variables (X and Y) that maximizes the dependent
variable, we need to know the marginal effect of each independent variable on the dependent
variable, holding constant the effect of all other independent variables. In our utility framework
we call this the marginal utilities. For example, we need to know the marginal effect of Y on U
when X is held constant. To get this information, we obtain the partial derivative of U with
respect to X and the partial derivative of U with respect to Y.
Y
To obtain the partial derivative of U with respect to X, denoted X , one applies the rules for
finding derivatives described above to equation 1.8, but treats Y as a constant. Similarly, to
U
obtain the partial derivative of U with respect to Y, denoted Y , one applies these rules to
equation 1.8, but treats X as a constant.
Example. Consider the following equation

U 20 100X 80Y 10X 2 10Y 2 5XY

49

To find the particle derivative of U with respect to X, we treat Y as constant, and find that

U
100 20 X 5Y
X
To find the particle derivative of U with respect to Y we treat X as a constant, and find that

U
80 20Y 5X
Y

Using derivatives to solve maximization and minimization problems

Having determined how to find the derivative of Y with respect to X, we now take up the way to
determine the value of X that maximizes or minimizes Y. The central point to recognize is that
a maximum or minimum point can occur only if the slope of the curve showing Y on the vertical
axis and X on the horizontal axis equals zero.
Look at Figure 2. Since the derivative of Y with respect to X equals the slope of this curve, it
follows that Y can be a maximum or minimum only if this derivative equals zero. To see that Y
really is maximized when this derivative equals zero, note that the relationship between Y and X
in Figure 2 is
(1.9)

Y = -50 + 100X 5X2

which means that

(1.10)

dY
100 10X
dX

Therefore, if this derivative equals zero,

100 10X = 0
X = 10
This is the value of X where Y is maximized. So, to find the value of X that maximizes or
minimizes Y, we must find the value of X where this derivative equals zero.
Now, on the basis of the derivative alone we can not distinguish between a point in the curve
where Y is maximized or minimized. To find this, we must find the second derivative of Y with
respect to X (d2/dX2), which is the derivative of dY/dX. The reason the second derivative is so
important is that it is always negative at a point of maximization and always positive at a point of
minimization.
50

Figure 2

Constrained optimization

Example. Suppose that the Rumba Company produces two products and that its total cost equals
(1.11)

TC 4Q12 5Q 22 Q1Q 2

where Q1 equals its output per hour of the first product and Q2 equals its output per hour of the
second product. Because of commitments to customers the number produced of both products
combined cannot be less than 30 per hour. Rumbas president wants to know what output levels
of the two products minimize the firms costs, given that the output of the first product plus the
output of the second product equals 30 per hour.
This constrained optimization problem can be expressed as follows:
Minimize

TC 4Q12 5Q 22 Q1Q 2
51

Subject to

Q1 Q 2 30

Solving the constraint for Q1, we have

Q1 = 30 Q2
Substituting (30 Q2) for Q1 in equation 1.11, it follows that

TC 4(30 Q 2 ) 2 5Q 22 (30 Q 2 )Q 2

TC 4(900 60Q 2 Q 22 ) 5Q 22 30Q 2 Q 22

TC 3600 270Q 2 10Q 22

Now we can used the unconstrained optimization methods described in the previous section to
find the value of Q2 that minimizes TC. As indicated above, we must obtain the derivative of TC
with respect to Q2 and set it equal to zero:
dTC
270 20Q 2 0
dQ 2

20Q 2 270

Q 2 13.5

To find the value of Q1 that minimizes total cost, recall that the constraint requires that
Q1 + Q2 = 30
which means that
Q1 = 30 Q2
Since the know that the optimal value of Q2 is 13.5, it follows that the optimal value of Q1 must
be
Q1 = 30 -13.5 = 16.5

52

PART II:
CLASSROOM
PROBLEMS

53

LAB 1: What are we going to do here?

Intermediate Micro basically takes most of the same concepts you already covered in your
Principles classes and develops them even more. Particularly, the approach moves from the
strictly graphical world (which you use in your principles course) to the world of Algebra and
Calculus. Nevertheless, it is important for you to understand the crazy way economists view the
world in order to fully appreciate what we are going to be doing here. In order to help me get a
sense of where you are, I have prepared the following short quiz on basic economic principles.
In order to answer these questions, you must use concepts you should have covered in your
principles classes (rationality, incentives, positive versus normative statements, value, etc).
Discuss the question with the person next to you and write a short sentence or two for each one.

1. If water is needed to survive, and diamonds are simply for jewelry, then why are
diamonds so expensive, and water so inexpensive?

2. Discuss the positive and normative aspects of the economics of the Food Stamp program.

3. What assumptions might you make to simplify the task of building an economic model
of the grape market?

4. Agree or disagree: We should strive to be a zero pollution society.

5. Can you think of a real-world example where rational behavior does not seem to be
present?
55

6. Consider the terrorist attacks of September 11, 2001. Can a suicide terrorist be considered
rational by rational choice standards? If so, how? If not, what does that mean for antiterrorist policies?

7. Do you think school vouchers are the best way to fix the problems in our public
education system? Why or Why not??

8. Determine the first derivative of each of the following functions:

a. Y = 3 + 10X + 5X2

b. Y = 2X(4 + X3)

9. Suppose that the Rumba Company produces two products and that its total cost equals
(1.11)

TC 4Q12 5Q 22 Q1Q 2

where Q1 equals its output per hour of the first product and Q2 equals its output per hour
of the second product. Because of commitments to customers the number produced of
both products combined cannot be less than 30 per hour. What output levels of the two
products minimize the firms costs, given that the output of the first product plus
the output of the second product equals 30 per hour?

56

Lab 2: The Tools of Microeconomics

I. Solving Simultaneous Equations: Can Iraq Affect Oil Prices?3

The ongoing military engagement in Iraq have caused much concern about how this might affect
oil prices. Specifically, can Iraq, by withholding some of its oil production, affect world prices
and potentially cause harm to the US economy? A simple supply-demand model can be used to
suggest the potential size of such a problem4
1. Suppose demand and supply for crude oil in the world market is given by the following
two equations:
QD = 80 0.4P
QS = 55 + 0.6 P
where QD is the quantity of crude oil demanded in millions of barrels per day and P is the
price in dollars per barrel.
a. Use both a graph and algebra to find the equilibrium values for quantity and price
in this market.

b. Iraq produces about 2.5 million of barrels per day. Given the equations above,
what would be the impact of a decision by Iraq to sell no oil? Again, use a graph
and algebra to find out the new equilibrium values in the presence of the policy.

c. Why is the reduction in world oil supply less than the reduction in supply from
Iraq?
II. Rules of exponents

3
4

Reproduced from Nicholson 2004.

These equations are chosen to be roughly consistent with empirical evidence from the crude oil market.

57

2. Expand and simplify the following

a. 38*3-2*3-3

b.
c.
d.

(-3xy2)3
p 24 P 3
p4p
p ( pq )
p 2 q 2

III. Differentiation (The Derivative)

3. Determine the first derivative of each of the following functions:
a. Y = 3 + 10X + 5X2

b. Y = 2X(4 + X3)

4. The Batholomew Companys profit is related in the following way to its output:
= -40 + 20Q 3Q2

where is total profit and Q is output.

a. What output maximizes the firms profit?

5. You manage a small firm that produces wool rugs and cotton rugs. Your total cost per
day (in dollars) equals

C 7X 12 9X 22 1.5X 1X 2
where X1 equals the number of cotton rugs produces per day and X2 equals the number of
wool rugs produced per day. Because of commitments to retail stores that sell your rugs
to consumers, you must produce 10 rugs per day, but any mix of wool and cotton is
acceptable.
58

a. If you want to minimize your costs (without violating your commitment to the
retail stores), how many cotton rugs and wool rugs should you produce per day?

59

Lab 3: Consumer Choice (Part I)

I. Constructing indifference curves

1. Construct an indifference curve for each of the following combinations of goods (Use a
different diagram for each combination of goods; you need at least 4 diagrams).
a. Nickels and Dimes

b. Right-shoes and left-shoes

c. CDs from Bob Dylan and CDs from Brittney Spears (and you hate Brittney Spears)

d. Tickets to last seasons Illini Football and Tickets for this seasons Illini Basketball
Tickets

61

II. The Budget Limitation

2. Now lets do our budget. Obviously, we really cant buy everything we want since we have
limited income. Suppose that your parents give you a weekly allowance every week of $200
and that is all you have to spend each week. Furthermore, lets continue to assume you are
making choices between beers and everything else. Can you use the same diagram we have
been using to represent your budget limitations if a beer costs you $2? (Hint: this is very
similar to the production possibilities frontier, PPF, you covered in your principles class).

III. An Application: Cash or Gifts?

3. O.k., now Im going to give you a chance to repeat the same process but this using your own
indifference curves. Remember, your original weekly allowance is $200 and Beers cost $2
each
i. Graph the initial utility-maximizing situation but this time you are free
to draw indifference curves in accordance to your own tastes.

ii.

Now suppose your parents have decided to increase your allowance by

$50!! Nevertheless, they have stipulated you may only use the extra $50
to buy beer (lucky you!!). Show the new budget constraint with the
addition of the extra conditional $50

62

iii.

Using the same type of indifference curves you used in (a), identify your
new utility-maximizing situation with new budget constraint. Are you
better off with the additional $50?

iv.

Now the key question: would it be better if your parents gave you the
$50 with no strings attached? Why or Why not? Please use the diagram
to answer your question (hint: you are going to have to adjust your BC
once again; but continue to use the same shape of indifference curves).

63

LAB 4: Consumer Choice (Part II)

I. More Practice Problems

1. Linda loves buying shoes and going out to dance. Her utility function for pairs of shoes, S,
and the number of times she goes dancing per month, T, is U (S,T) = 2ST. It costs Linda $50
to buy a new pair of shoes or to spend the evening out dancing. Assume that she has $500 to
spend on clothing and dancing.
a. What is Lindas marginal rate of substitution, MRS?

b. Solve mathematically for her optimal bundle. Also, use the numbers you get from the
mathematical solution and represent them in a diagram using indifference curves and
a budget line.

2. Suppose that a family spends $5,040 on either food (F) or clothing (C). Moreover, suppose
that this familys utility function is given by U(F, C) = 30F2C and the price of food is $10 per
unit while the price of clothing is $1 per unit.
a. If the family is in equilibrium, how much of its income of $5,040 will be spent on
food?

65

b. The government decides to lift this familys level of utility or satisfaction by

subsidizing the familys consumption (i.e., paying part of the price) of food. By
allowing this family to purchase food at half the market price (with the other half of
the market price paid by the government), how many more units of food will be
purchased?

c. What would be the cost of this program to the government per family that receives
the subsidy?

d. The government could also achieve its objective of lifting this familys level of
satisfaction to the same level as that provided by the food subsidy program by giving
instead a cash subsidy. How large must the cash subsidy be? (Hint: The answer to this
part will be less than your answer to part c. Why?)

3. Suppose that your utility function for cola is estimated to be TU = 10Q 2.5Q2. You have $5
and the price of each cola is $3.
a. How many colas should you drink to maximize your utility? What if you were offered
a free cola by a friend sitting next to you?

4.

Public School vs. School Vouchers.

a. Using a graph, show that it is possible for a student who goes to a public school to
consume more units of schooling if there were no public schools available at all. If
education is a normal good, would this student consume more, less or the same
amount of education with a voucher system?

66

b. Kevin and Jill have two options for educating their children. The children can go to a
public school for no charge, or they can use a government voucher for private school
equal to the cost per pupil of the public school. Show their options using a graph. In
your graph, which option do Kevin and Jill prefer? Would all families prefer the
same option?

67

LAB 5: Income and Substitution Effects

I.

Effect of a Price Change

1. You enter the grocery store ready to spend your money buying only two types of foods: Frozen
Pizza (P) and Fresh Spinach (S). Both items cost the same thing: $1.00 per unit, and you have a
total of $100 to spend on them. The way you derive happiness from these two goods is given by:
U (P,S) = PS.
a. If you want to maximize your happiness, how many Frozen Pizzas (P) and how many
bags of Fresh Spinach (S) you will buy?

b. This was your plan. But, as soon as you go to the refrigerator to get your Pizzas you
realize the price of Frozen Pizza has been reduced! Now Pizza is being sold for $0.80 per
unit. Obviously this changes things. What are the new values of Pizza and Spinach you
will consume (remember, you are trying to maximize your happiness)?

c. You are consuming more Pizza, right? Good for you. But why? List the two reasons
why you have decided to buy more Pizza (yes, there are two reasons; not one).

d. Is there any way to separate these two effects? Well, think about this. Suppose you
really dont want any more happiness than what you achieved in part (a). In other words,
you are not going to spend all your $100! All youre going to do is spend enough to
make you as happy as you would have been when you thought the price of Pizza was
$1.00. How much money you will have to spend in order to do this.

69

II. The Paradox of Crime Prevention

Policy makers are sometime bewildered by the fact that the crime rate (for certain types of crimes) seem
to increase with more enforcement. This has been called by some: The paradox of crime prevention .
An economist looks at crime as a rational act of an economic agent who faces the problem of allocating
time between legal and illegal activities. For example, assume that we are studying a person who must
decide whether to be a criminal or not. In either case, this agent will work 8 hours a day and must
allocate these eight hours between legal and illegal activities. If he/she works at a job that involves legal
activities, he or she will earn an hourly wage of WH. We will call this amount the honest wage. If he/she
works in illegal activities (i.e. drug dealer) his/her wage will be WD. We will call this amount the
dishonest wage. Our agent is moral person and therefore has preferences about how he/she earns his/her
income. However, money is still money to him/her once he/she earns it, so dishonest dollars are just as
good as honest ones. Finally, if he/she engages in illegal activities, there is a chance that he/she will be
caught and sent to jail. Obviously, this risk makes illegal activities less attractive to him/her. Let us
represent the cost of our agents risk of being put in jail by an amount , which is subtracted from the
dishonest wage.
Lets use the diagram below in order to understand this agents decision. On the x-axis we have the
amount of money this agent gets from legal activities, while on the y-axis we have the amount he/she gets
from illegal activities. For simplicity, lets assume both the WH = WD = 1. So for instance, if this person
spends all his/her time in legal activities, he/she will make 8 dollars
( WH x 8 hours ).
1. Draw the initial budget constraint for this individual if we assume that = 0.
2. Use one of the indifference curves given and identify the utility-maximizing point for this person
(label that point a). How many hours this person spends in illegal activities?
3. Now suppose society increasing the cost of committing crimes (i.e. increase enforcement) so that
now = 0.5. Draw the new budget constraint and the new utility-maximizing point. Does the
number of hours this person spends in illegal activities increased or decreased after the effort of
society to reduce crime?
4. Identify both the income and the substitution effect in the diagram. Can you use these effects to
explain the paradox of crime prevention?

9
8
7
6
5
4
3
2
1
1

70

10 11 12 13 14 15

III. More Problems

a. Suppose the government wants to increase the ability of families to pay for college
education. Would a $500 income tax rebate differ from a $500 tax credit for tuition
reimbursement? Explain.
b. Suppose Joe earns $1,000 in year 1 and $0 in year 2. Any amount he saves will earn
interest at a rate of 10%. Draw Joes budget line. (Hint: He can either consume all
$1000 this year or consume nothing this year and have $1,100 next year.) Assuming
convex indifference curves, show that an increase in the rate of interest can cause
Joes savings to either increase or decrease. Explain in terms of income and
substitution effect.

71

LAB 6: Elasticity
I. Estimating Elasticities: the Demand for Abortions in the US.
1. Using econometric techniques, Marshall Medoff (1997) estimated the following demand
equation for abortion services in the United States using data between 1982 and 19925:
A = -60.51 0.80 PA+ 0.01 I + 5.28 SNGL + 2.04 LFP 51.46 M + 1.33 CATH + 42.24 WEST
a. How would you interpret the coefficient of Pa? What would be the reduction in the number
of abortions if the price increase by $10?

b. How would you interpret the coefficient of I?

c. Medoff also found out that average price of an abortion in the US is around $259, the average
income of women 15 or older was 8,247 , while the average abortion rate was 239.69. Given
these averages, calculate and interpret the price and income elasticities for abortions in the
US?

d. Is the demand for abortion elastic or inelastic? What are the implications of this for any state
restrictions on abortions?

e. Is abortion a normal or inferior good? What are the implication of this when one consider
the accessibility of abortions between low and high-income women?

II. More Problems

Marshal Medoff, A Pooled Time-Series Analysis of Abortion Demand. Population Research and Policy Review,
16:597-605, 1997
5

73

2. Suppose you are a trustee at the University. At a meeting of the board of trustees, one
university official argues that the demand for places in the student body at the university is
completely inelastic. As evidence he cites the fact that, although the university ahs doubled
its tuition in the last decade, there has been no appreciable decrease in the number of students
enrolled. Do you agree? Comment on this argument.

3. Having gained exclusive rights to his library of tapes, a former president planned to sell
them, with the objective of maximizing his proceeds from the sale. The demand curve for
these tapes is given by Q = 700 35P. What price should he have set, given that the same
price must be charged for all tapes?

4. Suppose the Los Angeles Dodgers hope to draw a record-breaking number of fans to their
seventy home games next season. Dodger Stadium seats 56,000 per game. Suppose the
demand for stadium seats (per playing date) by fans is given by
P = 21 2Q1/2
where P is the price per ticket and Q represents the number of seats (expressed in thousands).
a. Assuming that the owner of the LA club is first and foremost interested in
maximizing his revenue, does this mean that at a price of $6 per ticket he will
overprice tickets to Dodger games?

b. How many empty seats (per playing date) make sense from the owners point of
view?

c. When revenue is maximized, will the Dodgers break the single-season (club and
major league) attendance record of 3,347,845 fans?

74

5. Some would argue that food purchases should be relatively price inelastic since food is
essential for life. Yet if that were the case, food stores would not engage in such heavy price
promotions. How can you reconcile the fact that the more essential the item, the more price
inelastic it should be with the behavior of most food stores which suggests consumers are
very price elastic?

6. Suppose your demand function for good x in a particular market has been estimated as
Qx = 15,000 300Px + 150Py + 0.01POP + 5Y + 0.25AD
where y = another good, POP = population in this market, and AD = advertising dollars spent
to market
X. If Px = $40, Py = $50, Y = $15,000, POP = $300,000, and AD = $25,000, find all the
relevant
elasticities and interpret your answer.

7. In the face of declining total revenues, many states turn to utilizing sin taxes; that is, taxes
levied on items such as beer, wine, whiskey, cigarettes, and gambling. The implicit argument
is that since taxes raise prices and higher prices tend to discourage the consumption of most
goods, these taxes will raise revenues and reduce consumption. If these taxes are to become
revenue sources, what is the expectation regarding price elasticity? How does that compare
with the logic of taxing such activities?

75

8. The 1990 oil price shock sent gasoline prices soaring. Suppose that in the State of Surprises
gasoline consumption amounts to 2 billion gallons per year and that prices before the shock
were $1 per gallon. If the shortrun price elasticity is estimated to be 0.5, and the price
increase is estimated to be 30%, what will happen to total spending on gasoline in this state?
Suppose that this state imposes a 6-cent-per-gallon tax for highway construction. What will
happen to tax collections? If expenditures for gasoline change, what other change can you
expect in the short run?

9. The incidence of heart disease among women aged 30 to 50 who are smokers has been found
to be several times that of women in the same age bracket who are nonsmokers. As a
consequence, the womens caucus proposes that still higher taxes be imposed on every pack
of cigarettes sold. One congressional representative argues, First, the tax will cut back
dramatically the rate of use of cigarettes. Moreover, it will raise revenue for the Treasury. If
the demand for cigarettes has an arc elasticity less than 1, will the tax produce the desired
twofold effect? Explain.

10. Is the demand for Coca-Cola more or less elastic than the demand for all soft drinks? If we
know that the price elasticity of demand for Coca-Cola is 5, how much would purchases fall
if the price were increased by 10%? Suppose that the price of other soft drinks were also
increased by 10%. Would purchases of Coca- Cola fall by more or less in this case?

76

LAB 7: Taxes: An Initial Analysis

I. The Lump-Sump Principle: Taxing cigarettes.
1. Suppose your preferences for cigarettes follow the following utility function:
U = (C,O) = (OC)1/2
where O is the quantity of other goods consumed, C is the quantity of cigarettes consumed and U
is the level of utility (happiness). Furthermore, you have an allowance of $50 and the prices for
other goods and cigarettes are: PC = $2.00 (per pack) and PO = $1.00.
a. How many cigarettes and other goods you will consume to maximize your utility?
What would be your utility at that point?

b. Now suppose the government imposes a tax of $2 on every pack of cigarettes

consumers buy in order to reduce the consumption of cigarettes. What would be the
effect of this tax to your cigarette consumption (calculate the quantity of C with the
tax)? What would be the new level of utility?

c. Now suppose the government to about it in a different way. Suppose they want to
reduce consumption with an income tax (a tax on income) instead of an excise tax.
The government wants this tax to be equivalent to the revenue they were collecting
with the price tax. What would be the new utility-maximizing level of other goods
and cigarettes you would consume with the income tax (and the old price of cigarettes
of course)? What is the new level of utility?

d. What did you learn? Can you say something about the welfare effects of price tax
versus the welfare effects of an equivalent income tax? Please explain your answer.

77

II. Other Problems and Applications

2. In the face of declining total revenues, many states turn to utilizing sin taxes; that is, taxes
levied on items such as beer, wine, whiskey, cigarettes, and gambling. The implicit argument
is that since taxes raise prices and higher prices tend to discourage the consumption of most
goods, these taxes will raise revenues and reduce consumption. If these taxes are to become
revenue sources, what is the expectation regarding price elasticity? How does that compare
with the logic of taxing such activities?

3. Jane currently pays an excise tax of $1.00 per pack of cigarettes and consumes four packs a
day. The government replaces the tax with a fixed daily tax of $4.00 per day. How will this
change affect Janes consumption patterns? Which tax would Jane prefer? Under which
plan will she smoke more? Explain

78

LAB 8: The firm technological problem

I. Some Problems
1. Write the equation for the marginal product of capital for each of the following production
functions.
a. Q = K + L

b. Q = 4K0.5L

c. Q = 5L0.5K L

2. Using the production function from part (c) above, assume that capital is fixed at two units.
At what point does MPL reach zero?

3. As you know my dream business (well, one of them really; some other ones are a ski lodge, a
surfers inn, etc) is a coffee house around campus town. Suppose that the production
function for my coffee house is the following:
Q = AL1/2K1/2
where A = 1 and Q = output (coffee cups per day), L = units of labor per day
(employees), and K = units of capital per day (i.e. espresso machines).

a. Calculate the levels of output, as given by the following table, for all levels of output
when K=1 and for all levels of output when L=1.
79

Capital, K
0
1
2
3

Labor, L
3

4
5
6
MPL1
MPL2
b. When K is fixed at 1, what are the units of output this firm can achieve? Graph this
on a diagram (preferably using graphing paper)

c. What happens to Q as we increase L by each additional unit? Calculate the Marginal

Product of Labor (MPL) when K = 1 (enter the results on row of the table titled
MPL1). Graph this curve just below the graph you constructed for part (b).

d. What will happen to the two graphs if K increased from 1 to 2? (If you cant see it
intuitively, make the necessary calculations and enter it on the row titled MPL2).

e. Now lets K vary and see how the production set would look like. Solve the
production function for K when Q = 20, 25, 30, and 35 respectively.

f. Now use calculus to derive the MPL and the MPK.

80

g. Does this production function have increasing, constant, or decreasing returns to

scale?

2. Suppose you have a short-run production function estimated to be

Output = 100L + 50L2 3L3
where L = number of workers.
a. At what number of workers will you first experience diminishing returns?

b. At what level of employment will total output be maximized with this plant size?

4. Suppose inputs are only substitutable at two units of labor for every one unit of capital. What
would be the equation for the production function? What is the average and marginal product
of labor in this case?

5. In some firms, managers are given sales volume-based bonuses. Explain why this might not
be an efficient compensation strategy.

6. The average number of yards gained by a college football team on a passing play is 8 + 12r,
where r is the fraction of their total plays that are running plays. Their average gain per
running play is 10 8r. What is their optimal fraction of running plays? At this value of r,
what is the average gain per pass? The average gain run?

81

7. If the average number of yards gained when a team passes is 8 and the average number of
yards gained on running plays is 3.4, why don't teams always pass?

82

LAB 9: Minimizing Costs for the Firm

II. Some Problems
1. Suppose a firms average cost curve is described by the equation AC = 2q2 16q + 90. At
what output level does the marginal cost curve cross the average cost curve?

2. Suppose the cost of producing milkshakes is C = .333Q3 3Q2 + 15Q + 50. What is the
equation for marginal cost? At what point is marginal cost minimized?

3. If input prices are w = 4, and r = 1, and q = 4K0.5L0.5,

a. What is the least cost input combination required to produce 40 units of output?

b. Suppose instead that capital was fixed at 16 units. What would be the implications for
labor usage and total cost?
83

c. Suppose the government, in an effort to increase employment, offers firms in this

industry a $1 per unit subsidy. How would this affect input usage (assume q = 60).
How is this likely to affect employment in the capital goods (K) industry?

4. If input prices are w = 3, and r = 2, and q = 10KL, what is the least cost input combination
required to produce 60 units of output? How would input usage change if output is increased
to 240 units? Sketch the solutions on a graph.

84

LAB 10: Cost Curves

III. Problems
1. Give the formulas for and plot AFC, MC, AVC, and AC if the cost function is
a. C = 10 + 10q

b. C = 10 + q2

c. C = 10 + 10q 4q2 + q3

2. Explain the relationship between the shape of the marginal cost curve and the marginal
product of labor curve.

3. Consider the following Cobb-Douglas production function: Q = AL.5K.5

a. Derive the all the following short-run cost measures for this equation: FC, AFC, VC,
AVC, MC, and ATC (hint: remember that in the short-run capital is fixed at K0).

4. Suppose a company that produces _______________ faces the following production

function: Q = 4KL, where Q is the quantity of __________made, K is the amount of capital
85

and L is the amount of labor employed. The price of capital (r ) is $2 and the price of labor
(w) is $8.
a. If the firm wanted to produce Q = 100, how much K and L would need to use in order
to minimize the costs of production.

b. If this firm operates in a competitive industry, what are the marginal costs, MC, when
the firm produces Q = 100?

5. A firm manufactures skis according to the production function Q = K1/2 L1/2, where Q is the
number of skis made, K is the amount of capital, and L is the amount of labor employed. The
firm is currently producing Q = 20 using K = 20 and L = 20. The factor price of capital (r) is
$1 and the factor price of labor (w) is $4. Its current expenditures are thus $100. The firm
suspects that it is not minimizing the cost of producing Q = 20 and has hired you, a student
taking a course with the most famous economist in campus, to help it understand the nature
of its inefficiency.
a. Does your analysis suggest that the firm should use more K and less L or the reverse
if it wants to minimize costs?

b. Your next task is to show the firm that, if it wants to continue to spend $100, it could
produce more output than Q = 20 by choosing K and L efficiently. What is the
maximum amount of Q that the firm could produce with an expenditure of $100?

86

c. If this firm operates in a competitive industry, what would the market price for output
have to be if the firm is maximizing profit when it efficiently produces Q = 20?

6. Mr. Hunt and Ms. Peck agree to type a manuscript for Professor Paul. The production
function for the manuscript is given to be Q = H1/4P3/4 , where Q = the number of typewritten
pages, H = the number of hours Mr. Hunt spends typing, and P = the number of hours Ms.
Peck spends typing. Hunt and Peck receive $4 and $12 per hour, respectively.
a.

If Professor Paul decides to minimize the cost of production, how much of Ms.
Peck s labor will be used to produce a 300-page manuscript?

b.

What will be the marginal cost of the 227th page? Will this be greater than, equal
to, or less than the average cost of the 227th page?

7. Suppose that a cost-minimizing firms production function is given to be: Q = 12M1/3W1/4

,where M stands for the labor of men and W stands for the labor of women (both of which
are expressed in worker hours).
a. Suppose men receive $5.60 per hour and women receive $4.00 per hour. Moreover,
suppose the firm uses 81 worker hours of W and 64 worker-hours of M to produce
144 units of output. Is this firm minimizing the cost of producing this given level of
output? If so, explain why. If not, should the firm use more or less M?

87

b.

Determine the cost-minimizing ratio of inputs when men receive 40% more per hour
than women.

c.

Given your answer to part b, what percentage of women does this firm hire? Now,
consider a quota that requires all firms to hire at least 50% women. Will the quota
change the firms costs? Explain.

8. In recent years, the use of computers in production processes of many types has increased
tremendously. New software applications have been created to solve business and
engineering problems; at the same time, production of computer equipment has become
much more efficient, allowing prices to fall drastically.
a. Draw a series of isoquant maps in the diagrams below showing how the development
of these
computer resources
changed
the production options
available to many firms.

b.

Draw a series of isocost curves in new diagrams such as the ones above showing
how falling prices of computers changed firms options.
88

c.

How have firms optimal input decisions changed over this time period? Put your
isoquants and isocosts together and show how optimal employment of labor and
computers has changed. What impact has this had on workers? On firms? Carefully
explain. Again, use new diagrams but stick the same format as in (a).

9. The minimum wage was increased in 1996 amid cries by many economists that it would
cause unemployment. Critics pointed out that the last time the minimum wage went up the
same dire predictions from economists were made, but more people were employed after the
minimum wage increase. The same, they argued, would occur again. Using isoquant-isocost
analysis, analyze this situation and explain how it may be possible for increases in the
minimum wage to have little impact on employment levels.

10. Development economists often argue that the methods of production chosen by companies in
developing countries are inappropriate in the sense that they are too capital intensive.
Using an isoquant/isocost diagram, illustrate why use of very capital-intensive methods of
production might be inapproriate in a developing country where capital is relatively scarce.

89

LAB 11: Maximizing Profit

I. Market Structure
1. Please make a list of at least three business (brand names) in each category:
a. Perfect Competition
i. ________________________
ii. ________________________
iii. ________________________

b. Monopoly
i. ________________________
ii. ________________________
iii. ________________________

c. Oligopoly
i. ________________________
ii. ________________________
iii. ________________________

d. Monopolistic Competition
i. ________________________
ii. ________________________
iii. ________________________

91

II. Problems
2. Suppose the profit function for a perfectly competitive widget producer is given by
Profit = 100Q 5,000 0.2Q2 where Q represents the quantity of widgets produced and
sold each week.
a. What is the total cost function for this producer?

b. If output is 200 units, what are variable costs? What are total costs?

c. What is the profit-maximizing level of output for this producer? Show this using a
diagram.

d. Will the producer make positive or negative profits at this level of output?

3. The total cost curve of each firm in a perfectly competitive industry is given to be TC =
q3 6q2 + 18q
a. What is the short-run supply curve of the firm? Below what price will output q be
zero?

b. Suppose initially there are 30 firms. Describe the long-run adjustments in the
industry assuming any new firms have the same production costs and that market
demand is given to be Q = 180 3p.

4. Suppose a perfectly competitive firm has the short-run cost function C = 125 + q2.
a. Determine the firms output level and profit at prices of $30 and $20.
b. At what price does the firm reach the shut-down point?
92

5. If each competitive firm in an industry has the short-run cost function C = 50 + 5q + q2,
and the market price is $35:
a. What is the profit-maximizing output level for each firm? What is the total
revenue? What are the profits?

b. Suppose that fixed costs were $250 instead of $50. How does this change affect
the firms output decision and profits? Should the firm continue to operate?

93

LAB 12: The Model of Perfect Competition

1. Suppose the market for marijuana is nearly perfectly competitive. Furthermore, suppose
the total cost curve for a typical drug dealer is TC = 50 + 5q2 where q represents the
grams of marijuana sold by a single drug dealer each day. Suppose that there are 100
drug dealers in this industry, sharing a market demand given by P = 3,600 3.5Q, where
P represents price per gram of marijuana and Q represents the total number of grams of
marijuana (in thousands) sold in the entire industry.
a. Find an expression for the market supply curve in this industry.

b. Find the equilibrium price and quantity of marijuana exchanged in this market.
Show this using a diagram.

2. Consider three possible types of long-run industries: constant-cost, decreasing cost, and
increasing costs.
a. Of the three types above, which most likely describes the drug market at the
trafficking level (producers of the drug)? Explain in words and using a diagram.

b. Of the three types above, which most likely describe the drug market at the drug
dealer level? Explain in words and using a diagram.

95

LAB 13: Welfare

3. Suppose the demand and supply curve for a pack of cigarettes are as follows:
PD = 750 10Q
PS = 250 + 10Q
where P is the price in cents per pack and Q is the quantity in millions of packs.
a. What is the equilibrium price and quantity of cigarettes for this example?

b. Now, suppose an excise tax of $1 per pack is assessed on the purchase of each
pack of cigarettes sold. What is the new equilibrium price and quantity?

c. What is the welfare effect (the deadweight loss) as a result of the tax? (separate
the deadweight loss in: 1) loss of consumer surplus and2) loss of producer
surplus)

d. Repeat the analysis on (a) though (c), but now use the following supply curve:
PS = 250 + 5Q. What can you conclude from your results?

97

4. Suppose that by coincidence two markets for separate products had the same demand and
supply functions. In each market, Qd = 50 p, and Qs = p. The government decides to
discourage consumption in both markets. It institutes a $4 per unit tax in one market, and
a quota of 23 units in the other market. Are the welfare effects of these policies equal?
Explain.

5. Suppose the government decides to subsidize exercise by $2 for every mile (Q)
consumers run at a health club that charges by the mile. The current demand for running
is Q = 12 2P. The supply of miles available by the track owners is S = 2P. What is the
initial equilibrium price and quantity? How does the subsidy affect the total number of
miles run? What is the new price, including the subsidy?

6. The NFLs championship game, called The Super Bowl, is played at a neutral site. Home
team fans must put their names into a lottery for a chance to buy tickets to the game.
Winners then purchase tickets at the stated price. Explain why this allocation mechanism
does not maximize total fan welfare.

98

7. Some economists argue that government intervention into perfectly competitive markets
generates inefficiency. What do they mean by this? What benefits of intervention might
help to offset this efficiency loss?

99

LAB 14: Monopoly

1. Suppose you own a firm that produces widgets and is a monopoly. The market demand is
given by the equation P = 90 0.04Q, where P is the price of gadgets and Q is the quantity of
gadgets sold per week. The firms total cost function is given by the equation. TC = 5,000 +
0.05Q2
a. Draw the firms demand, marginal revenue, and marginal cost curves.

b. Find the profit-maximizing level of output for this firm. Will the firm earn positive or
negative profits?

101

c. Suppose that the surgeon general announces that recent research has proven that a
widget a day keeps the doctor away. Hence the demand for widgets increases 25%.
Find the new optimal level of output for the firm. What happens to profitability?

d. The medical community finds that widgets are so important that it wants to make
them more widely available to people. So, the government decides to encourage
competition in the industry. If the industry becomes perfectly competitive, what will
happen to price? to industry output? To the firms profitability?

e. Calculate the change in consumer and producer surpluses that would occur if the
market moved from monopolistic (part b) to perfectly competitive? Who will be in
favor of such a change in market structure? Who will be against it?

2. The See TV Company is a monopolist in two neighboring countries, East Egg and West Egg.
The elasticity of demand for TVs is 4 in East Egg and 10 in West Egg. The price of a TV in
East Egg is $60. If the company can successfully separate these two markets, how much
should it charge for a TV in West Egg?

3. Generally, economists believe that price discrimination results in a socially inefficient

allocation of resources. However, there are situations in which a particular good would not be
102

produced at all unless the firm practiced third-degree price discrimination. Illustrate this
situation.

4. Suppose the market for electricity is characterized by the following hypothetical diagram.

a. Calculate producer and consumer surpluses if electricity is produced by a monopolist.

b. Calculate producer and consumer surpluses if electricity is produced under perfectly

competitive conditions.

c. If you were advising the regulatory commission, what pricing strategy would you
recommend for a monopolist? Why? How would this change producer and consumer
surpluses?

5. An article appearing in The Economist on March 27, 1999, reported that Airbus, the huge
European consortium that manufactures airplanes, would challenge the monopoly position of
Boeing in the market for jumbo jets that it dominates with its 747 line of aircraft. The article
states:

a. How might this development affect Boeings dominant position in the market for
aircraft?

103

b. What defensive strategies might help Boeing to maintain its market share? Discuss
several alternative plans that might help to deter the entry of Airbus into this market.
6. Suppose that the demand equations of women and men for admission to Los Angeles Dodger
baseball games are given by:
Pw = 6 (1/8,000)Qw
and Pm = 10 (1/8,000)Qm
respectively. Moreover, suppose that the total seating capacity of Dodger Stadium is fixed at
56,000. If the ball club elects to practice third-degree price discrimination and would like to
fill the stadium, what prices should men and women be charged for a ticket?

7. Assume that there are 100 customers in the market for Vanity Wagons (VWs), each with the
demand curve q = 10 P/2, where P is the price of VWs, and q is the quantity of VWs
demanded by the consumer per day.
a. What is the market demand curve for VWs?

b. Assume that the VW market is a monopoly and that the average variable cost of
producing VWs is constant at $10. What is the monopolists profit maximizing output
of VWs?

c. What is the loss to society as a result of the VW market being a monopoly? Please
show a diagram with your numerical answer.
104

8. Suppose that a market currently can be described as approximating perfectly competitive

conditions and is in long-run equilibrium. The existing price for a product is $700 and total
market output is 5,000. Now suppose that a new technology is invented in which economies
of scale exist up to a total sales volume of 5,000 units. If the long-run total cost function
associated with this new technology is given by TC = 1,000 Q 100Q2 + 5Q3 (Qs are in
units of 1,000) and if the firm earns an economic profit equal to 20 percent of its cost at
equilibrium, what will the price of the product become if the industry becomes monopolized?
What is the likelihood that the market will become monopolized? How does the price and
output compare with pure competition? Should the government prevent the monopolization
of this market? What alternatives (besides monopolization) exist for society?

9. Assume that the bike rental industry consists of 10 identical competitive firms, each of which
has the following marginal cost schedule: the firms level of marginal cost is equal to twice
its own level of output per year. Assume further that there are 10 identical consumers in the
market for rental bikes, each with the demand schedule, q = 60 P, where q is quantity
demanded per year and P is the price per bike rental.
d. What is the short run equilibrium level of each firms output per year?

e. If all the bike rental producers organized themselves into a profit-maximizing

cooperative that acted like a monopoly, what would be the cooperatives profit
maximizing level of price and output?

f. If fixed costs were $100, what would the profits or losses be for the monopolist at its
equilibrium output?
105

g. Calculate and indicate on the graph the deadweight loss due to the monopolization of
the industry. Briefly state the meaning of deadweight loss.

h. Explain and illustrate what a government regulator might do to eliminate this market
failure.

106

LAB 15: Game Theory

1. In the TV clip you just watched; Why did Malcolms plan failed? Please explain in a few
sentences.

2. What is the main difference between Krelboyne classs academic competition and the
competition we have been studying so far in this course (i.e. perfectly competitive markets
and monopoly)?

3. Suppose you live in a town where only you and one other person own wells that produce
water safe fro drinking. Each Saturday, you and the other well owner decide how many
gallons of water to pump, bring the water to town, and sell it for whatever price the market
107

will bear. To keep things simple, suppose that both you and the other well owner can pump
as much water as you want without costs. That is, the marginal cost of the water equals zero.
The demand schedule for water is given by the following table:
Quantity
(in gallons)
0
10
20
30
40
50
60
70
80
90
100
110
120

Price
$120
110
100
90
80
70
60
50
40
30
20
10
0

Total Revenue
(and total profits)
$0
1,100
2,000
2,700
3,200
3,500
3,600
3,500
3,200
2,700
2,000
1,100
0

Before considering the duopoly case (the case of water being produce by TWO producers)
lets consider the two types of markets we have already studied: perfect competition and
monopoly.
a. Suppose the market for water in the town was perfectly competitive, what would be
the quantity of water produced and the price at which it would be sold?

b. Suppose the market for water in the town was a monopoly, what would be the
quantity of water produced and the price at which it would be sold?

c. Now, what do you think would be the market price and quantity that would prevailed
if only Two producers (you and someone else) owned the water wells? (The best way
to answer this is by working with the person next to you. Each of you can assume the
role of one of the two producers.)
4. In the movie clip we just watched, Nash character proposes that they all go for the brunettes;
is this outcome the Nash equilibrium for the game? Please explain.
108

5. O.k. now you will go from water producer to criminal. Suppose you and your partner are
two criminals who have just been capture by the police. The district attorney has little
evidence in the case and is anxious to extract a confession. She separates both of you (the
only suspects) and privately tells each, If you Confess and your partner doesnt, I can
promise you a reduced (one-year) sentence, and on the basis of your confession, your partner
will get 10 years. If you both Confess, you will each get a three-year sentence. Each suspect
also knows that if neither of them confesses, the lack of evidence will cause them to be tried
for a lesser crime for which they will receive two-year sentences.
a. If your goal is to reduce the time you spend in jail, what is your best strategy: confess
or remain silent. Please explain. (remember, you will not know what your partner
chooses before choosing your own action).

6. Consider the serious game that NATO and the Soviet Union played from 1945-1989.
Suppose the Soviet Union gets the first move and can either attack NATO or not attack. If
the Soviet Union moves first and attacks using conventional forces, NATO could respond
either with conventional weapons, in which case Western Europe would be overrun and
NATOs utility would be -100,000 and the Soviet Unions utility would be 100,000; or with
nuclear weapons, in which case there is a nuclear catastrophe and both the Soviet Union and
NATO suffer a cataclysm causing both to have utilities of -1,000,000. If the Soviet Union
chooses not to attack, the status quo in Europe is maintained and the relatively poor Soviet
Union has utility of 50,000 while the relatively rich members of NATO has utility of
200,000.
a. Present the game in extensive form.

b. What is difference between this game and the previous ones we have played?

109

c. What should NATO do? What should the Soviet Union do?

d. Now suppose the United States enters the game and automatically gets the first move.
If the United States commits to a full nuclear response to any attack on any NATO
member by the Soviet Union.
i. How does the game set up changes (develop a new extensive form of the
game).

ii. What is the Soviet Union best choice now?

iii. What conclusions you can make base on your answers?

110

7. Two classmates A and B are assigned an extra-credit group project. Each student can choose
to Shirk or Work. If one or more players chooses Work, the project is completed and
provides each with extra credit valued at 4 payoff units each. The cost of completing the
project is that 6 total units of effort (measured in payoff units) is divided equally among all
players who choose to Work and this is subtracted from their payoff. If both Shirk, they do
not have to expend any effort but the project is not completed, giving each a payoff of 0. The
teacher can only tell whether the project is completed and not which students contributed to
it.
a. Write down the normal form for this game, assuming students choose to Shirk or
Work simultaneously.

b. Find the Nash equilibrium or equilibria.

c. Does either player have a dominant strategy? What game from the chapter does this
resemble?

8. Three department stores, A, B, and C, simultaneously decide whether or not to locate in a

mall that is being constructed in town. A store likes to have another with it in the mall since
then there is a critical mass of stores to induce shoppers to come out. However, with three
stores in the mall, there begins to be too much competition among them and store profits fall
drastically. Read the payoff matrix as follows: the first payoff in each entry is for A, the
second for B, and the third for C; Cs choice determines which of the bold boxes the other
players find themselves in.
C chooses Mall
C chooses Not Mall
B

Mall

Mall

Not Mall

Mall

Not Mall

-2, -2, -2

2, 0, 2

2, 1, 0

-1, 0, 0

0, 1, 2

0, 0, -1

0, -1, 0

0, 0, 0

A
Not Mall

111

a. Find the pure-strategy Nash equilibrium or equilibria of the game. You can apply the
underlying method from the text as follows. First, find the best responses for A and B,
treating each bold box corresponding to Cs choice as a separate game. Then find Cs
best responses by comparing corresponding entries in the two boxes (the two entries
in the upper-left corners of both, the upper-right corners of both, etc.) and underlining
the higher of the two payoffs.

b. What do you think the outcome would be if players chose cooperatively rather than
noncooperatively?

112

9. Suppose there are two firms in a given market and each is considering an advertising
program to enhance its market share. The estimates of changes in market share associated
with the decisions to advertise or not to advertise are shown in the following payoff matrix.

a. Can you produce the strategy that each player will adopt? Is it the same as the Nash
equilibrium? How would collusion alter the outcome of this game? (4)

113

10. Two local discount stores dominate the local market; one, FloorMart, is rumored to be
planning a major price campaign to gain market share. The rival company, L-Mart, has
threatened to match any price cut and cut prices even further. You have been called in by
FloorMart to assist in the decision. The following payoff matrix was prepared at your request
(the first number is L-Marts profits, the second FloorMarts).

b. Do you think that the rumors of a potential low-price campaign by FloorMart are
credible? Why or why not? (5)

11. Two firms are in the chocolate market. Each can choose to go for the high end of the market
(high quality) or the low end (low quality). The payoff matrix below gives resulting profits.
What outcomes, if any, are Nash equilibria? Does either firm have a dominant strategy? (12)

114

12. Larry and Billy are brought in for questioning. The situation regarding jail sentences is as
follows: the government can make some small charges (e.g. perjury) stick if neither of the
two confesses (and they each get six months). If one confesses (and the other does not), then
the one who has confessed is considered to have turned states evidence and gets off with no
jail time, while the one who did not confess gets twenty years. If both confess, they each get
six years. Set this situation up as a game-theory problem and discuss whether separate
questioning or joint questioning is likely to result in more information and convictions.

115

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