Answer Key to Problem Set 2: Econ 403 Winter 2011

Professor Jason Lepore

1 Problem 1 (Taxation: Perfect Competition vs Monopoly)

The market is for cigarette packets. Assume market demand be D(p) = 24 p for both
cases below.
Case PC: Perfect Competition
Let market supply be S(p) = p.

1.a Graph supply, demand and equilibrium price and quantity. Calculate consumer sur-
plus, producers surplus and total surplus.

Answer:

Equilibrium solution:

S(p) = D(p)
p = 24 p , p = 12 and Q = 12

S
24

CS

p*=12

PS

Q*=12 Q
24

Consumer surplus:
1
CS = (24 12) 12 = 6 12 = 72
2

1
 Produces surplus:
1
CS = (24 12) 12 = 6 12 = 72
2
Total surplus: T S = 144

1.b Suppose that the government imposes a tax on consumers of 2 dollars per cigarette
packet. Find the equilibrium price and quantity. What is the deadweight loss and
how much money does the government collect?

Answer: Find demand to a price with tax on consumers: Dt (p) = D(p + 2) = 22 p

Equilibrium solution with tax:

S(p) = D(p)
p = 22 p , pt = 11 and (plug pt into Dt (p)) Qt = 11

Graphically,
P

S
24

DWL

CS
pt+2=13
Tax Revenue
pt=11

PS

D
Dt

Qt=11 Q
24

1
DW L = 2 1 2=1

T ax Revenue = 2 11 = 22.

1.c Suppose instead the government taxes producers 2 dollars per cigarette packet sold.
Find the equilibrium price and quantity. What is the deadweight loss and how much
money does the government collect? Compare your answer to 1.b.

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Answer: Find supply to a price with tax on producers: S t (p) = S(p + 2) = p 2

Equilibrium solution with tax:

S t (p) = D(p)
p 2 = 22 p , pt = 13 and (plug pt into S t (p)) Qt = 11

Graphically,
St
P

S
24

DWL

CS
pt=13
Tax Revenue
pt-2=11

PS

D
Dt

Qt=11 Q
24

1
DW L = 2 1 2=1

T ax Revenue = 2 11 = 22.

Case M: Monopolist
Let the cost function of the monopolist be C(Q) = Q2 =2.

1.d Find the monopolies pro…t maximizing price,quantity and pro…t. Graph this on the
price quantity space.

Monopolist price and quantity solve:

Qm 2 arg max fP (Q) Q C(Q)g .

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 The maximum satis…es,

24 2Qm Qm = 0 , Qm = 8 and pm = 16.

P
mc
24

pm=16

Qm=8 24
Q

1.e Calculate the consumer surplus, producers surplus, total surplus and deadweight loss.
1
Answer: CS = 2 (24 16) 8 = 32
1
P S = 16 8 28 8 = 96

T S = 32 + 96 = 128, thus DW L = 144 128 = 16

4
 P
mc
24

DW L
CS
pm=16

PS

Qm=8 24 Q

1.f Suppose that the government imposes a tax on consumers of 2 dollars per cigarette
packet. Find the monopoly price and quantity. What is the change in deadweight
loss. How much money does the government collect?

Answer: Find demand to a price with tax on consumers: Dt (p) = D(p + 2) = 22 p

The maximum satis…es,

22 44
22 2Qmt Qmt = 0 , Qmt = and pmt = .
3 3
P
mc
24
DWL

CS
pmt +2=50/3
Tax Revenue
pmt =44/3

PS

D
Dt

Qmt =22/3 24
Q

5
 1 22 22 22
DW Lt = 2 12 3 (24 3 3 ) = 21 78

Change in DWL: 4DW L = 21 78 = 16 = 5 87

22 44
T axRevenue = 2 =
3 3
1.g Suppose instead the government taxes producers 2 dollars per cigarette packet sold.
Find the monopoly price and quantity. What is the change in deadweight loss and
how much money does the government collect? Compare your answer to 1.f.

Answer: Recall that a monopolists marginal cost is essential it inverse supply curve. The
tax will just add two dollars to the …rms marginal cost, such that mc = 2 + Q

The maximum satis…es,

22
24 2Qmt 2 Qmt = 0 , Qmt = .
3
50
Here demand is used to …nd the market price pmt = 3
mc+2
P

mc
24

DWL

CS
pmt =50/3
Tax Revenue
pmt -2=44/3

PS

Qmt =22/3 24
Q

1 22 22 22
DW Lt = 2 12 3 (24 3 3 ) = 21 78

Change in DWL: 4DW L = 21 78 = 16 = 5 87

22 44
T axRevenue = 2 =
3 3

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2 Problem 2 (Single Price Monopoly)
A monopolist faces the inverse demand P (Q) = 25 2Q and has a constant marginal cost
of 1 dollars per unit and a …xed cost of 10 dollars.

2.a Find the monopolies pro…t maximizing price,quantity and pro…t.

Answer: The monopoly quantity is determined by the solution to

P 0 (Qm )Qm + P (Qm ) mc = 0

25 4Qm 1 = 0)
24
Qm = =6
4
pm = 25 2 6 = 13
m
= (13 1) 6 10 = 62

2.b Calculate the consumer surplus, producers surplus and total surplus.

Answer: CS = 12 (P (0) pm ) Qm = 12 (25 13) 6 = 36

PS = m + F C = 62 + 10 = 72

T S = 36 + 72 = 108

2.c Calculate the Lerner Index.

Answer: The Lerner index is

pm mc 13 1 12
L= = = :
pm 13 13

2.d If the government could subsidize the monopolist per unit of output, then subsidy
would lead to the monopolist pricing e¢ ciently? How much would the total subsidy
be?

Answer: The monopolist marginal revenue with a per unit subsidy s is M R = P 0 (Q)Q +
P (Q) + s Q. Thus, the monopolist will choose the quantity that maximizes this

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 function. This quantity is determined by the di¤ erential equation below.

25 4Qs + sQs 1 = 0
24
, Qs = .
4 s

Now we need to …nd the s that maximizes total surplus. The easy way to do this is …nd
the e¢ cient quantity Q and …nd the subsidy that induces the monopolist to choose
Q . In this model the e¢ cient quantity is at price equals marginal cost. Hence,

25 2Q = 1
24
, Q = = 12.
2

The subsidy is determined by s such that Qs = Q .

24
= 12
4 s
2 = 4 s
, s=2

The total government subsidy would be T s = Qs s = 12 2 = 24.

2.e Would a monopolist ever operate on the elastic portion of the demand curve? (Set a
price such that such that the absolute value of demand elasticity j p j < 1). Explain
your answer. (Try to make a formal proof argument, i.e. Start this way: Suppose to
the contrary that at the monopoly price level j p j < 1. Then show a contradiction.)

Answer: There was slight typo on the question; It should have been written that you
contradict inelastic demand j p j 1 when marginal cost is positive. Here is a proof:

Suppose to the contrary that a monopolist operates on the inelastic portion of demand, i.e.
that a monopolists picks a price such that j p j 1. We will show a contradiction. We
start with the Lerner index. The relationship between the Lerner index and elasticity
was shown in class.
pm mc 1
L= =
pm j pj

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 Since, j p j 1 this implies that

pm mc 1
L = = 1
pm j pj
pm mc
, 1
pm
pm mc pm
mc 0 (1)

Thus, if mc > 0, (1) is contradicted.

You could have shown also derived the relationship between L and elasticity from the
monopolists …rst order condition. This is done below.

P 0 (Qm )Qm + P (Qm ) mc = 0

P (Qm ) mc = P 0 (Qm )Qm

Note that P (Qm ) = pm and divide both sides by the monopoly price pm ,

pm mc Qm
= P 0 (Qm )
pm pm
1
L = :
j pj

3 Problem 3 (Dominant Firm)

Suppose that market demand is D(p) = 80 2p. There is one dominant …rm and four
fringe …rms. The cost function for each fringe …rm is Cf (q) = 10q + q 2 =2. The dominant
…rm has cost function Cd (q) = 12q + 10.

3.a What is the supply curve the competitive fringe faces?

Answer: Step 1. To …nd supply we use the fact that price equals mc when mc> average
cost(ac) to …nd each fringe …rms inverse supply function.

dCf (q)
mcf = = 10 + q.
dq

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 Note that average cost is
q
acf = 10 + .
2
So mcf > acf as long as q > 0. Since price equals marginal cost, we have

pf = 10 + q.

Step 2. Next we invert to …nd supply and use the condition that q > 0

p = 10 + q
(
10 + p if qf > 0
, Sf (p) = :
0 if qf 0

Step 3. Aggregate to …nd fringe supply.

P4
SF (p) = f =1 Sf (p)
P4
= f =1 ( 10 + p)
= 4 Sf (p)
= 4 ( 10 + p)
(
40 + 4p if qf > 0
= .
0 if qf 0

3.b What is the residual demand left for the dominant …rm?

Answer: The residual demand is the demand minus the aggregate fringe supply.

Dd (p) = D(p) SF (p)

= (80 2p) ( 40 + 4p)
(
120 6p if qf 0
= :
80 2p if qf < 0

3.c Find the market price, and each …rm’s pro…t.

Answer: Two ways:

Method 1: Use standard demand.

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Assume qf > 0.

M Rd (p) = M Cd (p)
) 120 12p = 72
192
, p = = 16.
12

Since, p > 10 then qf > 0. The fringe produces a positive amount. Now we …nd qd
and qf .

qd = Dd (p )
= 120 6 16
= 120 96
= 24:

qf = Sf (p )
= 10 + 16
= 6:

Method 2: Assume qf > 0. Inverse demand

Dd (p) = 120 6p
qd
, Pd (qd ) = 20
6

The dominant …rm sets marginal revenue equal to marginal cost

M Rd (qd ) = M Cd (qd )
qd
, 20 = 12
3
qd
, =8
3
, qd = 24.

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 The market price is

24
Pd (qd ) = 20
6
= 16:

Accordingly, qf = 6:

Now we calculate the pro…ts-

Pro…t of Dominant Firm:

d = p qd 12qd 10
= (16 12) 24 10
= 4 24 10
= 46

Pro…t of Any Fringe Firm:

qf2
f = p qf 10qf
2
62
= (16 10) 6
2
= 36 18
= 18

3.d Suppose the total cost of the dominate …rm is instead Cd (q) = 10. Find the market
price, and each …rm’s pro…t.

Answer: Parts 3.a-c are the same as above. Thus, we look at the dominant …rms problem

Method 2: Assume qf 0. Inverse demand

Dd (p) = 120 6p
qd
, Pd (qd ) = 20
6

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 The dominant …rm sets marginal revenue equal to marginal cost

M Rd (qd ) = M Cd (qd )
qd
, 20 =0
3
qd
, = 20
3
, qd = 60.

The market price is

60
Pd (qd ) = 20
6
= 10:

The dominant …rms pro…t is

d = Pd (qd ) qd 10
= 10 60 10
= 590

Notice that at a price of 10 the fringe produces nothing. Hence, each fringe …rms pro…t
is zero.

4 Problem 4 *(Dynamic Monopoly: Capacities and Prices)*

(**This is a challenge problem. Do not attempt to complete this problem until
you have …nished the …rst three.***)

Suppose a monopolist hotel owner must choose size of her hotel and then a price for
di¤erent times of year. For parsimony lets assume the hotel owner makes her decision for
a single year. In this year there are two periods high demand (tourist season) and low
demand (o¤ season). The monopolist chooses one hotel size K which is an absolute limit
on the number of people she can serve. Building the hotel is expensive and the cost of this
is C(K). The marginal cost of production up to capacity is assumed to be zero. So for

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any given K the marginal cost of production of the hotel owner is zero for D(p) K and
in…nite for D(p) > K. For this problem we must be more careful how we de…ne demand.
The high demand period has demand function
(
18 ph 18 ph 0
Dh (ph ) = .
0 pl > 18

The low demand period has demand function

(
4 pl 4 pl 0
Dl (pl ) = .
0 pl > 4

The …rms pro…t function is:

= minfDl (pl ); Kg pl + minfDh (ph ); Kg ph C(K)

The monopolist …rst must choose the hotel size, then chooses its prices to maximize
the constrained pro…t. To solve this type of multiple stage problem, work backwards:

Step 1 For any …xed K …nd pel (K) and peh (K) that maximize .1 (Drawing pictures should
help you with this).

Step 2 Find K that maximizes

e = minfDl (e
pl (K)); Kg pel (K) + minfDh (e
ph (K)); Kg peh (K) C(K):

(Note this can be tricky since this function might not be concave. Graphing the
function should help your intuition.)

4.a Find the monopolists prices and capacity (K) when the cost of capacity is C(K) = 2K.

Answer: The prices are determined by,

( (
2 if K 2 9 if K 9
pel (K) = and peh (K) =
4 K if K 2 18 K if K 9
1
pel (K) and peh (K) are the price sollutions in terms of K.

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 In the picture below the e¤ect of the capacity constraint on monopoly pricing is
K1 K2 K3

18
ph(K1)

ph(K2)

4
pl(K1)
2 Dh
Dl

2 4 9
shown. 18

For the very large capacity K3 , prices are at the unconstrained monopoly levels. For the
medium capacity K2 , price is at the unconstrained monopoly level in the low demand
period, but higher in the high demand period. For the low capacity K1 , prices are
higher than unconstrained monopoly levels in both periods.

The optimal capacity and prices:

From the above monopoly price functions we know that if the monopoly capacity is greater
than 2 marginal change in revenue of the demand period is zero. Thus, we know that
the monopoly capacity choice is characterized by the following implicit equalities.

@ pel (K m ) m @ peh (K m ) m @C(K m )

(1) : K + pel (K m ) + K + peh (K m ) = 0 if K m < 2
@K m @K m @K
@ peh (K ) m @C(K )
(2) : K + peh (K m ) =0 if 9 > K m 2
@K @K

To …nd the maximum we must maximize piece-wise and if both maximum of (1)
K m1 < 2 and (2) is 9 > K m2 2, then we must compare pro…ts.

To solve for the K m we …rst check if (1) is true for any K m < 2

4 2K m + 18 2K m 2 = 0
20 4K m = 0
, Km = 5 > 2

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 Thus, it we must look for K m by solving (2)

18 2K m 2 = 0
Km = 8

The prices are determined by the pel (K m ) and peh (K m )

pel (8) = 2
peh (8) = 10:

4.b Find the monopolists prices and capacity (K) when the cost of capacity is C(K) =
12K.

Answer: Using the same process as above you will …nd the optimal capacity and prices:

18 2K m 12 = 0
Km = 3
pel (8) = 2
peh (8) = 15:

I intended to give a cost such that both periods would be capacity constrained. So let us
assume a marginal cost of 16 and go through the steps.

To solve for the K m we …rst check if (1) is true for any K m < 2

4 2K m + 18 2K m 16 =
m
6 4K = 0
3
, Km = <2
2

Check (2) :

18 2K 16 = 0
Km = 1 < 2

16
So, the maximum is at K m = 32 . The prices are

pel (3=2) = 4 1:5 = 2:5

peh (3=2) = 18 1:5 = 16:5:

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