Exercise for Final Exam - MAN401

1. Consider a firm with monopoly power that faces the demand curve P =
100 3Q + 4A1/2 and has the total cost function T C = 4Q2 + 10Q + A where
A is the level of advertising expenditures, and P and Q are price and output.
a. Find the values of A, Q and P that maximize this firms profit.

max
Q,A

(100 3Q + 4A1/2 )Q 4Q2 + 10Q + A

/Q = 100 6Q + 4A1/2 8Q + 10 = 0
/A = 2A1/2 1 = 0

(1)
(2)

when we solve equation (1) and (2) together, optimal advertising budget, A =
900, output, Q = 15 and price, P = 175.
b. Calculate the profit margin at its profit-maximizing levels of A, Q and P .
M C = 8Q + 10 = 8(15) + 10 = 130 so, Lerner = (175 130)/175 = 0.2571
2. Sals satellite company broadcasts TV to subscribers in Los Angeles and New
York. The demand functions for each of these groups are
QN Y = 50 (1/3)PN Y
QLA = 80 (2/3)PLA
where Q is in thousands of subscribers per year, and P is the subscription price
per year. The cost of providing Q units of service is given by T C = 1000 + 30Q
where Q = QN Y + QLA .
a. What are the profit-maximizing prices and quantities for the New York and
Los Angeles markets?
First, we write demand functions are inverse demand function, i.e, P = f (Q)
and then derive M Rs for each location:
From QN Y = 50(1/3)PN Y , we can find inverse demand as: PN Y = 1503QN Y
and from QLA = 80 (2/3)PLA , we can write PLA = 120 (2/3)PLA . Thus,
M RN Y
M RN Y

=
=

150 QN Y = 30 = M C and QN Y = 20, P N Y = 90

120 (3/2)QLA = 30 = M C and QLA = 30, P LA = 75

b. As a consequence of a new satellite that the government recently deployed,

people in Los Angeles receive Sals New York broadcast and people in New York

receives Sals Los Angeles broadcasts. As a result, anyone in New York or Los
Angeles can receive Sals broadcasts by subscribing in either city. Sal can charge
only a single price. What price should he charge, and what quantities will he
sell in New York and Los Angeles?

QT
P
MR
QN Y
QLA

=
=
=
=
=

QN Y + QLA = 50 (1/3)P + 80 (2/3)P = 130 P

130 Q
130 2Q = 30 = M C and Q = 50, P = 80
50 (1/3)(80) = 69/3
80 (2/3)(80) = 78/3

c. In which of the above situations, (a) and (b), is Sal better off? In terms of
consumer surplus, which situation do people in New York prefer and which do
people in Los Angeles prefer? Why?
Under market condition in (a) profit is equal to the sum of revenues from each
market minus the cost of producing quantity for both markets: QN Y PN Y +
QLA PLA T C(QN Y + QLA ) = 20(90) + 30(75) 1000 30(20 + 30) = 1550.
Under market condition in (b) profit is equal to the total revenue minus total
cost: QP T C(Q) = 50(80) 1000 30(50) = 1500. So, Sal makes more money
when two markets are separated.
3. Your firm produces two products, the demands for which are independent.
Both products at zero marginal cost. Yo face four consumers (or groups of
customers) with following reservation prices:
Consumer
A
B
C
D

Good 1($)
30
40
60
90

Good 2 ($)
90
60
40
30

a. Consider three alternative pricing strategies: (i) selling the goods separately;
(ii)pure bundling; (iii)mixed bundling. For each strategy, determine the optimal
prices to be charged and the resulting profits. Which strategy is best?

Sell Separately
Pure Bundling
Mixed Bundling

Price 1
40
69.95

Price 2
40
69.95

Bundled
Price
100
100

Profit
240
400
339.9

Pure bundling is the best strategy. Notice that in the mixed bundling, if single

prices are $70 or more, consumers A and D will prefer the bundle because by
paying $100, they will purchase least wanted product with reservation price of
$30 and the other less than its reservation value.
b. Now suppose the production of each good entails a marginal of $35. How
does this change your answers to (a)? Why is the optimal strategy now different?

Sell Separately
Pure Bundling
Mixed Bundling

Price 1
90
69.95

Price 2
90
69.95

Bundled
Price
100
100

Profit
110
120
129.9

Notice that in the separate pricing, only customer types A and D purchases
goods 2 and 1 respectively, so profit is (90-35)+(90-35)=110). In the pure
bundling profit is (100-70)x4=120. Finally, in the mixed pricing profit is (69.9535)+(100-70)+(100-70)+(69.95-35)=129.95. Thus, mixed bundling is the best
strategy.
4. Reebok produces and sells running shoes. It faces a market demand schedule
P = 11 1.5Qs , where Qs is the number of pairs of shoes sold (in thousands)
and P is the price in dollars per thousand pairs of shoes. Production of each
pair of shoes requires 1 square meter of leather. The leather is shaped and cut
by the Form Division of Reebok. The cost function for leather is
T CL = 1 + QL + 0.5Q2L ,
where QL is the quantity of leather (in thousands of square meter) produced.
The cost function for running shoes is (excluding leather)
T Cs = 2Qs .
a. What is the optimal transfer price?
Each shoe requires 1 square meter leather, Qs = QL , so
max s

(11 1.5Qs )Qs 2Qs (1 + Qs + 0.5Q2s )

s
Qs

11 3Qs 2 1 Qs = 0

Qs

(3)

The solution of equation (3) yields Qs = 2. Thus, QL = 2 sq meter and transfer

price is $3 since M C(QL = 2) = 1 + 2 = $3.
b. Leather can be bought and sold in a competitive market at the price of
P = 1.5.

The transfer price is now $1.5, and the optimal number of shoes can be derived
from
max s

(11 1.5Qs )Qs 2Qs 1.5Qs

s
Qs

11 3Qs 2 1.5 = 0 Qs = 2.5

Qs

and 2 square meter of it is purchased from the outside market.

c. Now suppose that the leather is unique and of extremely high quality. Therefore the Form Division may act as a monopoly supplier to the outside market
as well as a supplier to the downstream division. Suppose the outside demand
for leather is given by P = 32 QL . What is the optimal transfer price for the
use of leather by the downstream division? At what price, if any, should leather
be sold to the outside market? What quantity, if any, should leather be sold to
the outside market?
This time, number of shoe sales depends on the imperfectly competitive leather
market. In particular, upstream divisions pricing on leather determines the
overall profit. Thus, the choice variables would be inside sale of leather (Qs =
QIL ) and outside sale of leather (QO
L ):

max

QIL ,QO
L

QIL

QO
L

O
I
O
I
O 2
(11 1.5QIL )QIL 2QIL + (32 QO
L )QL (1 + QL + QL + 0.5(QL + QL ) )

11 3QIL 2 1 QIL QO
L =0

(4)

I
O
32 2QO
L 1 QL QL = 0

(5)

Solving (4) and (5) together, QIL < 0 and QO

L = 10.54 sq meter. Thus, price is
P = 32 10.54 = $21.46.
5. Suppose that two identical firms produce widgets and that they are the only
firms in the market. Their costs are given by C1 = 30Q1 and C2 = 30Q2 where
Q1 is the output of Firm 1 and Q2 is the output of Firm 2. Price is determined
by the following demand curve:
P = 150 Q
where Q = Q1 + Q2 .
a. Find the Cournot-Nash equilibrium. Calculate the profit of each firm at this
equilibrium.

Write profit functions for firm 1 and 2 respectively,

max 1

(150 Q1 Q2 )Q1 30Q1

1
Q1

150 Q1 Q2 Q2 30 = 0

max 2

(150 Q1 Q2 )Q2 30Q2

2
Q2

150 Q1 Q2 Q1 30 = 0

Q1

Q2

(6)

(7)

Now, solve equations (6) and (7) together and find Q1 = Q2 =40, P = 150
40 40 = 70 and 1 = 2 = 1600.
b. Suppose the two firms for a cartel to maximize joint profits. How many
widgets will be produced? Calculate each firms profit.
Now, Q1 = Q2 = Q and
max

(150 Q)Q 30Q

150 2Q 30 = 0 Q = 60,

and price is P = 150 60 = $90 and = 90(60) 30(60) = $3600. Thus,

Q1 = Q2 =30, and 1 = 2 = 1800. By cooperating, both firms are better off.
c. Suppose Firm 1 were the only firm in the industry. How would the market
output and Firms profit differ from that found in part (b) above?
If firm 1 is the only firm, it would be same solution as in part b but Q1 = 60
and 1 = $3600.
6. EGO decides to use peak-load pricing for electricity during the summer
months. During the week between the hours of 8:00 a.m. and 5:00 p.m., the
demand for electricity is high; during the off hours the demand is low. The
respective demand functions can be given as:
QH = 400 5P (high demand) QL = 50 2P (low demand)
where P is the unit price of electricity per hour and Q is amount of electricity
used each hour. The total cost of providing electricity is given by: T C =
10 + 2Q2 .
a. What is the firms marginal cost function, and what does this equation imply
about EGOs ability to provide electricity?
Since Marginal cost is linear function of Q (M C = 4Q), more demand will
increase cost of providing electricity service.

b. In order to divert electricity use to off-house, EGOs management uses

peak-load pricing. Calculate the appropriate prices charged and determine the
amount of electricity used for each time period.
The optimization rule argues that we have to produce where M R = M C:
2
M RH = 80 Q = 4Q = M C
5
M RL = 25 Q = 4Q = M C

400
(P eakLoad)
22
QL = 5 (Of f P eakLoad)

QH =

and PH = 80 (1/5) (400/22) = $76.36 and PL = 25 (1/2)5 = $22.5.

c. Calculate the own-price demand elasticity in each market. Do the numbers
make sense in the context of this problem?
H =

76.36
22.5
d QP
= 5
= 21 and L = 2
= 9
dPQ
18.18
5

These elasticities do not make sense because consumers who use the service at
the peak load period are less price elastic but we found contradictory results.
7. In the inland waterways shipping industry, bulk carriers (barges) are chartered on an annual basis to haul grain, oil, and other bulk commodities. As far
as the shippers are concerned, the service provided by barges of any given class
are homogenous products. Industry demand for carriers vary over time, depending on grain and oil movements. At present, industry demand is estimated
as:
Q = 40000 0.2P
The industry consists of one large firm, Mississippi Barge Transport Company
(MBT), and ten smaller firms of roughly equal size. MBT is the industry leader
with regard to pricing decisions, and its marginal cost curve is given by:
M CL = $20000 + $6Q
The following firms marginal cost curve, derived by summing the MC curves
of the ten follower firms, is given by:
M CF = $44000 + $4Q
a. Under this market structure, what price will MBT establish, and what will
be its output at this price?
First, we have to derive the supply function of the follower firms and subtract
this amount from industry demand to get dominant firms demand function.
From M C relation of the follower firms, we can write down their supply function
as
M C = 44000+4Q Q =

M C 44000

since MC=P in the perfectly competitive firms,

4
4

the supply function is written as Q = 0.25P 11000. When we subtract this from
industry demand: QL = Q QF = 40000 0.2P (0.25P 11000) = 51000
0.45P (=Demand for Leader). Thus, to derive marginal revenue for leader, we
will write demand curve as inverse demand curve: P = 51000/0.45 (1/0.45)Q
and
M RL = 113333 4.44Q = 6 = 20000 + 6Q

QL = 12765.96

and P = 51000/0.45 (1/0.45)12765.96 = $84964.2.

b. How many units of output will the following firms supply?
From P = M C,$84964.2=44000+4Q QF = 10241.05.
c. Check whether industry supply equals to industry demand?