P ROBLEM SET 4

1. A price-taking firm has short-run total costs given by C(q) = 100 + 2q + q 2 .

(i) Find the average avoidable cost and the marginal cost as a function of the output?
In the short run, fixed costs are sunk. So, the avoidable cost = 2q + q 2 . The average
dC(q)
avoidable cost is AAC(q) = 2 + q and the marginal cost is M C(q) = = 2 + 2q.
dq
(ii) Find its short-run supply curve and show it graphically.
Since the firm is a price taker for every price, p, the profit-maximizing quantity is
given by p = 2 + 2q =⇒ q = .5p − 1. To find the shut-down point, we need to find
dAAC(q)
AACmin . Note that = 1. This means that AAC(q) is minimum at q = 0 and
dq
AACmin = 2. Hence, the short-run supply curve is given by q = 0.5p − 1 for all p ≥ 2
and q = 0 for all p < 2.

2. Suppose a firm’s marginal cost is given by M C(q) = 10 + q and its average variable cost
q
is AV C(q) = 10 + (this is also the average avoidable costs in the short run). If the firm’s
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fixed costs are Rs 5000 and the market price is Rs 100, find the firm’s maximum profit. Will
it continue to operate in the short run?
The profit maximizing quantity is 100 = 10 + q =⇒ q = 90. The profit corresponding to
90
q = 90 is π = 100 × 90 − (10 + ) × 90 − 5000 = 9000 − 9950 = −950. If it shuts down then
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it has to still bear the fixed costs. So, the profit will be −5000. The maximum profit is −950.
Hence, it is better for the firm to operate in the short-run.

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3. John’s Lawn Moving Service is a small business that acts as a price taker (i.e., M R = P ).
The prevailing market price of lawn mowing is $20 per acre. John’s costs are given by total
cost = 0.1q 2 + 10q + 50, where q = the number of acres John chooses to cut a day.

(i) How many acres should John choose to cut in order to maximize profit?
To find the profit maximizing quantity, we set p = M C. The marginal cost is given by
M C(q) = 0.2q + 10. Hence, 20 = 0.2q + 10 =⇒ q = 50.

(ii) Calculate John’s maximum daily profit.

(iii) Graph these results.

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4. The production function for a firm in the business of calculator assembly is given by q = 2 l,
where q denotes finished calculator output and l denotes hours of labor input. The firm is a
price taker both for calculators (which sell for P ) and for workers (which can be hired at a
wage rate of w per hour).

(i) What is the total cost function for this firm?

(ii) What is the profit function for this firm?

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 (iii) What is the supply function for assembled calculators q(P, w)?
For any given P and w, the firm will supply a quantity such that its profit is maximized.
So to find the firm’s supply function, we maximize the firm’s profit.
dπ(q) P P
= 0 =⇒ P = 2wq =⇒ q = . Hence, the supply function is q(P, w) = .
dq 2w 2w
(iv) What is this firm’s demand for labor function l(P, w)?
P 2 P
The firm’s demand for labor function is l(P, w) = (0.5 × ) = .25( )2 .
2w w

5. Consider a city that has a number of hot dogs stands operating throughout the downtown
area. Suppose that each vendor has a marginal cost of $1.50 per hot dog sold, and no fixed
cost. Suppose the maximum number of hot dogs any one vendor can sell in a day is 100.

(i) If the price of a hot dog is $2, how may hot dogs does each vendor want to sell?
As there is no fixed cost, AC=MC=1.5. The profit function is given by π(q) = 2q −1.5q =
dπ(q)
0.5q. Note that = 0.5. This means profit is increasing in q. Hence, each vendor
dq
will sell as many hot dogs as possible. So, each vendor will sell q = 100 hot dogs.

(ii) If the industry is perfectly competitive will the price remain at $2 for a hot dog? If not,
what will the price be?
If the industry is perfectly competitive, then at $2 price, there is a profit of $50. This
means new vendors will enter the market. The entry of firms will only stop when
profit is 0. This will happen when the price = $1.5.

(iii) If each vendor sells exactly 100 hot dogs a day and the demand for hot dogs from
vendors in the city is Q = 4400 − 1200P , how many vendors are there?
At P = $2, quantity demanded is Q = 4400 − 1200 × 2 = 2000. Hence, there are 200
vendors. In the long run, P = $1.5, quantity demand is Q = 4400 − 1200 × 1.5 = 2600.
So, there should be 26 vendors in the long run.

(iv) Suppose the city decides to regulate hot dog vendors by issuing permits. If the city
issues only 20 permits, and if each vendor continues to sell 100 hot dogs a day, what
price will a hot dog sell for?
If there are only 20 permits, then there will be only 20 vendors. So, the quantity
supplied is 2000. At equilibrium quantity demanded=quantity supplied. Hence,
4400 − 1200P = 2000 =⇒ P = $2.

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(v) Suppose the city decided to sell the permits. What is the highest price a vendor would
pay for a permit?
If there are 20 permits, then the profit of each firm with a permit is $50. So, the highest
price a vendor would pay for a permit is $50.