EC 370 Department of Economics

Intermediate Microeconomics II Wilfrid Laurier University

Instructor: Sharif F. Khan Summer 2008

Suggested Solutions to Assignment 1 (OPTIONAL)

Total Marks: 50

Part A True/ False/ Uncertain Questions

Explain why the following statement is True, False, or Uncertain according to economic
principles. Use diagrams and / or numerical examples where appropriate. Unsupported
answers will receive no marks. It is the explanation that is important. Each question is
worth 10 marks.

A1.

A monopoly produces a Pareto inefficient level of output at the equilibrium.

[Diagrams Required]

Uncertain

Without perfect price discrimination, a monopoly produces a Pareto inefficient level of

output at the equilibrium. See Section 24.4 and Figure 24.4 of Varian’s textbook (7th ed.)
for a graphical explanation.

With perfect price discrimination or first degree price discrimination, a monopoly

produces a Pareto efficient level of output at the equilibrium. See Section 25.2, Figure
25.1 and Figure 25.2 of Varian’s textbook (7th ed.) for a graphical explanation.

A2.

In a location model of product differentiation with only two firms, the equilibrium
location pattern is Pareto efficient. [Diagrams Required]

False

In a location model of product differentiation with only two firms, the equilibrium
location pattern is Pareto inefficient. See Section 25.8 and Figure 25.7 of Varian’s
textbook (7th ed.) for a graphical explanation. Alternatively, see pages 62 to 76 of Lecture
Slides for Chapter 25, which are available on the course website, for a graphical
explanation.

Page 1 of 8 Pages
Part B Problem Solving Questions
Read each part of the question very carefully. Show all the steps of your calculations to
get full marks.

B1. [15 Marks]

The monopolist faces a demand curve given by D( p ) = 100 − p . Its total cost
function is c( y ) = 700 + 20 y.

(a) Calculate the monopoly output level, the monopoly price, and the profits
of the firm. Calculate the deadweight loss from this monopoly. [4 marks]

The given market demand function, D( p ) = 100 − p , can be also be written as,
p( y ) = 100 − y. (1)

Total revenue function of the monopolist: TR ( y ) = p ( y ) ∗ y = (100 − y ) ∗ y = 100 y − y 2 .

dTR ( y )
Marginal revenue function of the monopolist: MR ≡ = 100 − 2 y.
dy
dc( y )
Marginal cost function of the monopolist: MC ≡ = 20 .
dy

Profit maximization requires that the monopolist produces where MR = MC. Solving for
the profit maximizing quantity:

MR = MC
⇒ 100 − 2 y = 20
⇒ 80 = 2 y
⇒ y = 40.

Monopoly price is determined by the demand curve. So, substituting y = 40 into the
demand function, equation (1), we get:

p( y ) = 100 − y = 100 − 40 = 60.

So, the equilibrium levels of output and price of the monopolist are 40 and 60,
respectively.

Page 2 of 8 Pages
The monopolist’s profits at the equilibrium = Total revenue – Total cost
= p ( y ) ∗ y − (700 + 20 y )
= 60 ∗ 40 − 700 − 20 ∗ 40
= 2400 − 700 − 800
= 900.

To find the deadweight loss we have to first find the competitive equilibrium price and
output by setting price equals to marginal cost.
p( y ) = MC
⇒ 100 − y = 20
⇒ y = 80

So, the competitive equilibrium price and output are 20 and 80, respectively. The
deadweight loss due to the monopoly is given by the area of the triangle ∆bfd in
Figure B1.

Deadweight loss = area of ∆bfd

1
= (80 − 40 )(60 − 20 )
2
1
= (40)(40)
2
= 800.

So, the deadweight loss due to the monopoly is 800.

(b) Draw a diagram to illustrate your answers to part (a). [2 marks]

Point “b” in Figure B1 shows the monopoly equilibrium price and quantity combination.
The areas of the deadweight loss and the profit are identified clearly in Figure B1.

(c) Explain why this market might be considered to be a “natural”

monopoly. [2 marks]

The market can be considered to be a natural monopoly because average costs are
declining over the whole range of the market. The average cost function of the
monopolist is:

c( y ) 700 + 20 y 700
AC ( y ) ≡ = = + 20.
y y y

Page 3 of 8 Pages
The ever-decreasing average cost function shows that it is cheaper for one firm to serve
this market than it would be for more than one firm to do so.

(d) If the government regulates the monopolist by imposing average cost

pricing, what will be the monopolist’s price and quantity? Draw a
diagram to illustrate your answers. Explain the problem that exists with
this average cost pricing. [4 marks]

The monopolist’s price and quantity with average cost pricing can be calculated by
setting price equals to average cost.

p ( y ) = AC
700
⇒ 100 − y = + 20
y
700 + 20 y
⇒ 100 − y =
y
⇒ 100 y − y 2 = 700 + 20 y
⇒ 80 y − y 2 − 700 = 0
⇒ y 2 − 80 y + 700 = 0
⇒ y 2 − 70 y − 10 y + 700 = 0
⇒ y ( y − 70 ) − 10( y − 70 ) = 0
⇒ ( y − 70 )( y − 10 ) = 0

So, either y − 70 = 0 or y − 10 = 0. Therefore, y = 70 or y = 10. However, y = 10 is not a

reasonable value of the monopolist’s quantity with average cost pricing because without
government regulations the monopolist will choose to produce 40 units of output. So, the
reasonable value of the monopolist’s quantity with average cost pricing is y = 70 , which
close to the competitive equilibrium quantity.

The monopolist’s price with average cost pricing is:

p( y ) = 100 − y = 100 − 70 = 30.

So, the monopolist’s price and quantity with average cost pricing are 30 and 70,
respectively. This is shown as point “c” in Figure B1.

The problem with this average cost pricing equilibrium is that it is still not efficient.
Some deadweight loss remains. It is shown in Figure B1 as area of the triangle ∆cde.

Page 4 of 8 Pages
Deadweight loss with average cost pricing = area of ∆cde
1
= (80 − 70 )(30 − 20 )
2
1
= (10)(10)
2
= 50.

So, the deadweight loss due to the monopoly with average cost pricing is 50.

(e) Illustrate and explain the problem that emerges when the government
regulates the monopolist by imposing marginal cost pricing. What level of
subsidy should the government provide to the monopolist if the
government wants to overcome this problem? [3 marks]

The monopolist’s price and quantity with marginal cost pricing can be calculated by
setting price equals to marginal cost.

p ( y ) = MC
⇒ 100 − y = 20
⇒ y = 80

So, the monopolist’s price and quantity with marginal cost pricing are 20 and 80,
respectively. This price and quantity combination, which is shown as point “d” in
Figure B1, is same as the price and quantity combination at the competitive equilibrium.
This solution is Pareto efficient. But at this solution price is less than average cost, which
is clearly evident from Figure B1. This means the monopolist is making a loss and would
require a subsidy to stay in business.

The monopolist’s profits with marginal cost pricing = Total revenue – Total costs
= p ( y ) ∗ y − (700 + 20 y )
= (100 − y ) y − 700 − 20 y
= (100 − 80 )80 − 700 − 20(80)
= −700

Thus, the government should provide a subsidy of 700 to the monopolist.

Page 5 of 8 Pages
B2. [15 Marks]

Suppose the market demand can be separated into two distinct markets, where
p1 = 80 − 5 y1 , p 2 = 180 − 20 y 2 , and the common total cost function is
C = 50 + 40( y1 + y 2 ).

(a) Determine the equilibrium price and quantity in each market and the
overall profit that result from the actions of a price discriminating
monopolist. Draw a diagram to illustrate your answers. [ 8 marks]

In this scenario the monopolist can exercise third-degree price discrimination. We can
find the third-degree price discriminating price and quantity by setting marginal revenue
in each market equals to marginal cost in each market. That is, the optimal solution must
have
MR1 ( y1 ) = MC1 ( y1 + y 2 )
MR2 ( y 2 ) = MC 2 ( y1 + y 2 )

Total revenue function in market 1: TR1 ( y1 ) = p1 ( y1 ) y1 = (80 − 5 y 1 ) y1 = 80 y1 − 5 y12

dTR1 ( y1 )
Marginal revenue function in market 1: MR1 ( y1 ) ≡ = 80 − 10 y1
dy1
Common total cost function: C ( y1 + y 2 ) = 50 + 40( y1 + y 2 )
dC ( y1 + y 2 )
Marginal cost function in market 1: MC1 ( y1 + y 2 ) ≡ = 40
dy1
Total revenue function in market 2:
TR2 ( y 2 ) = p 2 ( y 2 ) y 2 = (180 − 20 y 2 ) y 2 = 180 y 2 − 20 y 22
dTR2 ( y 2 )
Marginal revenue function in market 2: MR2 ( y 2 ) ≡ = 180 − 40 y 2
dy 2
dC ( y1 + y 2 )
Marginal cost function in market 2: MC 2 ( y1 + y 2 ) ≡ = 40
dy 2

At the equilibrium in market 1,

MR1 ( y1 ) = MC1 ( y1 + y 2 )
⇒ 80 − 10 y1 = 40
⇒ 10 y1 = 40
⇒ y1 = 4

The equilibrium price in market 1: p1 ( y1 ) = 80 − 5 y1 = 80 − 5(4) = 80 − 20 = 60

So, the equilibrium price and quantity in market 1 are 60 and 4, respectively.

Page 6 of 8 Pages
At the equilibrium in market 2,

MR2 ( y 2 ) = MC 2 ( y1 + y 2 )
⇒ 180 − 40 y 2 = 40
⇒ 40 y 2 = 140
⇒ y 2 = 3 .5

The equilibrium price in market 2: p 2 ( y 2 ) = 180 − 20 y 2 = 180 − 20(3.5) = 180 − 70 = 110

So, the equilibrium price and quantity in market 2 are 110 and 3.5, respectively.

The overall profit at the equilibrium: π = p( y1 ) y1 + p( y 2 ) y 2 − (50 + 40( y1 + y 2 ))

= 60 ∗ 4 + 110 * 3.5 − (50 + 40(4 + 3.5))
= 240 + 385 − 350
= 275

I have illustrated the results in Figure B2. Point “a’’ in Panel A of Figure B2 shows the
equilibrium price and quantity combination in market 1 and Point “b’’ in Panel B of
Figure B2 shows the equilibrium price and quantity combination in market 2. I have
clearly identified the areas of profits in each market in Figure B2.

(b) Determine the price elasticity of demand in each market, evaluated at the
equilibrium price and quantity. [ 3 marks]

The demand function in market 1: p1 = 80 − 5 y1

⇒ 5 y1 = 80 − p1
1
⇒ y1 = 16 −   p1
5
dy1 1
So, =− .
dp1 5

The price elasticity of demand at the equilibrium in market 1:

dy1
y dy p  1  60 
ε y ,p = 1 = 1 1 =  −   = −3
1 1
dp1 dp1 y1  5  4 
p1

Page 7 of 8 Pages
The demand function in market 2: p 2 = 180 − 20 y 2
⇒ 20 y 2 = 180 − p 2
 1 
⇒ y 2 = 9 −   p2
 20 
dy 2 1
So, =− .
dp 2 20

The price elasticity of demand at the equilibrium in market 2:

dy 2
y dy p  1  110 
εy 2 , p2
= 2 = 2 2 =  −   = −1.57
dp 2 dp 2 y 2  20  3.5 
p2

(c) What is the relationship between the price elasticity of demand in each
market and the price prevailing in each market? [ 2 marks]

Market 2 is relatively less elastic than market 1. The equilibrium price is higher in market
2 than in market 1. Therefore, we can conclude that there is a negative relationship
between the price elasticity of demand in each market and the price prevailing in each
market.

(d) Suppose now that the government imposes a 10% tax on the overall profit
of the monopolist. Explain what will be the monopolist’s equilibrium
price and quantity in each market under this form of taxation? [ 2 marks]

The maximization problem the monopolist faces with 10% tax on the overall
profit, π ( y1 , y2 ) , is

max (1 − 0.10)π ( y1 , y 2 ) = (1 − 0.10 )[ p( y1 ) y1 + p( y 2 ) y 2 − (50 + 40( y1 + y 2 ))] .

y1 , y 2

But the value of y1 and y 2 that maximize π ( y1 , y2 ) will also maximize (1 − 0.10)π ( y1 , y2 ) .
Thus a pure profits tax will have no effect on a monopolist’s choice of output. This
means that the monopolist’s equilibrium price and quantity in each market under 10% tax
on the overall profit will be same as the ones we found in part (a).

Page 8 of 8 Pages