8 January 2019

2 hour
Full points: 40
ECN 201E Final Examination Solutions
Answer all 4 questions below. I suggest you spend 25 minutes on each question. If you are
stuck on a question, I recommend moving on to the next question and returning to the
problem after you have finished answering all the other questions.
Make sure to show all your working and calculations for significant partial credit. You must
show all the steps that you did to get to your answer. If you just give me the answer, you
will get 0 even if it is correct. I will also give you 0 if all you give me is a formula without
any working.
Good luck!
Please write your name and ITU ID number on your answer sheet.
Question 1
1
The market demand for a good that has price 𝑝 is 𝐷(𝑝) = 𝑝.

a) What is the price elasticity of demand 𝝐 in terms of 𝑝 ? How does it vary with quantity
demanded? [3 points]
The market supply for the good is 𝑆(𝑝) = 𝑝.
b) What is the equilibrium price 𝒑∗ and equilibrium quantity 𝒒∗ ? [2 points]
c) Suppose an ad valorem sales tax of 21% is levied by the government. Find the after-tax
equilibrium price paid by the demander 𝑝𝐷∗ and the after-tax equilibrium price received by the
supplier 𝑝𝑆∗ . [5 points]
Question 2
A firm uses two factors of production to produce a single output. Let the amount of factor 1
used in production be 𝑥1 and the amount of factor 2 be 𝑥2 . Let the prices of factor 1 and
factor 2 be 𝑤1 and 𝑤2 respectively. The firm’s production function is 𝑓(𝑥1 , 𝑥2 ) = 𝑥10.3 𝑥20.7 .
The firm wants to produce the output level 𝑦̅ at minimum cost
a) State the firm’s constrained minimization problem. [2 points]
b) Find the firm’s conditional factor demand functions 𝑥1 (𝑤1, 𝑤2 , 𝑦) and 𝑥2 (𝑤1 , 𝑤2 , 𝑦). [6
points]
c) Find the firm’s cost function 𝑐(𝑤1 , 𝑤2 , 𝑦). [2 points]
Question 3
A firm in a purely competitive market has to produce 1000 units of output 𝑦. The firm has
two plants in two different cities to produce this output. The firm’s cost function in the plant
in City 1 is 𝑐1 (𝑦1 ) = 500𝑦1 + 100 where 𝑦1 is the level of output the firm produces in the
plant in City 1. The firm’s cost function in the plant in City 2 is 𝑐2 (𝑦2 ) = 𝑦22 + 500 where 𝑦2
is the level of output the firm produces in the plant in City 2.
a) Find how the firm will allocate production in the two cities to produce the required level of
1000 units i.e. find the optimal values of 𝑦1 and 𝑦2 . [4 points]
b) The city council levies a quantity tax of $500 per unit produced in City 2. What are the
post-tax optimal values of 𝑦1 and 𝑦2 ? [6 points]
Question 4
A monopolist faces an inverse market demand curve 𝑝(𝑦) = 1001 − 0.5𝑦 where 𝑦
represents quantity. The cost function of the monopolist is 𝑐(𝑦) = 𝑦 + 1000.
a) Find the monopolist’s optimal level of price and output (𝑝𝑚 , 𝑦𝑚 ). [3 points]
b) Find the competitive level of price and output (𝑝𝑐 , 𝑦𝑐 ) . [3 points]
c) A government regulator sets the price of the monopolist at 𝑝𝑐 . Do you think this is a
sensible policy? Explain your answer. [4 points]

Answer to Question 1
a) The price elasticity of demand 𝝐 is:
𝑝 𝑑𝑞
𝜖 = 𝑞 . 𝑑𝑝
𝑝 1
= 1 . − 𝑝2
𝑝

𝑝2
= − 𝑝2

= −1 .
It is does not vary with quantity demanded.
b) The equilibrium price 𝑝∗ can be found from the equation:
𝐷(𝑝∗ ) = 𝑆(𝑝∗ )
1
⇒ 𝑝∗ = 𝑝 ∗

⇒ 𝑝∗2 = 1
∴ 𝒑∗ = $𝟏 because 𝑝 ≥ 0.
The equilibrium 𝑞 ∗ is:
𝒒∗ = 𝑺(𝟏) = 𝟏 unit.
a) The after-tax equilibrium is determined by the equations below:
1
𝐷(𝑝𝐷 ) = 𝑝 = 𝑝𝑆 = 𝑆(𝑝𝑠 ), (1)
𝐷

𝑝𝐷 = (1 + 𝜏)𝑝𝑆 , (2)
where 𝜏 is the ad valorem tax and is equal to 0.21 if the ad valorem tax is 21%.
Hence equation (2) becomes:
𝑝𝐷 = 1.21𝑝𝑆 . (3)
Substituting 𝑝𝐷 in equation (1) from (3):
1
= 𝑝𝑆 ,
𝑝𝐷

1
⇒ 1.21𝑝 = 𝑝𝑆 ,
𝑆

1
⇒ = 𝑝𝑆 ,
1.21𝑝𝑆

1
⇒ 𝑝𝑆2 = 1.21
1
⇒ 𝑝𝑆∗ = $ 1.1 because 𝑝𝑆 ≥ 0,

∴ 𝒑∗𝑺 = $𝟎. 𝟗𝟏.

We can find after-tax equilibrium price paid by the demander 𝑝𝐷∗ by substituting 𝑝𝑆∗ in
equation (3):
𝑝𝐷∗ = 1.21𝑝𝑆∗ ,
1
⇒ 𝑝𝐷∗ = 1.21(1.1),

∴ 𝒑∗𝑫 = $𝟏. 𝟏𝟎.

Answer to Question 2
a) The firm’s cost minimization problem is:
min 𝑤1 𝑥1 + 𝑤2 𝑥2 ,
𝑥1 ,𝑥2

𝑠. 𝑡. 𝑥10.3 𝑥20.7 = 𝑦̅.

b) To find the conditional factor demands, we must solve the above constrained cost
minimization problem. You can use substitution to solve this but I will use a Lagrangian. The
Lagrangian is:
𝐿 = 𝑤1 𝑥1 + 𝑤2 𝑥2 − 𝜆(𝑥10.3 𝑥20.7 − 𝑦̅). (1)
𝜆 is the Lagrangian multiplier. The first-order conditions are:
𝜕𝐿
= 𝑤1 − 𝜆0.3𝑥1−0.7 𝑥20.7 = 0, (2a)
𝜕𝑥1

𝜕𝐿
= 𝑤2 − 𝜆0.7𝑥10.3 𝑥2−0.3 = 0, (2b)
𝜕𝑥2

𝜕𝐿
= 𝑥10.3 𝑥20.7 − 𝑦̅ = 0. (2c)
𝜕𝜆

The three first-order conditions can be re-written as:

𝑤1 = 𝜆0.3𝑥1−0.7 𝑥20.7 , (3a)
𝑤2 = 𝜆0.7𝑥10.3 𝑥2−0.3, (3b)
𝑦 = 𝑥10.3 𝑥20.7 . (3c)
We can multiply 𝑥1 on both sides of (3a) and 𝑥2 on both sides of (3b) and substitute
𝑥10.3 𝑥20.7 = 𝑦̅ in both equations to get:
𝑤1 𝑥1 = 𝜆0.3𝑦̅. (4a)
𝑤2 𝑥2 = 𝜆0.7𝑦̅. (4b)
So that we get:
𝜆0.3𝑦̅
𝑥1 = , (5a)
𝑤1

𝜆0.7𝑦̅
𝑥2 = . (5b)
𝑤2

We can substitute 𝑥1 and 𝑥2 from equations (5a) and (5b) into equation (3c) and solve for 𝜆:
𝜆0.3𝑦̅ 0.3 𝜆0.7𝑦̅ 0.7
( ) ( ) = 𝑦̅,
𝑤1 𝑤2

0.30.3 .0.70.7 𝜆𝑦̅

⇒ = 𝑦̅,
𝑤1 0.3 𝑤2 0.7

𝑤 0.3 𝑤 0.7
∴ 𝜆 = 0.310.3 .0.72 0.7 . (6)

Substituting the value of 𝜆 from equation (6) into equations (5a) and (5b), we get the
conditional factor demand functions:
𝜆0.3𝑦̅ 𝑤 0.3 𝑤 0.7 0.3𝑦̅ 𝑤2 0.7 𝑦̅ −0.7
𝑥1 = = 0.310.3 .0.72 0.7 . = 0.30.7 . 0.7−0.7 . =0.30.7 . 0.7−0.7 . 𝑤1 𝑤2 0.7 𝑦̅, (7a)
𝑤1 𝑤1 𝑤1 0.7

𝜆0.7𝑦̅ 𝑤 0.3 𝑤 0.7 0.7𝑦̅ 𝑤1 0.3 𝑦̅ 0.3

𝑥2 = = 0.310.3 .0.72 0.7 . = 0.3−0.3 . 0.70.3 . =0.3−0.3 . 0.70.3 . 𝑤1 𝑤2 −0.3 𝑦̅. (7b)
𝑤2 𝑤2 𝑤2 0.3

The conditional factor demands for factors 1 and 2 are given by equations (7a) and (7b)
respectively:
−𝟎.𝟕
𝒙𝟏 = 𝟎. 𝟑𝟎.𝟕 . 𝟎. 𝟕−𝟎.𝟕 . 𝒘𝟏 𝒘𝟐 𝟎.𝟕 𝒚
̅, (7a)
 𝟎.𝟑
𝒙𝟐 = 𝟎. 𝟑−𝟎.𝟑 . 𝟎. 𝟕𝟎.𝟑 . 𝒘𝟏 𝒘𝟐 −𝟎.𝟑 𝒚
̅. (7b)
c) The cost function is found by substituting the conditional factor demands into the objective
function:
𝑐(𝑤1 , 𝑤2 , 𝑦) = 𝑤1 𝑥1 (𝑤1 , 𝑤2 , 𝑦) + 𝑤2 𝑥2 (𝑤1 , 𝑤2 , 𝑦),
−0.7 0.3
⟹ 𝑐(𝑤1 , 𝑤2 , 𝑦) = 𝑤1 . 0.30.7 . 0.7−0.7 . 𝑤1 𝑤2 0.7 𝑦 + 𝑤2 . 0.3−0.3 . 0.70.3 . 𝑤1 𝑤2 −0.3 𝑦,
0.3 0.3
⟹ 𝑐(𝑤1 , 𝑤2 , 𝑦) = 0.30.7 . 0.7−0.7 . 𝑤1 𝑤2 0.7 𝑦 + 0.3−0.3. 0.70.3 . 𝑤1 𝑤2 0.7 𝑦,
∴ 𝒄(𝒘𝟏 , 𝒘𝟐 , 𝒚) = (𝟎. 𝟑𝟎.𝟕 . 𝟎. 𝟕−𝟎.𝟕 + 𝟎. 𝟑−𝟎.𝟑 . 𝟎. 𝟕𝟎.𝟑 )𝒘𝟏 𝟎.𝟑 𝒘𝟐 𝟎.𝟕 𝒚. (8)
The cost function is given by equation (8).
Answer to Question 3
a) The firm will allocate its production in the two cities to minimize production. Hence, his
constrained minimization problem is:
min 𝑐1 (𝑦1 ) + 𝑐2 (𝑦2 )
𝑦1 ,𝑦2

𝑠. 𝑡. 𝑦1 + 𝑦2 = 1.
You can solve the above constrained minimization by Lagrangian but I will solve by the
substituting 𝑦2 = 1000 − 𝑦1 into the objective function. With this substitution the
unconstrained minimization problem of the firm is.
min 𝑐1 (𝑦1 ) + 𝑐2 (1000 − 𝑦1 ) .
𝑦1

The first-order condition for this minimization problem is:

𝑐1′ (𝑦1 ) + 𝑐2′ (𝑦2 ). −1 = 0,
⟹ 𝑐1′ (𝑦1 ) = 𝑐2′ (𝑦2 ),
⟹ 500 = 2𝑦2 , (I can solve 𝑦2 from here but because I did the differentiation with respect to
𝑦1 , I will continue to solve using 𝑦1 )
⟹ 500 = 2(1000 − 𝑦1 ),
⟹ 500 = 2000 − 2𝑦1 ,
⟹ 2𝑦1 = 1500,
∴ 𝒚𝟏 = 𝟕𝟓𝟎 𝒖𝒏𝒊𝒕𝒔.
∴ 𝒚𝟐 = 𝟏𝟎𝟎𝟎 − 𝟕𝟓𝟎 = 𝟐𝟓𝟎 𝒖𝒏𝒊𝒕𝒔.
b) With a per unit tax of $500 the marginal cost in the plant in City 2 will increase by 500.
Therefore, the post-tax first order condition is now:
𝑐1′ (𝑦1 ) = 𝑐2′ (𝑦1 ) + 500,
⟹ 500 = 2(1000 − 𝑦1 ) + 500,
⟹ 2(1000 − 𝑦1 ) = 0 ,
⟹ 2𝑦1 = 2000 ,
∴ 𝒚𝟏 = 𝟏𝟎𝟎𝟎 𝒖𝒏𝒊𝒕𝒔.
∴ 𝒚𝟐 = 𝟏𝟎𝟎𝟎 − 𝟏𝟎𝟎𝟎 = 𝟎 𝒖𝒏𝒊𝒕𝒔.
Post tax no units will be produced in the plant in City 2.
Answer to Question 4
a) The monopolist sets 𝑦𝑚 to maximize her profit i.e.:
max 𝑝(𝑦)𝑦 − 𝑐(𝑦),
𝑦

⇒ 𝑚𝑎𝑥(1001 − 0.5𝑦 )𝑦 − 𝑦 − 1000,

𝑦

⇒ 𝑚𝑎𝑥 1001𝑦 − 0.5𝑦 2 − 𝑦 − 1000.

𝑦

The first-order condition is:

𝑑𝜋
= 1001 − 𝑦 − 1 = 0,
𝑑𝑦

∴ 𝒚𝒎 = 𝟏𝟎𝟎𝟎 𝒖𝒏𝒊𝒕𝒔.
We can find 𝑝𝑚 from the inverse market demand function:
𝑝𝑚 (𝑦𝑚 ) = 1001 − 0.5𝑦𝑚 ,
⟹ 𝑝𝑚 (𝑦𝑚 ) = 1001 − 0.5.1000 ,
⟹ 𝑝𝑚 (𝑦𝑚 ) = 1001 − 500,
∴ 𝒑𝒎 = $𝟓𝟎𝟏.
b) At the competitive level of output 𝑦𝑐 , the monopolist’s marginal cost will equal price:
𝑀𝐶(𝑦) = 𝑝(𝑦),
⇒ 1 = 1001 − 0.5𝑦,
⇒ 0.5𝑦 = 1000,
∴ 𝒚𝒄 = 𝟐𝟎𝟎𝟎 𝒖𝒏𝒊𝒕𝒔.
Also 𝒑𝒄 = $𝟏 because price must equal marginal cost at the competitive level of output.
c) This is not a sensible idea. This is because if you observe the cost function of the
monopolist, we see that her monopoly is a natural monopoly i.e. her average cost of
production is always more than her marginal cost. Pricing at marginal will result in losses.
This can be seen by calculating her profit 𝜋𝑐 at 𝑝𝑐 = $1:
𝜋𝑐 = 𝑝𝑐 𝑦𝑐 − 1000 − 𝑦𝑐 ,
⇒ 𝜋𝑐 = 1.2000 − 1000 − 2000,
⇒ 𝜋𝑐 = −$1000.
Hence, marginal-cost pricing will cause the monopolist to go out of business.