University of Toronto

Department of Economics

ECO200Y1Y:Microeconomic Theory
Winter 2024

Sample Term Test 2 (with Solution)

Instructor: Mir Ahasan Kabir

Duration: 90 Minutes
Total Points: 100

Answer the questions in the spaces provided. If you run out of

room for an answer, continue on the back of the page.

Name:

Student ID:
1. (56 points) Suppose a competitive firm has production function
0.4 0.4
Q = F (K, L) = 3K N

We also have W = 10, and R = 5, and the market price of output is P = 25.
(a) (8 points) Derive the firm’s short run cost function when K = 50 in the short run.

Answer

If K is fixed at K = 50,
0.4 0.4 0.4
we have Q = 3(50) N = 14.345N .
2.5
So N = 0.00128Q .

Total cost is T C = F C + V C
2.5
= 250 + 10N = 250 + 0.0128Q .

(b) (8 points) How much output should the firm produce when K = 50 in the short run to maximize
its profits?

Answer

Continuing from (a), M R is P = 25 since the firm is competitive.

1.5
M C(Q) = 0.0321Q .

Setting M C = M R,
∗
Q = 84.7.

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(c) (8 points) Derive the firm’s long run cost function.

Answer

Now K can vary.

So T C = W N + RK with both N and K variable. From the factor mix optimality condition
we have K = 2N .

So T C = 20N .

From the production function,

0.4
0.4 0.8
Q = 3N 2N = 3.96N .
1.25
Rearranging, we have N = 0.179Q .

Combining the expression for Q and the expression for T C to get cost function C(Q), we have
1.25
C(Q) = 3.58Q .

(d) (8 points) How much output should the firm produce in the long run to maximize its profits?

Answer

Produce in the long run until M C = M R = P .

0.25
M C = C ′ (Q) = 4.48Q = 25.

Solving this expression for Q gives

∗
Q = 969.7 ≈ 970.

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(e) (8 points) Why is the firm’s profit-maximizing output so much smaller in the short run with K = 50
than in the long run in this question?

Answer
∗
In the long run, Q = 969.7, which implies N = 968.6 and K ≈ 1, 937. The optimal K is much
∗
larger in the long run. In the short run, with K fixed, producing up to long run Q would require
hiring much more N , which would lead to diminishing returns and a very sub-optimal factor mix.
In general, unless K is very close to its optimal long run value in the given short run, production
in the short run will be more expensive than production in the long run and therefore the firm will
produce less in the short run whenever K is below its optimal long run value.

(f) (8 points) Suppose instead that this firm was a monopolist facing a market inverse demand func-
tion given by P = 995 − 0.10QD where QD is market demand. What is the monopolist’s profit
maximizing level of output and price in the long run? (It is fine to approximate the answer here to
the nearest 100).

Answer

M R is given by 995 − 0.20Q and

0.25
M C is still C ′ (Q) = 4.48Q .
∗
Equating these gives approximately Q = 4800.

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(g) (8 points) Compare the monopolist in (f) to the case where there are 10 competing firms in the
industry, each taking the market price as given at $25. Which market structure generates lower
average total cost of production (LAT C) in the long run? Is this industry consistent with natural
monopoly?

Answer

First, note that when P = 25, QD = 970 so if firms are identical, each firm is optimizing just
like the firm in part (d). This is a competitive equilibrium in the short run (though not in the long
run since new firms will enter if they can given there are positive profits). We can easily work out
the LAT C for the representative competitive firm and the monopolist, but we already know the mo-
nopolist’s LAT C will be higher than the competitor’s because this industry has decreasing returns to
scale, and a constant optimal factor mix, and therefore diseconomies of scale over all levels of scale.
This industry is the polar extreme from a natural monopoly since there are economies of scale at
all! Production will be most efficient when there are as many competing firms as possible operating
at very small scale.

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2. (10 points) Disney World charges $140 for one round of golf from morning until 2:00 P.M. and $60 for
one round of golf from 2:00 P.M. until closing. Suppose the marginal cost of one round is $20.
(a) (2 points) What does this price differential suggest about the price sensitivities of people who play
golf early in the day compared to those who play in the late afternoon?

Answer

The early golfers are less price-sensitive than the late golfers.

(b) (8 points) Calculate the price elasticity of demand for the early-morning golfers and for the late-
afternoon golfers.

Answer

Use the Lerner index:

P −M C 1
P = −ED

For early golfers:

140−20 1
140 = −ED

ED = −1.17

For late golfers:

60−20 1
60 = −ED

ED = −1.50

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3. (10 points) Trick or Treat Candy Company has lots of customers, some of whom have an inverse de-
mand of P = 160 – 10Q, while others have an inverse demand curve of P = 120 – 5Q. Unfortunately, the
owner, Hazel, does not know which customers are which until they buy. She knows that her marginal
costs are constant at $25 and that she would like to use quantity discounting. Is this price scheme
incentive-compatible? If more than 9.5 units are purchased, the price per unit will be $72.50; otherwise,
the price per unit will be $92.50 per unit.

Answer

For the scheme to be incentive-compatible, a person in the first group would have to prefer the $92.50
price to the $72.50 price.

A person in the second group must prefer the $72.50 price to the $92.50 price.

(1) will be satisfied if the consumer surplus is larger under the $92.50 scheme: CS(92.50) = 0.5(160–92.5)∗
6.75 = $227.81

CS(72.50) = 0.5(160–72.5) ∗ 8.75–0.5(72.5–62.5)0.75 = $379.06

Since CS(72.50) > CS(92.50), this package is not incentive-compatible.

(2) will be satisfied if the consumer surplus is larger under the $72.50 scheme:

This package is incentive-compatible, as the consumers in this group will face higher prices and lower
quantities if the price equals $92.50, reducing their consumer surplus below that for a price of $72.50.

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4. (14 points) Aunty’s Kitchen has locations in two distant neighborhoods, Midtown and Downtown. Mid-
town customers’ demand is given by QM T = 1, 000 − 10P where Q is the number of cars detailed per
month; Downtown customers’ demand is QDT = 1, 600−20P . The marginal and average cost of detailing
a car is constant at $20.
(a) (6 points) Determine the price that maximizes Aunty’s Kitchen profit if she prices uniformly in
both markets. How many customers will she serve at each location? What will her profits be?

Answer

If Aunty wants to uniformly price, she can combine the demands in Midtown and Downtown:

Q = QM T + QDT = (1, 000 − 10P ) + (1, 600 − 20P ) = 2, 600 − 30P

The inverse demand is

P = (2, 600/30) − (1/30)Q

And the marginal revenue is

M R = 2, 600/30 − (1/15)Q

If Aunty wants to sell in both markets at single price, she will equate this MR with MC:

2, 600/30 − (1/15)Q = 20

Q = 1, 000

Plug that quantity into the combined demand curve to find the single price that maximizes profits
in both markets: P = (2, 600/30) − (1/30)(1, 000) = $53.33

In Aunty’s Midtown location, she will serve

QM T = 1, 000 − 10(53.33) = 466.67 customers

In Aunty’s Downtown location, she will serve

QDT = 1, 600 − 20(53.33) = 533.33 customers

Aunty’s profits will be

P rof it = (P − AC)Q = (53.33 − 20)1, 000 = $33, 333.33

(b) (6 points) Suppose Aunty decides to charge different prices at each location. What price should
she establish in each location? What will her profits be?

Answer

If Aunty sets separate prices in both Midtown and Downtown markets,

In Midtown:

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 Inverse Demand Midtown: PM T = 100 − (1/10)QM T

Marginal Demand Midtown: M RM T = 100 − (1/5)QM T

Maximize profits where M R = M C:

100 − (1/5)QM T = 20

QM T = 400

PM T = 100 − (1/10)QM T = 60

Aunty’s profits in Midtown will be

P rof itM T = (P − AC)Q = (60 − 20)400 = $16, 000

In Downtown:

Inverse Demand Downtown: PDT = 80 − (1/20)QDT

Marginal Demand Downtown: M RDT = 80 − (1/10)QDT

Maximize profits where M R = M C:

80 − (1/10)QDT = 20

QDT = 600

PDT = 80 − (1/20)QDT = 50

Aunty’s profits in Downtown will be

P rof itDT = (P − AC)Q = (50 − 20)600 = $18, 000

So, Aunty’s total profits will be the combined profits from Midtown ($16,000) and Downtown
($18,000), or $34,000.

(c) (2 points) How big are the gains to Aunty’s Kitchen differential pricing scheme?

Answer

Profits from Aunty’s differential scheme ($34,000) are $666.66 greater than the profits she would
earn by charging the same price in both markets ($33,333.33).

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5. (5 points) Explain how it’s possible (though unlikely) for a firm to have decreasing returns to scale in
production but still benefit from economies of scale over some range of output.

Answer

Typically, economies of scale refer to the cost advantages that a firm can achieve as it increases its
level of production. This is often associated with spreading fixed costs over a larger output, leading to
lower average costs per unit. However, it is theoretically possible for a firm to experience decreasing
returns to scale in production while still benefiting from economies of scale over a certain range of output.

Specialized Inputs or Processes: The firm might be using specialized inputs or production processes
that become less efficient as production scales up beyond a certain point. This could result in decreasing
returns to scale due to inefficiencies in managing larger production volumes.

Fixed Costs Spread Over Output Range: In the initial stages of production, fixed costs may be spread
over a small range of output, leading to decreasing average costs. This is the typical scenario associated
with economies of scale. However, as production continues to increase, the specialized inputs or processes
mentioned earlier might lead to diminishing marginal returns, causing costs to rise faster than output.

Optimal Production Range: There might be an optimal or efficient range of production where the ben-
efits of spreading fixed costs outweigh the drawbacks of decreasing returns to scale. Within this range,
the firm experiences economies of scale. Beyond this range, the increasing inefficiencies in production
processes lead to higher average costs, resulting in decreasing returns to scale.

6. (5 points) Explain why there is no unique profit-maximizing level of output for a perfectly competitive
firm with constant returns to scale technology.

Answer

In a perfectly competitive market with constant returns to scale technology, several factors contribute
to the absence of a unique profit-maximizing level of output for a firm. Let’s break down the key reasons:

Price Equals Marginal Cost (P = M C): In perfect competition, firms are price takers, meaning they
can sell any quantity of output at the market-determined price. Since the market sets the price, a
perfectly competitive firm faces a horizontal demand curve at the market price. In the short run, the
profit-maximizing condition is where marginal cost (MC) equals the market price (P).

Constant Returns to Scale: With constant returns to scale technology, the firm’s production func-
tion allows it to increase output without experiencing increasing or decreasing returns as it expands
production. This implies that the firm’s long-run average total cost remains constant over a range of
output levels.

Given these conditions, the profit-maximizing level of output for a perfectly competitive firm can be
identified where marginal cost equals market price. However, there isn’t a unique profit-maximizing
level because the firm can produce any quantity of output and still earn zero economic profit in the long
run due to constant returns to scale.

If the firm produces below the profit-maximizing level, it can increase production without experiencing
rising costs, and thus, it would increase its profit.If the firm produces above the profit-maximizing level,
it can decrease production without significantly increasing costs, reducing its losses.This flexibility allows
the firm to adjust its output continuously without facing diminishing returns or diseconomies of scale,
resulting in multiple output levels that yield zero economic profit in the long run.

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The End

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