EF3442 – Homework 2

Not For Distribution Beyond the Class

Yunan Li
March 5, 2021

This homework is designed to provide practice in determining cost functions, returns to scale, com-
puting elasticities and computing monopoly profit maximizing prices. It also serves as a bridge to
getting you to use what you need to know to analyze a particular economic situation.

Two questions from this homework will be selected at random and graded for a total of 10 points.
Again, very little partial credit, so, please check your work. I encourage the use of Wolfram
Alpha or similar software to verify your calculations.

Submissions must follow the following format: the answer to be clearly displayed first, demar-
cated, followed by a justification written in clear, concise English. Mangled telegrams and streams
of consciousness should be avoided, variables and functions should be defined. Marks are deducted
for submissions that don’t follow this format, are hard to read or incomprehensible.

Question 1
A monopolist sells Soma at the same price into two different markets. The demand for Soma in
market #1 is denoted D1 (p) = 30 − 2p where p is the unit price. The demand for Soma in market
#2 is given by D2 (p) = 80 − 3p. Assume the monopolist’s cost function is C(q) = cq where q
represents the quantity produced.

1. If c = 2, what is the profit maximizing price for the monopolist to charge?

2. What is the elasticity of total demand at the price computed in part (1)?

3. Now let c = 0, that is, assume the monopolist faces zero production costs. What is the
optimal price for the monopolist to charge now?

4. What is the elasticity of demand at the price computed in part (3)?

5. If c = 1.5 compute the optimal price for the monopolist to charge using the markup formula.

1
Solution:
3 points total.

1.5 points for part 1. If they do not consider both cases, then, award 1 point
only for computing profit maximizing price wrt to total demand.

0.25 point for part 2, no partial credit.

0.5 point for part 3. If they do not consider both cases, then, award 0.25 point
only for computing profit maximizing price wrt to total demand.

0.25 point for part 4, no partial credit.

0.5 point for part 5, no partial credit.
1. Answer: p∗ = 12

Justification: The problem of the firm is to maximize profits by choosing the optimal
price p∗ . Let DT (p) denote the total demand in both markets. Profits Π(p) are given by
Π(p) = pDT (p) − cDT (p). Now, we need to evaluate two scenarios:

Scenario #1: p ∈ [0, 15], and DT (p) = D1 (p) + D2 (p) = 110 − 5p.

Scenario #2: p ∈ (15, 80/3], and DT (p) = D2 (p) = 80 − 3p. (Note that market #1
has no demand if p > 15.)

In scenario #1, Π(p) = (p − 2)(110 − 5p) and the FOC is 110 − 10p + 10 = 0 which yields
p1 = 12 ∈ [0, 15]. Notice that SOC is negative everywhere so this is indeed a maximum.
Profit is Π(12) = (12 − 2)(110 − 5 × 12) = 500.

In scenario #2, Π(p) = (p − 2)(80 − 3p) and the FOC is 80 − 6p + 6 = 0 which yields
p2 = 86
6
= 43
3
< 15, so there is no critical point satisfying the constraints on p. However,
the derivative of profit is negative for p ∈ (15, 80/3]. Therefore, profit in this scenario is
maximized by setting p to its lowest allowed value, i.e., p = 15. We get that Π(15) = 455.

Comparing the profit in each scenario, we find that he optimal solution is to sell to
both markets at price p∗ = p1 = 12.

2. Answer: e(p∗ ) = 1.2

∗
Justification: The elasticity of demand e(p∗ ) = −[ DTp(p∗ ) ]D0 (p∗ ) = 12
110−5×12
× 5 = 1.2

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3. Answer: p∗ = 11

Justification: The problem of the firm is to maximize profits by choosing the optimal
price p∗ . Profits Π(p) are given by Π(p) = pDT (p) − cDT (p). Now, we need to evaluate
two scenarios:

Scenario #1: p ∈ [0, 15], and DT (p) = 110 − 5p

Scenario #2: p ∈ (15, 80/3], and DT (p) = 80 − 3p.

In scenario #1, Π(p) = (p − 0)(110 − 5p) and the FOC is 110 − 10p = 0 which yields
p1 = 11 ∈ [0, 15]. Notice that SOC is negative everywhere so this is indeed a maximum.
Profit is Π(11) = (11 − 0)(110 − 5 × 11) = 605.

In scenario #2, Π(p) = (p − 0)(80 − 3p) and the FOC is 80 − 6p = 0 which yields
p2 = 80
6
= 40
3
< 15, so there is no critical point satisfying the constraints on p. However,
the derivative of profit is negative for p ∈ (15, 80/3]. Therefore, profit in this scenario is
maximized by setting p to its lowest allowed value, i.e., p = 15. We get that Π(15) = 525.

Comparing the profit in each scenario, we find that he optimal solution is to sell to
both markets at price p∗ = p1 = 11.

4. Answer: e(p∗ ) = 1
∗
Justification: The elasticity of demand e(p∗ ) = −[ DTp(p∗ ) ]D0 (p∗ ) = 11
110−5×11
×5=1

5. Answer: p∗ = 11.75
Justification: As 1.5 ∈ [0, 2] and the optimal solution is to serve both markets when
either c = 2 or c = 0 (refer to answer 1 and 3), the optimal solution is also to serve both
market when c = 1.5. So, DT (p) = 110 − 5p.
p∗ −c 1 1
According to the markup formula p∗
= e(p∗ )
= −[ D p∗ 0 ∗
,
∗ ]D (p )
T (p )
p∗ −1.5 1 110−5p∗ 22−p∗
we have p∗
= p∗
×5
= 5p∗
= p∗
.
110−5p∗
So, p∗ − 1.5 = 22 − p∗ . We get p = 11.75. ∗

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Question 2
The production of Soma requires two inputs, called carisoprodol and alginic acid. If x units of
carisoprodol are combined with y units of alginic acid, the total output of Soma is f (x, y) =
x1/4 y 3/4 . Suppose a unit of carisoprodol costs $1 and a unit of alginic acid costs $3. The demand
for Soma as a function of its unit price p, is 100 − p.
1. Find the minimum cost combination of carisoprodol and alginic acid to produce q units of
Soma.
2. What kind of returns to scale does the Soma production technology exhibit?
3. Suppose Soma is sold by a monopolist. What volume of Soma should it produce to maximize
profit?
4. What combination of carisoprodol and alginic acid should be purchased to maximize profit?

Solution:

1. Answer: The minimum cost combination is q units of carisoprodol and q units of alginic
acid.

Justification: The minimization problem that defines C(q).

C(q) = min x + 3y
x,y

s.t. x1/4 y 3/4 = q

x ≥ 0, y ≥ 0

This can be solved with either the substitution method, or the Lagrange method:

Substitution Method

Using the constraint, solve for y in terms of x.

x1/4 y 3/4 = q

=⇒ y = q 4/3 x−1/3
Substituting this into the objective function yields a minimization problem that is un-
constrained except for non-negativity:

min x + 3q 4/3 x−1/3

x≥0

Taking the derivative with respect to x yields the first order condition:

1 − q 4/3 x−4/3 = 0 ⇒ x∗ = q ⇒ y ∗ = q

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The second order condition is verified by taking another derivative with respect to x and
verifying that it is positive.
4 4/3 −7/3 4 4/3 −7/3
q x = q q >0
3 3
So we have found a global minimum.
Lagrange Method

The Lagrangian is:

L(x, y, λ) = x + 3y + λ(q − x1/4 y 3/4 )

The first order conditions are:

∂L 1
= 0 =⇒ 1 − λx−3/4 y 3/4 = 0
∂x 4
=⇒ λx−3/4 y 3/4 = 4
∂L 3
= 0 =⇒ 3 − λx1/4 y −1/4 = 0
∂y 4
1/4 −1/4
=⇒ λx y =4
∂L
= 0 =⇒ q − x1/4 y 3/4 = 0
∂λ
Taking the ratio of the first two equations yields:
y
= 1 =⇒ y = x
x
Substituting this into the constraint yields:

x1/4 x3/4 = q ⇒ x∗ = q ⇒ y ∗ = q ⇒ λ = 4

To check the SOCs, form the bordered Hessian matrix:

− 14 x−3/4 y 3/4 − 34 x1/4 y −1/4

   
Lλλ Lλx Lλy 0
H = Lλx Lxx Lxy  = − 14 x−3/4 y 3/4 3λ −7/4 3/4
16
x y − 3λ
16
x−3/4 y −1/4 
3 1/4 −1/4 3λ −3/4 −1/4 3λ 1/4 −5/4
Lλy Lxy Lyy −4x y − 16 x y 16
x y

Evaluated at the candidate solution (x = q, y = q, λ = 4), the bordered Hessian becomes:

0 − 41 − 34
 
− 14 4q 3
− 4q3 

− 34 − 4q3 3
4q

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 The determinant is negative:
   
1 1 3 3 3 3 1 3 3 3
· − · − · − · · + ·
4 4 4q 4 4q 4 4 4q 4 4q
3 9 3
=− − = − < 0.
16q 16q 4q
Therefore, we have found a minimum.

2. Answer: Constant returns to scale.

Justification: Using the optimal values of x and y from part (1) we find that C(q) =
q + 3q = 4q. This means C 00 (q) = 0, implying that the production technology exhibits
constant returns to scale.

3. Answer: The monopolist should produce 48 units of Soma.

Justification: From part (2), the monopolist’s cost function is C(q) = 4q. Invert-
ing the demand function gives us the inverse demand is p(q) = 100 − q. This is more
convenient because the question asks us to find the profit maximizing quantity. So, the
monopolist’s profit maximization problem is:

max q(100 − q) − 4q
q≥0

The FOC is 100 − 2q − 4 = 0, which yields q = 48. The SOC is −2 < 0, so this is indeed
a maximum.

4. Answer: The monopolist should purchase 48 units of carisoprodol and 48 units of al-
ginic acid.

Justification: From part (1), the optimal value of x is q and the optimal value of
y is q. Since the monopolist wants to produce 48 units of Soma, it means that the
monopolist should purchase 48 units of each input good.

Question 3
Bunter was asked the following:

A Soma producing monopolist faces an inverse demand curve p = 100 − 2q. The cost
it incurs to produce q units of Soma is 2q 2 . Use the markup formula to determine its
profit maximizing price.

Here is his solution:

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 2p
The elasticity of demand is 100−2p . The seller has a constant marginal cost of $2 a
unit. The markup formula says that
p−2 100 − 2p
=
p 2p
⇒ p − 2 = 50 − p
⇒ p = 26

Is Bunter’s solution correct? If not, what is the correct solution and what are the mistakes that
Bunter has made ?

Solution:
2 points total.

0.5 points for identifying that Bunter has incorrectly computed elasticity of de-
mand.

0.5 points for identifying that Bunter has incorrectly applied the markup for-
mula.

1 points for determining the correct solution.

Answer: Bunter is incorrect. The profit maximizing price is 75.

He made mistakes in calculating the elasticity of demand and the marginal cost.

Justification: Bunter has mistaken the inverse demand curve for the demand curve. The
demand curve is D(p) = 50 − 0.5p. So, the elasticity of demand is
p p p
e(p) = −[ ]D0 (p) = × 0.5 = .
DT (p) 50 − 0.5p 100 − p

dC
As the cost of producing q units is C(q) = 2q 2 , the marginal cost is M C(q) = dq
= 4q.
p∗ −M C(q ∗ ) 1
According to the markup formula p∗
= e(p∗ )
. Therefore,

p∗ − 4q ∗ 100 − p∗
= .
p∗ p∗
Since q ∗ = 50 − 0.5p∗ , we get

p∗ − 4 × (50 − 0.5p∗ ) 100 − p∗

= ⇒ p∗ − 4 × (50 − 0.5p∗ ) = 100 − p∗ .
p∗ p∗
Solving this equation, we get p∗ = 75.

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Question 4
Devlin-McGregor is the monopoly producer of Provasic which is composed of a mixture of elec-
trolytes and Soma. If e units of electrolytes and s units of Soma are combined they generate
min{e, 2s} units of Provasic. Devlin-McGregor can purchase any amount of electrolytes for $2
a unit. Soma, however, is produced by a monopoly supplier, the Umbrella Corp. The Umbrella
Corp.’s cost of producing y units of Soma is C(y) = 0.5y 2 .

The Umbrella Corp. sets a wholesale price of w per unit of Soma to Devlin-McGregor. Devlin-
McGregor in turn sets the downstream price of Provasic to end users. Downstream demand is
characterized by an inverse demand curve of 100 − q.

1. Determine Devlin-McGregor’s minimum cost to produce q units as a function of q and w.

2. Determine the profit maximizing quantity of Provasic that Devlin-McGregor will sell as a
function of w.

3. What is Umbrella Corp.’s profit maximizing choice of w?

4. What is the most that Devlin-McGgegor should pay to acquire Umbrella Corp. (this means
control of their Soma production technology)?

Solution:

1. Answer: 2q + 0.5wq
Justification: First we determine Devlin-McGregor’s cost function by solving:

min 2e + ws

s.t. min{e, 2s} = q

e, s ≥ 0
The optimal solution is e = q and s = 0.5q. Therefore, Devlin-McGregor’s cost to sell q
units of Brawndo is 2q + 0.5wq.

2. Answer: q = 49 − 0.25w
Justification: Devlin-McGregor’s profit maximization problem is

max(100 − q)q − (2 + 0.5w)q

s.t. q ≥ 0
The FOC is 100−2q−(2+0.5w) = 0. The second derivative is negative and q = 49−0.25w
is the optimal quantity that Devlin-McGregor selects.

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3. Answer: w = 103.76
Justification: Note that if the wholesale price of Soma is w, the demand of Soma is
s = 0.5q = 0.5(49 − 0.15w) by parts (1) and (2). Then, Umbrella must solve:
 2
(49 − 0.25w) 49 − 0.25w
max w − 0.5
2 2
s.t. w ≥ 0,
which yields the first order condition
1 49 1
24.5 − w + − w = 0.
4 16 64
Solving the first order condition, we get w = 1764
17
≈ 103.76. The second derivative of the
profit function (− 17
64
) is negative, which ensures this is a maximum.

4. Answer: ≈ 1602.46
Justification: If Devlin-McGregor owned the production of Soma, its cost function would
be
1  q 2 1
C(q) = 2q + = 2q + q 2 .
2 2 8
The profit maximizing quantity of Provasic must solve:
1
max(100 − q)q − 2q − q 2 .
q≥0 8
The first order condition is
1
100 − 2q − 2 − q = 0 ⇒ q = 43.56
4
The second derivative of the profit function (− 49 ) is negative, which ensures this is a
maximum. At this level of production, Devlin-McGregor earns a profit of
1
(100 − 43.56) × 43.56 − 2 × (43.56) − × (43.56)2 = 2134.22.
8
Before acquiring Umbrella Corp., the quantity of Provasic chosen by Devlin-McGregor
was 49 − 0.25w. Plugging in the value of w from part (3), we get that Devlin-McGregor
would have chosen q old = 23.06 units of Provasic. Therefore, Devlin-McGregor’s profit
pre-acquisition is

(100 − 23.06) × 23.06 − 2 × (23.06) − 0.5 × 103.76 × 23.06 = 531.76.

This means that buying Umbrella will increase Devlin-McGregor’s profit by = 2134.22 −
531.76 ≈ 1602.46, which is also the maximum amount they should be willing to pay to
own .

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Question 5
Brawndo Corp. is the monopoly producer of Brawndo an electrolyte rich energy drink (‘it has
what plants crave’). It is produced using a combination of labor and electrolytes. If L denotes the
amount of labor (measured in hours) used and E the number of gallons of electrolytes, Brawndo’s
production function is f (L, E) = min{L, E}. Each gallon of electrolytes costs Brawndo Corp. $1
dollar per gallon to purchase. The supply of labor in the city in which Brawndo Corp.’s manufac-
turing facility is located, increases with the hourly wage offered. If Brawndo Corp. were to offer
a wage of w per hour, it will be able to acquire αw hours of labor where α > 0, is a constant to
be specified later.

Brawndo Corp. does not sell its energy drink directly to consumers but through a retailer, Buy-
More, at a wholesale price of u per gallon of Brawndo. BuyMore in turn sets the price per gallon to
the final consumer. The inverse demand curve for Brawndo that BuyMore faces is p(q) = 100−0.5q
where q is the quantity of Brawndo supplied by BuyMore.

Selling Brawndo at the retail level also requires labor. For every unit of Brawndo that Buy-
More sells it must employ half an hour of labor. The supply of labor that BuyMore has access
to, differs from the one that Brawndo Corp. pulls from. The supply of labor hours that BuyMore
faces increases with the hourly wage offered. If BuyMore were to offer a wage of w per hour, it
will be able to acquire 0.5w hours of labor.

1. Determine Brawndo Corp.’s cost function. Specifically, if C1 (h) is the minimum cost in-
curred to produce h units of Brawndo, what is C1 (h) as a function of h and α.

If done correctly, for α = 1, you should have C1 (0.5) = 0.75.

2. Determine BuyMore’s cost function. Specifically, if C2 (q) is the minimum cost incurred to
sell q units of Brawndo, what is C2 (q) as a function of q and u.

If done correctly, for u = 1, you should have C2 (2) = 4.

3. What is the profit maximizing quantity of Brawndo that BuyMore will acquire at the whole-
sale price of u per gallon? Your answer will be an expression involving u.

4. What is the profit maximizing choice of u for Brawndo Corp.? Your answer will be an
expression that depends on α.

5. Suppose α increases. This would correspond to an increase in the available supply of labor
that Brawndo Corp. has access to because at the same hourly wage we see a larger supply
of labor hours. What is the effect on Brawndo’s output?

6. Does an increase in α result in an increase in the hourly wage that Brawndo Corp. pays?

7. Does an increase in α result in an increase in the hourly wage that BuyMore pays?

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Solution:

1. Answer: C1 (h) = α−1 h2 + h

Justification: If Brawdo Corp. wants to acquire L hours of labor, it must choose a wage
w such that αw = L. Therefore, w = α−1 L. If Brawdo Corp. acquires L units of labor
and E gallons of electrolytes, its cost is wL + E = α−1 L2 + E.
Brando Corp. must solve:
C1 (h) = min α−1 L2 + E
s.t. min{L, E} = h
L, E ≥ 0
The optimal solution is to set L = E = h (this was discussed in the lecture). Clearly
we need L, E ≥ h and if we want to minimize the purchase cost of the inputs we would
choose L and E as small as possible. Therefore, C1 (h) = α−1 h2 + h.

2. Answer: C2 (q) = 0.5q 2 + uq

Justification: If BuyMore acquires q units of Brawndo, it must pay uq for it. In addition
it must acquire 0.5q units of labor. However, to acquire 0.5q hours of labor it must pay q
per hour. Hence, the total cost incurred from purchasing q units of Brawndo is 0.5q 2 +uq.

3. Answer: q = 100−u
2
Justification: BuyMore chooses q to solve

max q(100 − 0.5q) − 0.5q 2 − uq

q≥0

The FOC is
100 − u
100 − q − q − u = 0 ⇒ q = .
2
As the second derivative of profit is negative, this is indeed a maximum.

4. Answer: 50.5α+50
α+0.5
Justification: Brawndo Corp. will choose a wholesale price u for Brawndo to solve the
following:
100 − u 100 − u 2 100 − u
max u − α−1 ( ) −( )
u≥0 2 2 2
The FOC is
100 − u
50 − u + α−1 ( ) + 0.5 = 0 ⇒ (1 + 0.5α−1 )u = 50(1 + α−1 ) + 0.5
2
50(1 + α−1 ) + 0.5 50.5α + 50
⇒ u= =
1 + 0.5α−1 α + 0.5
α−1
The second derivative of profit is −1 − 2
which is negative, so we have a maximum.

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