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Chapter 2 - Solutions

Media Economics (University of Miami)

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SOLUTIONS MANUAL

CHAPTER 2
BASIC CONCEPTS FROM ECONOMICS

MIGUEL A. ORTEGA-VAZQUEZ | DANIEL S. KIRSCHEN

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Chapter 2

2.1 A manufacturer estimates that its variable cost for manufacturing a given product
is given by the following expression: C ( q ) = 25q 2 + 2000q [$] where C is the
total cost and q is the quantity produced.

a. Derive an expression for the marginal cost of production.

The marginal cost of production is the rate of change of the cost with respect of the
quantity produced; therefore:

d C (q)
MC (q) = = 50q + 2000
dq

b. Derive expressions for the revenue and the profit when the widgets are sold at
marginal cost.

Since the widgets are sold at marginal cost, π = MC ( q )

The revenue is then given by:

revenue = π q = ( 50q + 2000 ) q = 50q 2 + 2000q

Since the profit is the difference between the revenue and the production cost, we have:

profit = ( 50q 2 + 2000q ) − ( 25q 2 + 2000q ) = 25q 2

2.2 The inverse demand function of a group of consumers for a given type of widgets
is given by the following expression: π = −10q + 2000 [$/unit] where q is the
demand and π is the unit price for this product.

a. Determine the maximum consumption of these consumers

The inverse demand function can be represented by a straight line with a negative slope,
as shown below:

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2200

2000

1800

1600

1400

π 1200

1000

800

600

400 qmax
200

0
0 20 40 60 80 100 120 140 160 180 200 220
q, [units]
Figure P2.2-a: Price as a function of the quantity produced

The maximum consumption qmax is achieved when π = 0 [$/unit]. From the inverse
demand function, we get:

0 = −10q + 2000 $

−2000
qmax = = 200 units
−10

b. Determine the price that no consumer is prepared to pay for this product

The price that no consumer is prepared to pay is such that no widget is sold:

π = −10 × 0 + 2000 = 2000 $/unit

c. Determine the maximum consumers’ surplus. Explain why the consumers will
not be able to realize this surplus

Since the area under the inverse demand function represents the consumers’ surplus, this
surplus will maximum when the area is maximized. This occurs when the amount of
widgets sold is at its maximum (q = qmax and π = 0). Thus, we have:

qmax π max 200 × 2000

surplus = = = 200, 000 $
2 2

This surplus is not achievable because no rational producer would be willing to “sell” its
production at a price of 0 $/unit.

d. For a price π = 1000 $/unit, calculate the consumption, the consumers’ gross
surplus, the revenue collected by the producers and the consumers’ net
surplus.

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For a price of 1,000 $/unit the number of widgets sold would be:

π 1000
q= + 200 = − + 200 = 100 units
−10 10

2200

2000

1800

1600

1400

1200
A
π

1000

800

600

400
B qmax
200

0
0 20 40 60 80 100 120 140 160 180 200 220
q, [units]
Figure P2.2-b: Price as a function of the amount of widgets produced for a price of 1,000
$/unit

Therefore the consumers’ gross surplus would be given by the sum of areas A and B:

100 × 1000
A+ B = + 100 ×1000 = 150, 000 $
2

The revenue collected by the producers is given by area B, which is 100,000 $

The consumers’ net surplus is given by area A, which is 50,000 $

e. If the price π increases 20%, calculate the change in consumption and the
change in the revenue collected by the producers.

A 20% increases means that π would be 1,200 $/unit. The new amount of widgets
consumed would therefore be:

π 1, 200
q= + 200 = − + 200 = 80 units
−10 10

The revenue collected by the producers would then be 80 × 1,200 = 96,000 $. Therefore
the change in consumption is 80 – 100 = –20 units and the change on the revenue
collected is 96,000 – 10,0000 = – 4,000 $.

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f. What is the price elasticity of demand for this product and this group of
consumers when the price π is 1000 $/unit

The elasticity of demand is given by:

π dq
ε=
q dπ

From the inverse demand function we know that the amount of widgets consumed is
given by:

π
q= + 200
−10

Therefore the rate of change of the amount of widgets consumed with respect of the price
change is given by:

dq 1
=−
dπ 10

Since the price is 1000 $/unit for 100 units, the price elasticity of demand is:

1000  1 
ε=  −  = −1
100  10 

g. Derive and expression for the gross consumers’ surplus and the net
consumers’ surplus as a function of the demand. Check these expressions
using the results of part d.

The gross consumer surplus is given by the sum of the areas A and B; therefore:

q (π max − π )
gcs = A + B = +qπ
2

Where πmax = 2000 $/unit. And since the price is related to the demand
by: π = −10q + 2000 , we have:

gcs = ( 5q 2 ) + ( −10q 2 + 2000q ) = −5q 2 + 2000q

Evaluating the previous equation for an amount of 100 widgets we obtain a gross
consumers’ surplus of 150000 $, which is equal to the result obtained in part d.

The net consumer surplus is represented by area A, that is: ncs = 5q 2 ; again evaluating
this equation for 100 widgets we obtain ncs = 50,000 $.

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h. Derive and expression for the net consumers’ surplus and the gross
consumers’ surplus as a function of the price. Check these expressions using
the results of part d.

The gross consumer surplus is given by:

q (π max − π )
gcs = +qπ
2

And from the inverse demand function we know that the amount of widgets as a function
of the price is given by:

π
q=− + 200
10

Therefore the gross consumers’ surplus is:

π2   π2 
gcs =  − 200π + 200000  +  − + 200π 
 20   10 

−π 2
gcs = + 200000
20

For a price of 1000 $/unit the gcs = 150000 as in part d.

Finally the net consumers’ surplus is represented by area A, therefore:

π2 
ncs =  − 200π + 200000 
 20 

Evaluating this quantity for a price of 1000 $/unit, we get ncs = 50,000 $, as in part d.

2.3 Economists estimate that the supply function for the widget market is given by the
following expression:

q = 0.2 π − 40

a. Calculate de demand and the price at the market equilibrium if the demand is
as defined in problem 2.2.

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From problem 2.2, we know that the demand function is: π = −10q + 2000 , while the
supply function is now given as: π = 5q + 200 . If the market is at its equilibrium then the
market price is such that the values given by the demand function and the supply function
are equal. Therefore we have:

5q + 200 = −10q + 2000

The amount of widgets sold at market equilibrium is thus q = 120 while the market price
is: π = 5 (120 ) + 200 = 800 $/widget. These results are shown graphically as follows:

2200
demand
2000 supply

1800

1600

1400
p,[$/unit]

1200

1000 A
800

600

400
B
200 C
0
0 20 40 60 80 100 120 140 160 180 200 220
q, [units]
Figure P2.3: Market equilibrium

b. For this equilibrium, calculate the consumers’ gross surplus, the consumers’
net surplus, the producers’ revenue, the producers’ profit and the global
welfare.

The consumers’ gross surplus is given by the sum of areas labelled A, B and C on Figure
P2.3. Therefore we have:

120 ×1200
cgs = + 120 × 800 = 168, 000 $
2

The net consumers’ surplus is given by area A:

120 × 1200
ncs = = 72, 000 $
2

Areas B and C give the producers’ revenue:

pr = 120 × 800 = 96, 000 $

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And the producers’ profit is given by area B

120 × ( 800 − 200 )

pp = = 36, 000 $
2

Finally the global economic welfare is given by the sum of areas A and B

120 ×1200 120 × ( 800 − 200 )

gw = + = 108, 000 $
2 2

2.4 Calculate the effect on the market equilibrium of problem 2.3 of the following
interventions:
a. A minimum price of $900 per widget
b. A maximum price of $600 per widget
c. A sales tax of $450 per widget
In each case, calculate the market price, the quantity transacted, the consumers’
net surplus, the producers’ profit and the global welfare. Illustrate your
calculations using diagrams.

a) If a minimum price of $ 900 per widget is imposed on the market, π = −10q + 2000 we
can calculate the amount of widgets transacted from the demand function
( π = −10q + 2000 ):

π 900
q=− + 200 = − + 200 = 110 widgets
10 10

2200
demand
2000 supply

1800

1600

1400
p,[$/unit]

1200 A
1000

800 B
600

400
C
200 D
0
0 20 40 60 80 100 120 140 160 180 200 220
q, [units]
Figure P2.4-a: Effect on the market equilibrium of a minimum price of $900 per widget

The consumers’ net surplus is then given by area A:

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110 ×1100
cns = = 60,500 $
2

The producers’ profit is given by area B+C. In order to be able to compute area B, we
need to know the price at which the producers would be willing to sell 110 widgets
without market intervention. We can obtain this information from the supply function
( π p = 5q + 200 ):

π p = 5 (110 ) + 200 = 750 $/unit

110 × ( 750 − 200 )

pp = 110 × ( 900 − 750 ) + = 46, 750 $
2

Since the global welfare is the sum of the consumers’ surplus and the producers’ profit,
we have gw = 107250 $

b) If a maximum price of 600 $/widget is allowed in the market, then the demand is
obtained from the supply function as follows:

q = 0.2 π − 40 = 0.2 ( 600 ) − 40 = 80 widgets

The price that the customers would be willing to pay for this amount of widgets in the
absence of market intervention can be computed using the demand function:

π d = −10 ( 80 ) + 2000 = 1, 200 $

2200
demand
2000 supply

1800

1600

1400 A
p,[$/unit]

1200

1000

800 B
600

400 C
200 D
0
0 20 40 60 80 100 120 140 160 180 200 220
q, [units]

Figure P2.4-b: Effect on the market equilibrium of a maximum price of $600 per widget

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The consumers’ net surplus is given by the sum of areas the areas labelled A and B on
Figure P2.4-b:

80 × ( 2000 − 1200 )
cns = + 80 × (1200 − 600 ) = 80,000 $
2

And the producers’ profit is then given by area C:

80 × ( 600 − 200 )
pp = = 16, 000 $
2

The global welfare is given by the sum of the consumers’ net surplus and the producers’
profit: gw = cns + pp = 96,000 $.

If a sales tax of 450 $/widget is applied, then, the supply curve is offset by 450 $/widget
because this tax is passed on to the consumers.

2200

2000 demand
supply
1800

1600

1400
A
p,[$/unit]

1200

1000

800
B
600
C
400

200 D
0
0 20 40 60 80 100 120 140 160 180 200 220
q, [units]
Figure P2.4-c: Effect on the market equilibrium of a sales tax of $450 per widget

The market equilibrium is then given by:

5q + 200 + 450 = −10q + 2000

Therefore:

2000 − 650
q= = 90 widgets
15

And the market price can be obtained either from the supply function or from the demand
function. From the demand function we get:

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π d = −10 ( 90 ) + 2000 = 1,100 $/unit

The consumers’ net surplus is given by the area labelled A on Figure P2.4-c:

90 × ( 2000 − 1100 )
cns = = 40,500 $
2

The producers’ profit is given by the area labelled B on that same figure:

90 × (1100 − 650 )
pp = = 20, 250 $
2

The tax revenue is given by area D:

tr = 90 × 450 = 40,500 $

In this case the global welfare is given by the sum of the consumers’ net surplus, the
producers’ profit and the tax revenue:

gw = cns + pp + tr = 40,500 + 20,250 + 40,500 = 101,250 $

[Miguel: it might be nice to have a little table comparing these quantities for the four
cases considered: free market, min price, max price and tax].

2.5 The demand curve for a product is estimated to be given by the expression:
q = 200 − π
Calculate the price and the price elasticity of the demand for the following values
of the demand: 0, 50, 100, 150, and 200.
Repeat these calculations for the case where the demand curve is given by the
expression:

10000
q=
π

π dq
The demand elasticity is given by: ε =
q dπ

dq π
For the first demand function: = −1 ; therefore the elasticity is given by: ε = − .
dπ q

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dq −10000
For the second demand function: = , therefore the elasticity is given by:
dπ π2
π  −10000  −10000
ε=  =
q  π2  qπ

Substituting the expression of q given by the demand function in the previous expression,
we get ε = -1. This is an example of a product with a constant elasticity.

The table below shows the numerical results:

q = 200-π q = 10000/π
q (units) π ($/unit) ε π ($/unit) ε
0 200 -∞ ∞ -1
50 150 -3 200 -1
100 100 -1 100 -1
150 50 -1/3 200/3 -1
200 0 0 50 -1

2.6 Vertically integrated utilities often offer two-part tariffs to encourage their
consumers to shift demand from on-peak load periods. Consumption of electrical
energy during on-peak and off-peak periods can be viewed as substitute products.
The table below summarizes the results of experiments conducted by a utility
using a two-part tariff. Use these results to estimate the elasticities and cross
elasticities of demand for electrical energy during peak and off-peak periods.

On-peak Off-peak Average on- Average off-

price price peak demand peak demand
π1 ($/MWh) π2 ($/MWh) D1 (MWh) D2 (MWh)
Base case 0.08 0.06 1000 500
Experiment 1 0.08 0.05 992 509
Experiment 2 0.09 0.06 985 510

The price elasticity of a product j is given by:

π j dqi
ε=
qi dπ j

Let us denote by “1” the product “electricity consumed on-peak” and by “2” the product
“electricity consumed off-peak”.

The self-elasticity of the on-peak demand can be calculated using the difference in
demand and prices between the base case and experiment 2.

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π 1 ∆D1 0.08  −15 

ε11 = =   = −0.120
D1 ∆π 1 1000  0.01 

Similarly, the self-elasticity of the off-peak demand can be calculated using the difference
in demand and prices between the base case and experiment 1.

π 2 ∆D2 0.06  9 
ε 22 = =   = −0.108
D2 ∆π 2 500  −0.01 

The effect of a change in off-peak prices on on-peak demand is obtained using the change
in off-peak price between the base case and experiment 1 and the corresponding change
in on-peak demand. The corresponding cross-elasticity is:

π 2 ∆D1 0.06  −8 
ε12 = =   = 0.048
D1 ∆π 2 1000  −0.01 

Similarly, the cross-elasticity between the on-peak price and the off-peak demand
π ∆D2 0.06  9 
is: ε 22 = 2 =   = −0.108
D2 ∆π 2 500  −0.01 

π 1 ∆D2 0.08  10 
ε 21 = =   = 0.160
D2 ∆π 1 500  0.01 

2.7 Demonstrate that the marginal production cost is equal to the average production
cost for the value of the output that minimizes the average production cost.

The average cost is equal to the cost of producing a quantity “y” divided by this quantity:

c( y)
AC ( y ) =
y

The marginal cost of production at a quantity “y” is the rate of change of the cost with
respect to the change in production:

dc ( y )
MC ( y ) =
dy

The necessary condition for AC(y) to be minimum is that its derivative with respect to the
production be zero:

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d AC ( y )
=0
dy

Rewriting the previous equation in terms of the cost and the production we have:

d AC ( y ) 1  d c ( y) 
= 2 
y − c( y) = 0
dy y  dy 

Reordering the previous equation we get:

d c ( y) c( y)
=
dy y

The left-hand side of the equation is equal to the marginal cost while the right-hand side
of the equation is equal to the average cost, therefore at the minimum average cost:

MC ( y ) = AC ( y )

2.8 A firm’s short-run cost function for the production of gizmos is given by the
following expression:

C ( y ) = 10 y 2 + 200 y + 100000

a. Calculate the range of output over which it would be profitable for this firm
to produce gizmos if it can sell each gizmo for $2400. Calculate the value of
the output that maximizes this profit.
b. Repeat this calculation and explain your results for the case in which the
short-run cost function is given by:

C ( y ) = 10 y 2 + 200 y + 200000

In order for the sale of a product to be profitable, the average cost of production has to be
lower than the market price. For case (a), the average cost is:

C ( y) 100000
AC ( y ) = = 10 y + 200 +
y y

Therefore, to calculate the production for which the average cost is equal to the market
price we write:

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100000
2400 = 10 y + 200 +
y

Rearranging the previous equation we get:

10 y 2 − 2200 y + 10000 = 0

Solving the quadratic function we obtain that y1 = 155.82 and y2 = 64.17. Therefore the
range over which production would be profitable is: 65 ≤ y ≤ 155.

The production that maximizes the profit is such that the marginal cost is equal to the
market price:

d C ( y)
MC ( y ) = = 20 y + 200 = 2400
dy

20 y + 200 = 2400

The optimal production is thus y = 110 gizmos. Comparing this value to the range
calculated above, we conclude that the optimal production is profitable.

For case (b), the cost function is C ( y ) = 10 y 2 + 200 y + 200000 . Applying the same
procedure, we get the following equation for the range of productions that are profitable:

10 y 2 − 2200 y + 20000 = 0

Since this quadratic equation has only complex solutions, the average cost is always
higher than the market price. No amount of production is thus profitable.

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5000

4500

4000

3500
price, $/unit

3000

2500

2000

1500

1000
AC(y)
500 MC(y)
price
0
0 50 100 150 200 250 300 350 400
demand, units
Figure P2.8: Average cost of production for case (b)

The equation that gives the optimal production is the same in case (b) as it was in case (a)
because the only difference between the two cost functions is a constant term that
disappears when we calculate the marginal cost. The “optimal” production is case (b) is
thus also 110 gizmos. While this production is optimal, it is not profitable. Figure P2.8
shows that it is the value of production that minimizes the average loss per gizmo.

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