Answer Keys

(Problem Set-I)

1. Suppose you are the manager of a watchmaking firm operating in a competitive

2
market. Your cost of production is given by C = 200 + 2q , where q is the level of output
and C is total cost. (The marginal cost of production is 4q; the fixed cost is $200.)
a. If the price of watches is $100, how many watches should you produce to maximize
profit?
Profits are maximized where price equals marginal cost. Therefore,
100 = 4q, or q = 25.
b. What will the profit level be?
Profit is equal to total revenue minus total cost:  = Pq – (200 + 2q2). Thus,
2
 = (100)(25) – (200 + 2(25) ) = $1050.
c. At what minimum price will the firm produce a positive output?
A firm will produce in the short run if its revenues are greater than its total variable
costs. The firm’s short-run supply curve is its MC curve above minimum AVC. Also,
MC = 4q. So, MC is greater than AVC for any quantity greater than 0. This means
that the firm produces in the short run as long as price is positive.

2. Suppose that a competitive firm’s marginal cost of producing output q is given by

MC(q) = 3 + 2q. Assume that the market price of the firm’s product is $9.
a. What level of output will the firm produce?
The firm should set the market price equal to marginal cost to maximize its profits:
9 = 3 + 2q, or q = 3.
 b. What is the firm’s producer surplus?
Producer surplus is equal to the area below the market price, i.e., $9.00, and above
the marginal cost curve, i.e., 3 + 2q. Because MC is linear, producer surplus is a
triangle with a base equal to 3 (since q = 3) and a height of $6 (since 9 – 3 = 6). The
area of a triangle is (1/2)(base)(height). Therefore, producer surplus is (0.5)(3)(6) = $9.

Price
MC(q) = 3 + 2q
10
9 P = $9.00
8
Producer
Producer’s
7 Surplus
Surplus
6
5
4
3
2
1

Quantity
1 2 3 4

c. Suppose that the average variable cost of the firm is given by AVC(q) = 3 + q.
Suppose that the firm’s fixed costs are known to be $3. Will the firm be earning a
positive, negative, or zero profit in the short run?
Profit is equal to total revenue minus total cost. Total cost is equal to total variable
cost plus fixed cost. Total variable cost is equal to [AVC(q)]q. Therefore, at q = 3,
AVC(q) = 3 + 3 = 6, and therefore
TVC = (6)(3) = $18.
Fixed cost is equal to $3. Therefore, total cost equals TVC plus TFC, or
C = $18 + 3 = $21.
Total revenue is price times quantity:
R = ($9)(3) = $27.
Profit is total revenue minus total cost:
 = $27 – 21 = $6.
Therefore, the firm is earning positive economic profits. More easily, you might recall
that profit equals producer surplus minus fixed cost. Since we found that producer
surplus was $9 in part (b), profit equals 9 – 3 or $6.

3. A firm produces a product in a competitive industry and has a total cost function C
= 50 + 4q + 2q2 and a marginal cost function MC = 4 + 4q. At the given market price of
$20, the firm is producing 5 units of output. Is the firm maximizing its profit? What
quantity of output should the firm produce in the long run?
If the firm is maximizing profit, then price will be equal to marginal cost. P = MC results
in 20 = 4 + 4q, or q = 4. The firm is not maximizing profit; it is producing too much
output. The current level of profit is
  = Pq – C = 20(5) – (50 + 4(5) + 2(5)2) = –20,
and the profit maximizing level is
 = 20(4) – (50 + 4(4) + 2(4)2) = –18.
Given no change in the price of the product or the cost structure of the firm, the firm
should produce q = 0 units of output in the long run since economic profit is negative at
the quantity where price equals marginal cost. The firm should exit the industry.

4. Suppose the same firm’s cost function is C(q) = 4q2 + 16.

a. Find variable cost, fixed cost, average cost, average variable cost, and average
fixed cost. (Hint: Marginal cost is given by MC = 8q.)
Variable cost is that part of total cost that depends on q and fixed cost is that part of total
cost that does not depend on q (FC = 16)

b. Show the average cost, marginal cost, and average variable cost curves on a
graph.
Average cost is U-shaped.
Average cost is relatively large Cost Average and Marginal Costs
at first because the firm is not
able to spread the fixed cost 48 MC
over very many units of output. 44
As output increases, average
40
fixed cost falls quickly, leading
to a rapid decline in average 36

cost. Average cost will increase 32

at some point because the 28
average fixed cost will become AC
very small and average variable
24 AV
cost is increasing as q increases. 20
MC and AVC are linear in this 16
example, and both pass through 12
the origin.
8
Average variable cost is
4
everywhere below average cost.
Marginal cost is everywhere 0
0 1 2 3 4 5 6
above average variable cost. If
the average is rising, then the Quantity

marginal must be above the

average. Marginal cost intersects average cost at its minimum point, which occurs at a
quantity of 2 where MC and AC both equal $16.
c. Find the output that minimizes average cost.
Minimum average cost occurs at the quantity where MC is equal to AC:
16
𝐴𝐶 = 4𝑞 + = 8𝑞 = 𝑀𝐶
𝑞
 𝑞=2
d. At what range of prices will the firm produce a positive output?
The firm will supply positive levels of output in the short run as long as P = MC > AVC,
or as long as the firm is covering its variable costs of production. In this case, marginal
cost is above average variable cost at all output levels, so the firm will supply positive
output at any positive price.
e. At what range of prices will the firm earn a negative profit?
The firm will earn negative profit when P = MC < AC, or at any price below minimum
average cost. In part (c) above we found that the minimum average cost occurs where q =
2. Plug q = 2 into the average cost function to find AC = 16. The firm will therefore earn
negative profit if price is below 16.
f. At what range of prices will the firm earn a positive profit?
In part (e) we found that the firm would earn negative profit at any price below 16. The
firm therefore earns positive profit as long as price is above 16.

5.(a) Suppose that a firm’s production function is 𝒒 = 𝟗𝒙𝟏/𝟐 in the short run, where there
are fixed costs of $1000, and x is the variable input whose cost is $4000 per unit. What
is the total cost of producing a level of output q? In other words, identify the total cost
function C(q).
Since the variable input costs $4000 per unit, total variable cost is 4000 times the number
of units used, or 4000x. Therefore, the total cost of the inputs used is C(x) = variable cost
+ fixed cost = 4000x + 1000. Now rewrite the production function to express x in terms of
q2
q: x  . We can then substitute this into the above cost function to find C(q):
81
4000q2
C(q)   1000 .
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b. Write down the equation for the supply curve.
The firm supplies output where P = MC as long as MC ≥ AVC. In this example, MC =
98.7654q is always greater than AVC = 49.3827q, so the entire marginal cost curve is the
supply curve. Therefore P = 98.7654q, or q = .010125P, is the firm’s short-run supply
curve.
c. If price is $1000, how many units will the firm produce? What is the level of
profit? Illustrate on a cost curve graph.
Use the supply curve from part b: q = .010125(1000) = 10.125.
Profit is 1000(10.125) – [(4000(10.125)2/81) + 1000] = $4,062.50. Graphically, the firm
produces where the price line hits the MC curve. Since profit is positive, this occurs at a
quantity where price is greater than average cost. To find profit on the graph, take the
difference between the revenue rectangle (price times quantity) and the cost rectangle
(average cost times quantity). The area of the resulting rectangle is the firm’s profit.
d. What is the lowest price at which each firm would sell its output in the short run?
Is profit positive, negative, or zero at this price? Explain.
The firm will sell for any positive price, because at any positive price, marginal cost is
above average variable cost (MC = q/100 > AVC = q/200). Profit is negative if price is
below minimum average cost, or as long as price is below $3.80. Profit is zero if price is
exactly $3.80, and profit is positive if price is greater than $3.80.
6.
a. Find the equilibrium price, the equilibrium quantity, the output supplied by
the firm, and the profit of each firm.
Equilibrium price and quantity are found by setting market supply equal to market
demand: 6500 – 100P = 1200P. Solve to find P = $5 and substitute into either equation to
2q
find Q = 6000. To find the output for the firm set price equal to marginal cost: 5  ,
200
and therefore q = 500. Profit is total revenue minus total cost or
 q 2   2
  Pq   722   5( 500 )   722  500   $528 . Notice that since the total output in
 200  
 200 
the market is 6000, and each firm’s output is 500, there must be 6000/500 = 12 firms in
the industry.
b. Would you expect to see entry into or exit from the industry in the long run?
Explain. What effect will entry or exit have on market equilibrium?
We would expect entry because firms in the industry are making positive economic
profits. As new firms enter, market supply will increase (i.e., the market supply curve will
shift down and to the right), which will cause the market equilibrium price to fall, all else
the same. This, in turn, will reduce each firm’s optimal output and profit. When profit
falls to zero, no further entry will occur.
c. What is the lowest price at which each firm would sell its output in the long
run? Is profit positive, negative, or zero at this price? Explain.
In the long run profit falls to zero, which means price falls to the minimum value of AC.
To find the minimum average cost, set marginal cost equal to average cost and solve for q:
2q 722 q
 
200 q 200
q 722

200 q
q 2  722(200)
q  380
AC(q  380)  3.8.
Therefore, the firm will not sell for any price less than $3.80 in the long run. The long-run
equilibrium price is therefore $3.80, and at a price of $3.80, each firm’s economic profit
equals zero because P = AC.

d. What is the lowest price at which each firm would sell its output in the short
run? Is profit positive, negative, or zero at this price? Explain.
The firm will sell for any positive price, because at any positive price, marginal cost is
above average variable cost (MC = q/100 > AVC = q/200). Profit is negative if price is
below minimum average cost, or as long as price is below $3.80. Profit is zero if price is
exactly $3.80, and profit is positive if price is greater than $3.80.
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7. Suppose that a competitive firm has a total cost function C(q)  450  15q  2q and a
marginal cost function MC(q)  15  4q . If the market price is P = $115 per unit, find the
level of output produced by the firm. Find the level of profit and the level of producer
surplus.
The firm should produce where price is equal to marginal cost so that 115 = 15 + 4q, and
therefore q = 25. Profit is  = 115(25) – [450 + 15(25) + 2(25)2] = $800.
Producer surplus is profit plus fixed cost, so PS = 800 + 450 = $1250. Producer surplus
can also be found graphically by calculating the area below price and above the marginal
cost (supply) curve: PS = (1/2)(25)(115 – 15) = $1250.

8. A number of stores offer film developing as a service to their customers. Suppose that
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each store offering this service has a cost function C(q)  50  0.5q  0.08q and a
marginal cost MC  0.5  0.16q .
a. If the going rate for developing a roll of film is $8.50, is the industry in long-run
equilibrium? If not, find the price associated with long-run equilibrium.
Each firm’s profit maximizing quantity is where price equals marginal cost: 8.50 = 0.5 +
0.16q. Thus q = 50. Profit is then 8.50(50) – [50 + 0.5(50) + 0.08(50)2] = $150. The
industry is not in long-run equilibrium because profit is greater than zero. In long-run
equilibrium, firms produce where price is equal to minimum average cost and there is no
incentive for entry or exit. To find the minimum average cost point, set marginal cost
equal to average cost and solve for q:
50
MC  0.5  0.16q   0.5  0.08q  AC
q
2
0.08q  50
q  25.

To find the long-run equilibrium price in the market, substitute q = 25 into either marginal
cost or average cost to get P = $4.50.
b. Suppose now that a new technology is developed which will reduce the cost of
film developing by 25 percent. Assuming that the industry is in long-run
equilibrium, how much would any one store be willing to pay to purchase this
new technology?
The new total cost function and marginal cost function can be found by multiplying the
old functions by 0.75 (or 75%). The new functions are:
Cnew (q)  .75(50  0.5q  0.08q 2 )  37.5  0.375q  0.06q 2
MCnew (q)  0.375  0.12q.

The firm will set marginal cost equal to price, which is $4.50 in the long-run equilibrium.
Solve for q to find that the firm will develop approximately 34 rolls of film (rounding
down). If q = 34 then profit is $33.39. This is the most the firm would be willing to pay
per year for the new technology.
It will pay this amount only if no other firms can adopt the new technology, because if
all firms adopt the new technology, the long-run equilibrium price will fall to the
minimum average cost of the new technology and profits will be driven to zero.