Advanced Microeconomics II

Chap 1
1) Explain why price equals marginal cost is a necessary condition for profit
maximization not in general a sufficient condition.

Ans:

Just because we find a point where price equals marginal cost doesnot
mean that we have found the maximum profit point. From the figure shown
below, although there are two levels of output where price equals marginal
cost, the profit-maximizing quantity supplied can lie only on the upward-
sloping part of the marginal cost curve.

2) Why cannot the first intersection point of p and MC on the above figure the
profit maximization point?

Ans:

At the first intersection point, the MC is decreasing. That is, if we increase

the output by a little bit, the costs of each additional unit of output will
decrease. But this doesnot make sense because if output increases cost
 cannot decrease. This is the reason why this intersection point cannot be a
profit max point.

3) Derive the shutdown condition of a firm.

Ans:

The profits from producing zero units of output is -F because profit= py-cv-F
= 0-0-F = -F. Even if the firm produces nothing it still has to pay its fixed
costs.

Thus the firm is better off going out of business when the “profits” from
producing nothing exceed the profits from producing, that is:

-F>py- cv-F

→ 0 > py- cv

cv > py

dividing both sides by y

cv/y > py / y

AVC = cv/y > p

This is the shutdown condition.

If average variable costs are greater than p, the firm would be better off

producing zero units of output. The firm will not able to cover its variable
costs because cv/y > p means cv > py, the variable cost will be above the
revenue.

4) Only the portions of the marginal cost curve that lie above the average
variable cost curve are possible points on the supply curve.
5) How is producer’s surplus determined mathematically and graphically?

Ans:

Mathematically,

The area p*y* is the total revenue and the area y*AC(y*) is the total cost.
Hence profit = area p*y* - area y*AC(y*).
 The area where the revenue box (p*y*) minus the area under the MC curve
is the producer’s surplus.

6) Profit + fixed cost = producer surplus.

7) Show that a competitive firm’s profits are maximized when it produces at

a point where the marginal cost is rising. Show graphically also.

Ans:
8) For a firm with cost function given by c(y)=y2+1, compute the supply
function and the inverse supply function. (page 218)
9) Derive the inverse supply curve:

Ans:

From max π = py – c(y)

FOC: p = c’(y)

Or

p(y) = c’(y), inverse supply function.

Note, c’’(y) >0

10) Show that the supply curve of a competitive firm has a positive slope.

Ans:

11) Show that the firm will produce positive levels of output when price is
greater than average variable cost.

Ans:
12) Find the market or industry supply function if the firms supply
functions are given as below:

c1(y) = y2

c2(y) = 2y2

13) If the marker or industry demand function is given by X(p) = a-bP and
industry supply function by Y(p) = mp/2, and the cost of entry in the long
run is given by c(y) = y2 + 1. Show

a. the inverse relationship between price and number of firms,m.

b. What is the value of the break-eve price in the long-run?

c. the change in price with respect to number of firms, m.

Ans:

14) for a single representative consumer with a quasilinear utility

function of the form u(x) + y and a representative firm with a cost function
of c(x), show that:

a. the demand function is independent of income.

b. The level of output at which the marginal willingness-to-pay for the x-

good just equals its marginal cost of production.

Ans:
15) Using the welfare maximizing problem, show that:

a. The marginal willingness to pay is equal to the marginal cost.

b. Depict the area in the graph of demand vs supply curve which

represents u(x).

c. Depict the area in the graph which represents the amount of x which
maximizes u(x)-c(x) .

Ans:
16) Show that the competitive equilibrium level of output maximizes total
surplus.

Ans:
17) What is a Pareto efficient allocation?

18) Derive the condition necessary to have a Pareto efficient allocation:

u1’(x1) = u2’(x2)

Ans:
19) Assume good-x is only consumed in discrete and the consumer only
purchases 1 or 0 units of the x-good. For a consumer with income m facing
a price of p and reservation price r that makes the consumer indifferent
between purchasing the x-good or not. For a quasilinear utility function
show that

a. The reservation price is equal to the utility consumption of x-good.

b. Consumer surplus is given by r-p.

Ans:
20) Explain comparative statics. (page 228)

21) What is the relationship between demand price and supply price
based on quantity tax, value tax and quantity subsidy?
22) Find out,

a. The utility of consumption accruing to the consumer at the

equilibrium x*

b. The profits accruing to the firm.

c. The revenues accruing to the government.

23) What is the deadweight loss, show it also using a graph.

24) Q13.3 a ans:

25) Equilibrium rent on land = equilibrium price, p* - equilibrium cost.

26) What is the defining point for a monopolist?

Ans:
 A monopoly is a single supplier to a market. This firm may choose to produce
at any point on the market demand curve. It has a power to set prices.

A monopolist controls the price and because of this it will also controls the
qty sold. But it cannot control the price and qty at the same time.

27) Explain why the monopolist cannot control the price and qty at the
same time.

Ans:

The reason is, due to the diminishing marginal product as prices increases
the qty demanded will decrease and the vice-versa as shown on below
graph. When the monopolist increases the price from p1 to p2, the qty
demanded will drop from y1 to y1. It cannot keep the qty demanded fixed,
the change in p will definitely cause an inverse change in y.

28) Explain why the marginal revenue curve lies beneath the inverse
demand curve.

Ans:
29) What is the profit maximizing condition of a monopoly?

30) For a monopolist,

a. express marginal cost in terms of the inverse demand function (p(y))

and price elasticity of demand.

b. Express the inverse demand function in terms of MC and elasticity of

demand

Ans:
 b. p(y) = MC(1+1/ε)-1

31) For dd function given by, y = AP--b, compute the inverse demand
function.

Ans:

The elasticity of demand = -b. hence using

p(y) = MC(1+1/ε)-1 = MC(1-1/b)-1

32) Compute the ratio of the consumer surplus of the monopoly to the
perfect competition.

Ans:
33) Explain the first (perfect) price discrimination.

34) Explain the second and third price discrimination with example.

35) For the case of second degree discrimination with two consumers
with utility functions given by u1(x1) + y1 and u2(x2) + y2 and assuming
u2(x2) > u1(x1) and u’2(x2) > u’1(x1)

a. Select the binding equations

b. Compute the profit function of the monopoly.

c. How much will the low demand consumer consumes the good?

Ans:
36) For value adding tax γ and c(y) = cy
 (1-γ)Pd = (1+1/ε)c

For output tax t

Pd -t = (1+1/ε)

37) How is the output choice of firm i determined in the Cournot

equilibrium?

Ans:

yit = fi(yjt)

for example, y11= f1(y20) means firm 1 guesses that firm 2 will continue to

produce y20 in period 1.

38) Consider two firms which produce a homogeneous product with

output levels y1 and y2, and thus an aggregate output of Y = y1 + y2. The
market price associated with this output is p(Y) = p(y1 + y2). Firm i has a

cost function of ci(yi).

a. What is the optimization problem of each firm?

b. What is the reaction curve of firm 1?

c. Determine how firm 1 optimally changes its output as its beliefs

about firm 2’s output changes.

Ans:
39) Imagine that the firms adjust their outputs in the direction of
increasing profits, assuming that the other firm keeps its output fixed. Then

a. What will be the form of this dynamic system?

b. What will be the sufficient condition for local stability of this dynamic
system?

Ans:
 a.

where α1 > 0 and α2 > 0

and the sufficient condition is

40) For profit functions given as below for an oligopoly of two firms,
compute the variation of y1 and y2 with respect to a each.

π1(y1(a), y2(a), a) and π2(y1(a), y2(a))

where a is a parameter or constant.

Ans:
41) Explain the Bertrand model of oligopoly.

Ans:

The Bertrand model of oligopoly is a model where price the firm’s strategic
variable.
42) Suppose the consumer inverse demand function is given as :

Or

With direct demand function format as:

If the marginal cost is zero, compute the reaction curve of firm 1 in the
case of Cournot competitor and Bertrand competitor case.

Ans:

Note:

• In Cournot competition the profit is equal to inverse demand {p(y)} times

output, that is π1 = p(Y)y1-c(y1).
• In Bertrand competition, profit is equal to direct demand function {y(p)}
times price, that is π1 = y1p1
43) What does it imply the reaction curves in Bertrand model being
upward sloping?

Ans:

It implies that If firm 2 increases its output, then firm 1 will typically want
to reduce output in order to force the price up. However, if firm 2 increases
its price, firm 1 will typically find it profitable to increase its price in order
to match the price increase.

44) Explain the Stackelberg model

Ans:

This is essentially a two-stage model in which one firm gets to move first. The
other firm can then observe the first firm's output choice and choose its own
optimal level of output.

45) Suppose firm 1 is a leader and firm 2 is a follower in the Stackelberg

model. How would each want to maximize their profit?
 Ans:

The term f2’(y1) indicates firm 1's belief about how firm 2's optimal behavior
changes as y1 changes.

46) Compare the Cournot and Stackelberg profits?

Ans:

since the Stackelberg leader picks the optimal point on his competitor's
reaction curve, and the Cournot equilibrium is some "arbitrary" point on his
competitor's reaction curve, the profits to the leader in the Stackelberg
equilibrium will typically be higher than they would be in the Cournot
equilibrium of the same game.

47) What is a cartel?

Ans:

An industry structure where the firms collude to some degree in setting

their prices and outputs is called a cartel.

In a cartel the firms must equate the marginal costs.

 Q16.10 Ans

Public Goods
48) When is a good said to be excludable?

49) When is a good said to be non-rival and rival?

50) ----------goods are both excludable and rival.

51) Goods that are not excludable and are non-rival are called----------.

52) Mention examples of goods that are not excludable and non-rival.

53) What are club goods? Mention an example of a club good.

54) Mention an example of a good that is not excludable, but it is rival.

55) When is it Pareto efficient to provide public goods?

Ans:

For the case of two agents and two goods, let

• X -be the private goods or money to be spent on private goods

• G-be the public goods or money to be spent on public goods.
• w-initial endowment of private goods.
• gi- contribution by i.
• ui(G,x) be agent i’s utility function and assume that utility is strictly
increasing in consumption of both the public and the private good.

Then xi = wi – gi---------private consumption.

Assume that it costs c to provide one unit of the public good so that the
technology is given by

-------------------(a)

Providing public goods will be Pareto efficient if the contribution pattern is

(g1, g2) provided that g1 + g2 ≥ c.

From equation (a), when g1 + g2 ≥ c then G=1 and x1=w1-g1

When g1 + g2 < c , G = 0 and g1=g2=0 (b/c g1 & g2 exist only when g1 + g2

≥ c to be Pareto efficient).

Then

u1(1,w1-g1) > u1(0,w1)

u2(1,w2-g2) > u2(0,w2) ----------------------------(b)

Let ri be the maximum amount of the private good that agent i would be
willing to give up to get one unit of the public good. We call this the
maximum willingness-to-pay, or the reservation price of consumer i.
 By definition, ui(1, wi-ri) = ui(0, wi) ---------------------------(c)

From equations b and c,

ui(1, wi-gi) > ui(0,wi) > u1(0,w1) = ui(1, wi-ri)

since utility is strictly increasing in private and public consumption

wi-gi > wi-ri, that is

w1 - g1 > w1 – r1

w2 – g2 > w2 – r2

adding both equations

w1 - g1 + w2 – g2 > w1 – r1 + w2 – r2

-g1-g2 > -r1-r2

g1 + g2 < r1 + r2

r1 + r2 > g1 + g2 ≥ c

since r1 + r2 > c, it is Pareto improving to provide public goods.

Thus, it is a Pareto improvement to provide a discrete public good if and

only if the sum of the willingnesses-to-pay exceeds the cost of provision.

56) When G is provided in continuous, the condition for Pareto improving

is:

and
57) The conditions characterizing a Nash equilibrium

58) If f1(w) be agent 1’s demand for the public good as a function of his
wealth, then the reaction function for agent 1 will be:

A Nash equilibrium is a set of contributions (g1*, g2*), such that

59) The prices-the prices that support an efficient allocation of the public
good (Lindahl prices) are given by:

60) For a utility function for n agents given by:

If the total amount of the wealth w is divided among k ≤ n agents, then the
total amount of the public good with k contributors must satisfy:
61) When do we say there is externality? Mention examples. (page 19)

62) What is a Pigovian tax?

Ans:

A Pigovian tax is a tax placed on any good which creates negative

externalities.

63) Show that the price equals to the marginal cost of producing xe plus
the negative externality on firm 2 because of this production.

64) For r=cost per unit of pollution, y1=supply of pollution by firm 1,

y2=demand of pollution by firm 2, p=price of output, x=units of output;
compute the optimal p, r and how is the marginal cost of firm 1 related to
the marginal cost of the negative externality on firm 2?

65) Do the last assignment.