ME Problem Set – V

PGP 2020 - 22
(Answer Keys)

1.
(a) Since marginal cost is equal to $1.50 and the price is $2, each hot dog vendor will want to
sell as many hot dogs as possible, which is 100 per day.

(b) Each hot dog vendor is making a profit of $0.50 per hot dog at the current $2
price: a total profit of $50. Therefore, the price will not remain at $2, because these
positive economic profits will encourage new vendors to enter the market. As new
firms start selling hot dogs, market supply will increase and price will drop until
economic profits are driven to zero. That will happen when price falls to $1.50,
where price equals average cost. (Note that AC = MC = $1.50 for firms in this
industry because fixed cost is zero and MC is constant at $1.50)
(c) At the current price of $2, the total number of hot dogs demanded is Q = 4400 –
1200(2) = 2000, so there are 2000/100 = 20 vendors. In the long run, price will fall to
$1.50, and the number of hot dogs demanded will increase to Q = 2600. If each
vendor sells 100 hot dogs, there will be 26 vendors in the long run.
(d) If there are 20 vendors selling 100 hot dogs each then the total number sold is
2000. If Q = 2000 then P = $2, from the demand curve.
(e) At the price of $2, each vendor is making a profit of $50 per day as noted in part (b). This
is the most a vendor would pay per day for a permit.

2.
(a) Equilibrium price and quantity are found by setting market supply equal to market
demand: 6500 – 100P = 1200P. Solve to find P = $5 and substitute into either
equation to find Q = 6000. To find the output for the firm set price equal to marginal
2q
5
cost: 200 , and therefore q = 500. Profit is total revenue minus total cost or
q2 5002
(
π =Pq− 722+
200 )
=5 (500 )− 722+(200 )
=$ 528
. Notice that since the total
output in the market is 6000, and each firm’s output is 500, there must be 6000/500 =
12 firms in the industry.

(b) We would expect entry because firms in the industry are making positive
economic profits. As new firms enter, market supply will increase (i.e., the market
supply curve will shift down and to the right), which will cause the market
equilibrium price to fall, all else the same. This, in turn, will reduce each firm’s
optimal output and profit. When profit falls to zero, no further entry will occur.

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(c) In the long run profit falls to zero, which means price falls to the minimum value
of AC. To find the minimum average cost, set marginal cost equal to average cost
and solve for q:
2q 722 q
 
200 q 200
q 722

200 q
q 2  722(200)
q  380
AC(q  380)  3.8.
Therefore, the firm will not sell for any price less than $3.80 in the long run. The
long-run equilibrium price is therefore $3.80, and at a price of $3.80, each firm’s
economic profit equals zero because P = AC.
(d) The firm will sell for any positive price, because at any positive price, marginal
cost is above average variable cost (MC = q/100 > AVC = q/200). Profit is negative
if price is below minimum average cost, or as long as price is below $3.80. Profit is
zero if price is exactly $3.80, and profit is positive if price is greater than $3.80.

3.
(a) Each firm’s profit maximizing quantity is where price equals marginal cost: 8.50 =
0.5 + 0.16q. Thus q = 50. Profit is then 8.50(50) – [50 + 0.5(50) + 0.08(50)2] = $150.
The industry is not in long-run equilibrium because profit is greater than zero. In
long-run equilibrium, firms produce where price is equal to minimum average cost
and there is no incentive for entry or exit. To find the minimum average cost point,
set marginal cost equal to average cost and solve for q:
50
MC  0.5  0.16q   0.5  0.08q  AC
q
0.08q2  50
q  25.
To find the long-run equilibrium price in the market, substitute q = 25 into either
marginal cost or average cost to get P = $4.50.

(b) The new total cost function and marginal cost function can be found by
multiplying the old functions by 0.75 (or 75%). The new functions are:
Cnew (q)  .75(50  0.5q  0.08q 2 )  37.5  0.375q  0.06q 2
MCnew (q)  0.375  0.12q.
The firm will set marginal cost equal to price, which is $4.50 in the long-run
equilibrium. Solve for q to find that the firm will develop approximately 34 rolls of
film (rounding down). If q = 34 then profit is $33.39. This is the most the firm would
be willing to pay per year for the new technology.

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It will pay this amount only if no other firms can adopt the new technology, because if
all firms adopt the new technology, the long-run equilibrium price will fall to the
minimum average cost of the new technology and profits will be driven to zero.

4.
(a) The equilibrium price and rate of sales are computed by equating supply to demand.
25 + 0.5Q = 75 - 1.5Q
2Q = 50
Q = 25 (hundreds per day)

The equilibrium price is

(b)
Since the firm's supply curve is its MC, we can determine the rate of sales of the firm by
inserting $37.5 for price (MC) into the MC equation to get q for the firm.
MC = $37.5 = 2.5 + 10q.
q = 3.5 (hundreds per day)

(c)
The new market equilibrium price is
25 + 0.50Q = 100 - 1.5Q
Q = 75 / 2 (hundreds per day)
P = 100 - 1.5(37.5) = $43.75 / unit

Now the typical firm would sell daily:

(d)
The original supply and demand represented long-run equilibrium and a breakeven situation
for the typical firm. With the new higher demand in (c), the typical firm would likely be
earning a positive economic profit because price and output are both higher. This apparent
positive profit would encourage more firms to enter the market, which would increase market
supply. So, the new equilibrium would not represent a long-run equilibrium for the firm or
the market.

5.
(a)
The equilibrium price is the price at which the quantity supplied equals the quantity
demanded. Therefore,
.000002Q = 11 - .00002Q
Q = 500,000
P=1

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(b)
The profit maximizing short run equilibrium level of output for a tortilla factory is found
where marginal revenue equals marginal cost. For a perfectly competitive firm, marginal
revenue equals price. Therefore,
P = MC
1 = .1 + .0009Q
Q = 1,000

(c)
Given the information provided, it cannot be determined whether the firm is making a profit
or a loss, because total cost cannot be determined from marginal cost.

(d)
Since Q = 500,000 and Q = 1,000, there must be 500 firms.

6.
(a)
Market equilibrium price is found by equating S and D.
75 - 1.5Q = 25 + 0.50Q
50 = 2Q
Q = 25 (thousand yards per month)
The equilibrium selling price is
P = 75 - 1.5(25) = $37.5/yard.

(b)
Since the firm's supply is based on its MC curve, we can use MC to determine production
rate.
P = 37.5 = MC = 2.5 + 10q
35
q = 10 = 3.5 (thousand yards / month)
(c)
Since each firm produces 3.5 thousand yards per month and total production is at 25 thousand
yards per month, a total of 7.14 firms would be needed.

7.
(a) Begin by calculating the price elasticity of demand, ED:
ΔQ P
ED = ΔP ∙ Q
ΔQ
To find ΔP solve for Q in terms of P.
P = 500 - 2Q
P - 500 = -2Q
Q = 250 - 0.5P

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 ΔQ ΔQ P
ΔP = -0.5; ED = ΔP ∙ Q
300
ED = -0.5 ∙ 100 = -1.5
1
MR = P + P
( )
ED
1
( )
MR = 300 + 300 -1. 5
MR = 300 - 200 = 100

(b)
If MC = 0, the firm is not maximizing profit since MR should be equal to MC. The firm
should expand output.
MR = 500 - 4Q = 0
4Q = 500
Q = 125