EF3442 – Homework 2

Not For Distribution Beyond the Class

Yunan Li
February 23, 2025

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
Devlin-McGregor is the monopoly seller of blood substitutes. It makes two varieties, one for hu-
mans and the other for dogs.1 The unit cost of production for each is the same, a constant $2 a
unit. Demand (in pints) as a function of unit price for each product is shown below:
Human: D(p) = 100 − p
Dogs: D(p) = 50 − 2p
Devlin-McGregor uses a common production facility to make both with a capacity to produce a
total of 30 pints of blood substitute (whether human or dog). Bunter was asked to determine the
profit maximizing price of each product that Devlin-McGregor should produce. Here is Bunter’s
solution.

According to the markup formula, the profit maximizing price for the human blood substitute
should satisfy:
p−2 100 − p
= ⇒ p = 51.
p p
1
The product for one segment cannot be used by the other segment.

1
According to the markup formula, the profit maximizing price for the dog blood substitute should
satisfy:
p−2 50 − 2p
= ⇒ p = 13.5.
p 2p

Is Bunter correct? If not, what is the error that Bunter has made?
1. If Bunter is in error, compute the correct profit maximizing prices.
2. At the profit maximizing prices is marginal revenue equal to marginal cost for each product?

Solution:

1. Answer: Bunter is incorrect. At the prices he computes, Devlin-McGregor would have

to produce a volume that exceeds its capacity constraint. The correct profit maximizing
prices are $70 and $25 a unit for human and dog substitutes respectively.

Justification: If we adopt Bunter’s prices of (51, 13.5) we would produce 100 − 51

units of human blood substitute and 50 − 2 × 13.5 units of dog blood substitute. Note
the amount of human blood substitute already violates the 30 unit capacity constraint.

We will formulate Devlin-McGregor’s problem using prices as the variables. It can also
be formulated using quantities. Denote by p1 the unit price of the human blood sub-
stitute and p2 as the unit price of the dog blood substitute. Devlin-McGregor’s profit
maximization problem is:

max (100 − p1 )(p1 − 2) + (50 − 2p2 )(p2 − 2)

p1 ,p2 ≥0

s.t. 100 − p1 + 50 − 2p2 ≤ 30

0 ≤ p1 ≤ 100
0 ≤ p2 ≤ 25
Bunter’s solution solves this problem by ignoring the capacity constraint. Because
Bunter’s solution violates the capacity constraint, we know that in an optimal solution
the capacity constraint must hold at equality:

100 − p1 + 50 − 2p2 = 30.

We can use the method of elimination. Use the last equation to set p1 = 120 − 2p2 .
One must careful to ensure that all occurences of p1 are repalced with the corresponding
expression involving p2 . Then, our problem is equivalent to

max(100 − 120 + 2p2 )(120 − 2p2 − 2) + (50 − 2p2 )(p2 − 2)

p2 ≥0

s.t. 10 ≤ p2 ≤ 25

Page 2
 The lower bound of 10 on p2 comes from 120 − 2p2 ≤ 100.
The derivative of the function we are trying to maximize is positive for values of p2
between 10 and 25 (inclusive). So, the function is monotonically increasing in [10, 25]
and therefore attains its maximum at p∗2 = 25.
⇒ p∗1 = 70, q1∗ = 30, q2∗ = 0

2. Answer: No.

Justification: The marginal cost is constant at $2 per unit. We can find the marginal
revenue for each product by taking the derivative of the revenue of each product with
respect to quantity.

Using the inverse demand function, the revenue of human blood substitute as a function
of the quantity q1 , is (100 − q1 )q1 . Taking the derivative with respect to q1 , the marginal
revenue at q1 = 30 is (100 − 30) − 30 = 40 ̸= 2.

Similarly, the revenue of dog blood substitute as a function of q2 the amount of dog
blood substitute is ( 50−q
2
2
)q2 . Taking the derivative, the marginal revenue at q2 = 0 is
50−0 1
2
− 2 ∗ 0 = 25 ̸= 2.

In general, marginal revenue equals marginal cost iff there are no constraints (other
than non-negativity) on the quantity produced. In the question above, the constrained
maximizers do not coincide with the unconstrained maximizers.

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) =
x1/3 y 2/3 . Suppose a unit of carisoprodol costs $1 and a unit of alginic acid costs $2. The demand
for Soma as a function of its unit price p, is 100 − p. What combination of the two products should
be purchased to maximize profit?

Solution:
4 points in total

Answer: x∗ = 48.5 and y ∗ = 48.5

Justification:

First we determine the monopolist’s cost function. For a given quantity q of output, the

Page 3
monopolist chooses x and y to minimize the cost of producing q units of output:

min x + 2y s.t. x1/3 y 2/3 = q.

x,y≥0

We begin by using Lagrange’s method. The problem is:

L = min x + 2y + λ(q − x1/3 y 2/3 )

λ,x,y

The FOCs are:

∂L 1 y
= 1 − λ ( )2/3 = 0 (1a)
∂x 3 x
∂L 2 x
= 2 − λ ( )1/3 = 0 (1b)
∂y 3 y
∂L
= q − x1/3 y 2/3 = 0 (1c)
∂λ
Combining 1a and 1b we find that x = y. Now use 1c (which is just the constraint) to solve
for x and y.

(y)1/3 y 2/3 = q ⇒y=q

⇒x=q

Plugging these values back into 1a or 1b yields λ = 3.

To check the SOCs, form the bordered Hessian matrix (Checking SOCs for the Lagrangian
method is NOT required):
  2λ −5/3 2/3
− 2λ x−2/3 y −1/3 − 13 x−2/3 y 2/3
 
Lxx Lxy Lxλ 9
x y 9
H = Lyx Lyy Lyλ  = − 2λ 9
x−2/3 y −1/3 2λ 1/3 −4/3
9
x y − 23 x1/3 y −1/3 
Lλx Lλy Lλλ − 13 x−2/3 y 2/3 − 23 x1/3 y −1/3 0

Evaluated at the candidate solution (x = q, y = q, λ = 3):

 2 2
− 3q − 13

3q
2 2
H = − 3q 3q
− 32 
− 31 − 23 0
2
The determinant of the bordered Hessian matrix is − 3q < 0. Since the determinant is negative,
this solution is a minimum. (Reference: Second Order Conditions)
The cost function is therefore q + 2q = 3q.

Alternatively, one could use the method of substitution. From the constraint:

q3
x1/3 y 2/3 = q ⇒ x=
y2

Page 4
 Substitute the above equation into the objective function (x + 2y). Our goal, then, is to choose
3
y to minimize yq 2 + 2y. Differentiating and setting to zero:

−2q 3 y −3 + 2 = 0 ⇒ y=q (and x = q)

To verify that this is a minimum we check the second derivative:

6q 3 y −4 > 0 ⇒ minimum.

The cost function is therefore q + 2q = 3q.

The cost function has a constant unit cost of 3. The profit of the monopolist as a function of
p is
Π(p) = (p − 3)(100 − p) = 100p − p2 + 3p − 300
The FOC is:
Π′ = 100 − 2p + 3 = 0 ⇒ p∗ = 51.5
The SOC for a maximum is satisfied:

Π′′ = −2 < 0

The profit maximizing quantity is q ∗ = 100 − (51.5) = 48.5.

Using the answer from part 3, x∗ = 48.5, and y ∗ = 48.5.

Question 3
It costs a monopoly supplier of Soma, C(q) = q 2 to produce q units of Soma. If she charges a price
p per unit for Soma, the quantity demanded will be 100 − p2 (It will be useful to use Wolfram
Alpha or similar software to compute the numerical answers).

1. What kinds of returns to scale (increasing, decreasing, constant) does the supplier’s produc-
tion technology exhibit?

2. What quantity will she produce to maximize profit?

3. What is the inverse demand curve the monopolist faces?

4. What price should she charge to maximize profit?

5. What is the elasticity of demand at this price?

6. What is consumer surplus at this price?

7. If the monopoly supplier is forced to charge $9.5 a unit and is required to meet demand at
this price, would consumer surplus go up or down?

Page 5
8. If the monopoly supplier must either charge $9.5 a unit and meet demand operate at this
price or shut down, would consumer surplus go up or down?

9. What price should be set by the monopoly supplier to maximize total surplus?

Solution:

1. Answer: Decreasing returns to scale

2
Justification: As ddqC2 = 2 > 0, it follows that marginal costs are increasing with quantity.
This means that the technology exhibits decreasing returns to scale.

2. Answer: q ∗ = 4.76
Justification:
√ Profit is Π = (p · (100 − p2 )) − ((100 − p2 )2 ). Alternatively, we can write
Π = ( 100 − q) · q) − (q 2 ). As such, we obtain first-order conditions with respect to
quantity:
dΠ q
= (100 − q)1/2 − (100 − q)−1/2 − 2q = 0 ⇒ q ∗ = 4.76
dq 2
Note the second order condition is met for positive quantities less than 100:

d2 Π 1 1 q
2
= − (100 − q)−1/2 − (100 − q)−1/2 − (100 − q)−3/2 − 2 < 0
dq 2 2 4
√
3. Answer: p = 100 − q
Justification: Inverse demand curve can be obtained by rearranging the demand curve.

4. Answer: p∗ = 9.76
Justification: Using the inverse demand, p∗ = 9.76.

5. Answer: e(9.76) = 40.02

Justification: The price elasticity of demand is:

dD p p 2p2
e(p) = − · = −(−2p) =
dp D D D

Plugging in p = 9.76 and D = 4.76, it is immediate that e(9.76) = 40.02.

6. Answer: CS = 0.57
Justification: Consumer surplus at price p = 9.76 will be
Z 10
(100 − p2 )dp = [100p − p3 /3]10
9.76 = 0.57
9.76

Page 6
 7. Answer: If the firm is forced to operate, consumer surplus will increase.
Justification: If firm operates, and the price is lower than the monopoly price, then
clearly consumer surplus increases.
R 10
Formally, the consumer surplus is 9.76 (100 − p2 )dp and
Z 10 Z 10
2
(100 − p )dp < (100 − p2 )dp.
9.76 9.5

8. Answer: If the firm can choose to shut down, consumer surplus will decrease.
Justification: If firm operates, its profit will be negative:

9.5 × (100 − 9.52 ) − (100 − 9.52 )2 = −2.43 < 0.

To avoid such loss, it could simply shut down and earn a profit of 0. In this case,
consumer surplus drops to 0.

9. Answer: p∗ = 9.75
Justification: Total surplus is consumer surplus plus profits:
Z q
Σ(q) + Π(q) = p(x)dx − C(q)
0

Differentiating with respect to q and setting to zero yields

dC
p(q) − =0 ⇒ (100 − q)1/2 − 2q = 0
dq
q ∗ = 4.88 ⇒ p∗ = 9.75

As the SOC is satisfied for q < 100 − 1/4, this is indeed optimal.

Question 4
You are the monopoly supplier of SOMA to a sole retailer who in turn sells the SOMA to a
downstream market. The demand for SOMA (in the downstream market) as a function of the
retailers unit price p, is 100 − p. The retailer has sole authority to set the price in the downstream
market and will set the price to maximize her own profit.
Your manufacturing costs of SOMA are zero. Your currently sell the SOMA to the retailer for $45
a unit. In addition the retailer incurs an additional handling cost of $10 per unit. This $10 cost
is not a payment to you the manufacturer. Thus for each unit of SOMA sold the retailer incurs
a cost of $55.
1. What price should the retailer set to maximize her own profit?
2. Suppose the handling costs of the retailer rise from $10 to $15 a unit. Which of the following
possibilities should you entertain to maximize profit?

Page 7
 a) Keep your wholesale price at $45 a unit?
b) Raise your wholesale price?
c) Drop your wholesale price?

Explain why.

Solution:

1. Answer: The profit maximizing unit price is $77.5

Justification: The retailer takes her costs as given. If p is the unit price and Π(p)
denotes her profit as a function of p, her maximization problem is:

max Π(p) = (100 − p)(p − 55)

p≥0

The FOC gives (100 − p) − (p − 55) = 0, and so p∗ = 77.5.

Π′′ (p∗ ) = −2, so the SOC is satisfied.

2. Answer: (c) You should drop your wholesale price.

Justification: Your wholesale price w will affect the retailer’s downstream price, so
we first need to solve the retailer’s profit maximization problem for a general w:

max Π(p) = (100 − p)(p − w − 15)

p≥0

The FOC gives (100 − p) − (p − w − 15) = 0, and so p∗ = 115+w

2
.
Π′′ (p∗ ) = −2, so the SOC is satisfied.
Then, you solve your maximization problem, taking into account that the retailer will
adjust her downstream price given your wholesale price:
 
115 + w
max Π(w) = 100 − ·w
w 2

The FOC gives (100 − 115+w

2
) − w2 = 0, and so w∗ = 42.5.
Π′′ (w∗ ) = −1, so the SOC is satisfied. 42.5 < 45, so you should drop your wholesale
price.

Question 5
Consider a monopolist producing at dates t = 1, 2. The good that it produces is perishable in that
it will not last beyond one period. Therefore, the demand in each period is unaffected by past

Page 8
and future periods. The inverse demand curve in period t as a function of the period t quantity
qt is denoted pt (qt ).
If q1 is the number of units produced in period 1, the monopolist incurs a cost of C1 (q1 ) that
exhibits decreasing returns of scale. The cost of production in the second period depends on both
the amount produced in period 2 as well as period 1. If q2 is the number of units produced in
period 2 given q1 units produced in period 1, the cost incurred will be C2 (q1 , q2 ). This second
period cost is increasing in q2 holding q1 fixed. It exhibits decreasing returns to scale in q2 , holding
q1 fixed. However, C2 (q1 , q2 ) is decreasing in q1 holding q2 fixed. This captures the idea of ‘learning
by doing’.
1. Write down the monopolist’s total profit as a function of q1 and q2 .

2. Write down the first order conditions for optimality.

3. Let p∗ be the price that maximizes first period profits only. Explain why this price will be
higher than the optimal first period price from part (2).

Solution:
6 points in total. 2 points for each part.

1. Answer: Denote by Π(q1 , q2 ) the total profit and Π1 (q1 ) and Π2 (q1 , q2 ) as the profit in
periods 1 and 2 respectively. Therefore, the monopolist’s profit is:

Π(q1 , q2 ) = Π1 (q1 ) + Π2 (q1 , q2 )

= (p1 (q1 ) · q1 − C1 (q1 )) + (p2 (q2 ) · q2 − C2 (q1 , q2 ))

Justification: The total profit is the sum of profit in each period. Then, we can find
the profit in each period using the inverse demand curves and cost functions.

2. Answer: The first order conditions are:

∂C2
[q1 ] p1 (q1 ) + q1 · p′1 (q1 ) − C1′ (q1 ) − (q1 , q2 ) = 0
∂q1
∂C2
[q2 ] p2 (q2 ) + q2 · p′2 (q2 ) − (q1 , q2 ) = 0
∂q2

Justification: The monopolist maximizes total profit by choosing q1 and q2 :

max Π(q1 , q2 ) = (p1 (q1 ) · q1 − C1 (q1 )) + (p2 (q2 ) · q2 − C2 (q1 , q2 ))

q1 ,q2

Taking the partial derivatives gives us the first order conditions.

3. Answer: p∗ is higher than the optimal first period price from part (2) because maxi-
mizing over only first period profit does not take into consideration that a higher q1 will
lower costs in period 2.

Page 9
Justification: Consider the first order condition for first period profits only:

p1 (q1 ) + q1 · p′1 (q1 ) = C1′ (q1 ). (2)

The left hand side of this expression is decreasing in q1 . Compare this with the FOC
from part (2):

∂C2
p1 (q1 ) + q1 · p′1 (q1 ) = C1′ (q1 ) + (q1 , q2 ) < C1′ (q1 ). (3)
∂q1

The inequality on the right in (3) is true because we are told that the term ∂C
∂q1
2
is negative,
which means that costs in the future are lowered by producing more today.
Thus, in equation (2) we are equating marginal revenue to something smaller than in
(3). Therefore, the q1 that solves (2) will be larger than the q1 that solves (3). Hence,
the corresponding first period price will be lower in the first case than in the second.
Therefore, the corresponding first period price, p∗ , will be higher than in part 2.

Page 10