MGEB02: Price Theory

Winter 2023
Test-2 (Solutions)

Instructor A. Mazaheri
Instructions: This is a closed book examination. You are permitted to bring a non-programmable calculator.
Show all your work otherwise you will not get full credit.

Make sure you allocate time appropriately.

You have 2 hours.

Good Luck!
Last
Name:

First
Name:

ID

FOR MARKERS ONLY:

Q1 Q2 Q3 Q4 Q5 Total

Marks Earned

Maximum
Marks 41 20 15 10 10 95
Possible

The University of Toronto's Code of Behaviour on Academic Matters applies to all

University of Toronto Scarborough students. The Code prohibits all forms of academic
dishonesty including, but not limited to, cheating, plagiarism, and the use of unauthorized
aids. Students violating the Code may be subject to penalties up to and including suspension
or expulsion from the University.

Page 1 of 18
 Answer all following 5 questions:

Question-1 [41 Points] Answer the following Short Questions:

a) [5 Points] Based on the following figure comment on returns to scale and marginal return of labor.
Make sure to explain your answer:

1
Q= 50 Q2=80
Q3=100

1 2 3

Solution:

Returns to scale: Constant Returns to Scale because doubling the input will more than double the output.

Marginal return of Labor: MPL is diminishing because if we keep capital constant (say at 1). Initial MPL
𝜟𝒒 𝟖𝟎−𝟓𝟎 𝜟𝒒 𝟏𝟎𝟎−𝟖𝟎
is approximately (𝜟𝑳 = 𝟐−𝟏 = 𝟑𝟎) falling to (𝜟𝑳 = 𝟑−𝟐 = 𝟐𝟎)

Alternatively if we keep K=1 and we add to the labour, the slope of the isoquant declines implying that as
more labour is employed, more labour is needed to substitute for the same amount of capital => therefore
the MPL is declining.

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b) [5 Points] A firmʹs total cost function is given by the equation: TC = 1200 + 70Q + 40Q2. Find this firm
output elasticity of cost and use it to identify its returns to scale.

Solution:

1200
𝐴𝐶 = + 70 + 40𝑞
𝑞
𝑀𝐶 = 70 + 80𝑞
𝑀𝐶 70 + 80𝑞
𝐸𝑐 = =
𝐴𝐶 1200 + 70 + 40𝑞
𝑞
1200
𝐸𝑐 = 1 => 40𝑞 = => 𝑞 = 5.47(𝐶𝑅𝑆)
𝑞
𝑞 > 5.47, 𝐸𝐶 > 1(𝐷𝑅𝑆)
𝑞 < 5.47, 𝐸𝑐 < 1(𝐼𝑅𝑆)

Page 3 of 18
c) (8 Points) Suppose we have the following production function q = min {12L, 40K}. Prices for K and L
are 80 and 24 respectively. First find and graph the equation for the long run cost function. Then find and
graph the equation for the short run cost function for a fixed capital of 3.

Solution:

Long Run (5 Points):

𝑞
=> 12𝐿 = 𝑞 => 𝐿 =
12
𝑞 LRTC
=> 40𝐾 = 𝑞 => 𝐾 =
40
𝐿𝑅𝑇𝐶 = 2𝑞 + 2𝑞 = 4𝑞

q
Short Run (3 Points):

If K = 10, the only efficient production is Q = 40K = 120, which will need Q = 120 = 12L => L = 10 labor.
This efficient production will cost (TC = 24*10 + 80*3 = 480). There will be no other efficient production
so cost function will not be defined.

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d) [5 Points] The short run production curve for a firm is shown in the following figure. On the lower
diagram, graphically derive the APL and the MPL.

q
q

Page 5 of 18
e) [6 Points] In a perfectly competitive market, there are 100 firm split equally between the
following short run cost functions:

𝐶1 (𝑞1 ) = 24q21 + 30q1 + 1000

𝐶2 (𝑞2 ) = 8q22 + 60q 2 + 1000

Find the total short run market supply curve and graph it.

Solution:

𝐶1 (𝑞1 ) = 24q21 + 30q1 + 1000

SRMC = 48q1 + 30, 𝑆𝑅𝐴𝑉𝐶 = 24𝑞1 + 30
𝑆𝑅𝑀𝐶 = 𝑆𝑅𝐴𝑉𝐶(𝑞1 = 0, 𝑝 = 30 − shoutdown point)
𝑃 = 48q1 + 30(if P ≥ 30)
𝐶2 (𝑞2 ) = 8q22 + 60q 2 + 1000
SRMC = 16𝑞2 + 60, 𝑆𝑅𝐴𝑉𝐶 = 8𝑞2 + 60
𝑆𝑅𝑀𝐶 = 𝑆𝑅𝐴𝑉𝐶(𝑞2 = 0, 𝑝 = 0 − shoutdown point)
𝑃 = 16𝑞2 + 60(if P ≥ 60)

Market supply:
𝑃 30
𝑞1 = 48 − 48 (𝑖𝑓𝑃 ≥ 24)
𝑃 60
𝑞2 = − (𝑖𝑓𝑃(≥ 80)
16 16
𝑀𝑎𝑟𝑘𝑒𝑡 𝑑𝑒𝑚𝑎𝑛𝑑
𝑄=0 (𝑃 < 30)
𝑃 30
𝑄 = 50( − ) = 1.04P-3.125 (30 < 𝑃 < 60)
48 48
𝑃 30 𝑃 60
𝑄 = 50( − ) + 50( − ) = 4.17P-218.75 (𝑃 ≥ 60)
48 48 16 16

60

30

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f) [6 Points] The long-run cost function of a firm in a perfectly competitive market is given by
C(q) = 800q-12q2+0.2q3, where q is firm output. Market demand is given by

Qd = 10,000-2P

Find the long-run equilibrium values of output per firm, price, & the number of firms in the market.

Solution:

In long run equilibrium assuming identical firms we have:

1) P = MC
2) AC = MC
3) Qd = Qs = nq

P = MC = 800 – 24Q + 0.6q2

AC = 800 – 12Q + 0.2q2
1), 2) => AC = MC => q = 30 => p = 620
3) Qd = 10,000-2*620 = 8760 = n*30 => n = 292

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g) [6 Points] A production is characterized by q = (L1/2 + K1/2)2. Suppose Let w = 12 and r = 2.
Suppose in the short run capital is fixed at 36 units. What would be producer surplus if the market
price is 6?

Solution:

L = [q0.5 - 6]2
𝟐
=> 𝑻𝑪 = 𝟏𝟐[𝒒𝟎.𝟓 − 𝟔] + 𝟕𝟐
𝟔
𝑷 = 𝑴𝑪 = 𝟏𝟐 [𝟏 − 𝒒𝟎.𝟓 ]
𝟐
𝑽𝑪 = 𝟏𝟐[𝒒𝟎.𝟓 − 𝟔]

We know that in the short run fixed cost is sunk therefore:

P = 6 > q = 144
VC = 432
PS = TR - VC = 6×144 – 432 = 432

Page 8 of 18
 Question-2 [20 Points] A consumer has the following utility function U = ln( 2 I ) where I is the income.
She works for a store and earns a regular income of $4,000 per month. However, there is a chance that she
gets fired and in that case she has to go on unemployment insurance, which only pays $2,000 a month. The
probability of getting fired is 20%.

a) [5 Points] Depict the utility of this consumer on the following diagram. Calculate the expected utility
for this consumer and identify it on the graph. Demonstrate that his utility of expected is higher than his
expected utility. (round to three digits)

U 8.882

8.987

8.849
8.294

2000 CE 3600 4000

E ( I ) = 0.8  4000 + 0.2  2000 = 3600

U ( E ( I )) = ln( 2  3600) = 8.882
EU = 0.8  ln(8000) + 0.2  ln( 4000) = 8.849
U ( E ( I )) = 8.882  E (U ) = 8.849

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b) [5 Points] An insurance company is offering full insurance where in the case of lost job she will be paid
$2,000 – to cover all her loses. What is the maximum that the consumer will pay for the insurance?

Solution:

EU = 8.849
8.849 = ln( 2CE ) = CE = (6964.405) / 2 = 3482.202
RP = E ( I ) − CE = 4000 − 3482.202 = 517.6842

Note: In the case of full insurance $4,000 will be the income.

c) [5 Points] Now suppose that the insurance company is offering a partial insurance of $1,000 (in the case
of lost job $1,000 will be paid to the consumer) at a premium of $150. Would the consumer insure herself?

Solution:

EU with = 0.8  ln[ 2  4000 − 150)] + 0.2  ln[ 2  (2000 + 1000 − 150)] = 8.889

EU without = 8.849
EU with  EU without

Better off with the insurance.

=> Will take the insurance

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d) [5 Points] So far we have assumed that the probability of losing the job is 20%. Now suppose that is not
necessarily the case. What would be the maximum probability such that she is indifferent between insuring
and not insuring herself if she is offered the insurance as described in part (c).

Solution:

EU with = (1 − p )  ln[ 2(4000 − 150)] + p  ln[ 2(2000 + 1000 − 150)] = 8.949 − 0.301 p

EU without = (1 − p )  ln(8000) + p  ln( 4000) = 7.6 − 7.6 p + 6.91 p = 8.987 − 0.693 p

EU with = EU without
8.949 − 0.301 p = 8.987 − 0.693 p
p  0.0969

Page 11 of 18
Question-3 [15 Points] Suppose a high tech company's production function is given by:

q = 8LK − K 2 − L2

where q represents the weekly quantity of medicine produced and K and L are weekly capital and labor
inputs, respectively.

a) [5 Points] Suppose that K = 10: graph the average productivity of labor (APL). At what level of labor
does this average productivity reach its maximum? What is the level of output at this point?

b) [5 Points] Continuing to assume that K = 10, graph the MPL curve on the same figure. At what level of
labor input does MPL = 0? What is the maximum output that can be produced with K = 10?

c) [5 Points] Ignore parts (a) and (b). Find MRTS. Based on MRTS identify areas where the production
function is efficient?

Solution:

a)

K2 100
APL = 8 K − − L = 80 − −L
L L
MPL = K − 2 L = 80 − 2 L
APL = MPL
100
80 − − L = 80 − 2 L
L
L = 10, q = 600

b)

MPL = 80 − 2 L = 0 = L = 40
Maxoutput : MPL = 0 = L = 40, q = 8 * 40 *10 − 102 − 402 = 1500

L=10 L=40

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c)

L = 8K − 2 L
MP
MRTS =
K 8L − 2 K
MP

As long as MRTS is positive it exhibits diminishing returns to inputs: Keeping K constant if L

increases, MPL declines.

MRTS is positive if:

L
1)8 K − 2 L  0 = K 
4
2)8 L − 2 K  0 = K  4 L

MRTS is positive if L/4< K<4L.

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Question-4 [10 Points] A firm faces the following production function:
0.5 0.5
q = 5 (K-2) L

a) [5 Points] Find the expression for short run total cost, short run variable cost, and short run marginal
cost. Assume that the rental cost of capital is 10 and the wage is 2 and that in the short run, capital is fixed
at 6.
b) [5 Points] Find the long run cost function. Draw the firm’s expansion path.

Solution:

a)

K =6
q = 5( K − 2)0.5 L0.5
q
L0.5 =
10
q2
= L =
100
q2 q2
SRTC = wL + rK = 2( ) + 60 = + 60
100 50
q2
SRVC =
50
q
SRMC =
25

Page 14 of 18
b)

Solution:

2.5( K − 2) 0.5 L−0.5 K − 2 w 2

MRTS = = = =
2.5( K − 2) −0.5 L0.5 L r 10
10( K − 2) = 2 L = K = 2 + .2 L
q = (0.2 L) 0.5 L0.5 = q = 2.236 L
1
= L = q
2.236
0.2
= K = 2 + q
2.236
1 0.2
TC longterm = wL + rK = 2( q ) + 10(2 + q ) = 20 + 1.789q
2.236 2.236
20
LRAC = + 1.789
q
LRMC = 1.789

K=2+0.2L

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Question-5 [13 Points]: Suppose you are given the following information about a particular
industry:

𝑄 𝐷 = 6000 − 50𝑃
𝑄 𝑆 = 1200𝑃
𝑞2
𝐶(𝑞) = 222 +
100
2𝑞
𝑀𝐶(𝑞) =
100

Where the first two equations represent industry demand and supply and the next two stand for a
typical firm cost structure. Assume that all firms are identical, and that the market is
characterized by perfect competition.

a) (5 Points) 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?
b) (4 Points) 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.
c) (4 Points) 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.

Solution:

a)
Q D = Q S = P = 4.8, Q = 5,760
2q
MC = P = 4.8 = = q = 240
100
2402
 = pq − TC = 4.8  240 − (222 + ) = 354
100

Since profit is > 0 firms will have incentive to enter. As a result, the market quantity will
increase and the market price will fall.

b) The minimum price can be found by equating the marginal cost with the average cost:

2q
MC =
100
222 q
AC = +
q 100
2q 222 q
MC = AC = = +
100 q 100
2  149
q  149 = P = MC = = 2.89
100

Page 16 of 18
The firm will not sell for any price below 2.89. The long-run equilibrium price is therefore $2.89, and
at a price of $2.89, each firm’s economic profit equals zero because P = AC.

c)
2q
MC =
100
q
AVC =
100
MC = AVC = q = 0 = P = 0

The firm will sell for any positive price, because at any positive price, marginal cost is above average variable cost
(MC = 2q/100 > AVC = q/100). Profit is negative if price is below minimum average cost, or as long as price is below
$2.89. Profit is zero if price is exactly $2.89, and profit is positive if price is greater than $2.89.

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