MGEB02: Price Theory

Summer 2023
Test-2 (Solutions)

Instructor A. Mazaheri
Instructions: This is a closed book examination. You are permitted to bring a non-programmable calculator.
Show all your work otherwise you will not get full credit.

Make sure you allocate time appropriately.

You have 2 hours.

Good Luck!
Last
Name:

First
Name:

ID

FOR MARKERS ONLY:

Q1 Q2 Q3 Q4 Q5 Total

Marks Earned

Maximum
Marks 45 20 15 10 10 100
Possible

The University of Toronto's Code of Behaviour on Academic Matters applies to all

University of Toronto Scarborough students. The Code prohibits all forms of academic
dishonesty including, but not limited to, cheating, plagiarism, and the use of unauthorized
aids. Students violating the Code may be subject to penalties up to and including suspension
or expulsion from the University.

Page 1 of 18
 Answer all following 5 questions:

Question-1 [45 Points] Answer the following Short Questions:

a) [5 Points] Based on the following figure comment on returns to scale and marginal return of labor.
Make sure to explain your answer:

2
Q = 75 Q2 = 120
Q3 = 150

2 3 4

Solution:

Returns to scale: Increasing Returns to Scale: 2,2 produces 75 while 3,4 produces 150 so 4.4 should
produce more than 150.
Marginal return of Labor: MPL is diminishing because if we keep capital constant (say at 1). Initial MPL
𝜟𝒒 𝟏𝟐𝟎−𝟕𝟓 𝜟𝒒 𝟏𝟓𝟎−𝟏𝟐𝟎
is approximately (𝜟𝑳 = 𝟑−𝟐 = 𝟒𝟓) falling to (𝜟𝑳 = 𝟒−𝟑 = 𝟑𝟎)

Alternatively if we keep K=2 and we add to the labour, the slope of the isoquant declines implying that as
more labour is employed, more labour is needed to substitute for the same amount of capital => therefore
the MPL is declining.

Page 2 of 18
b) [5 Points] A firmʹs total cost function is given by the equation: TC = 4500 + 80Q + 20Q2. Find this firm
output elasticity of cost and use it to identify its returns to scale.

Solution:

2400
𝐴𝐶 = + 80 + 20𝑞
𝑞
𝑀𝐶 = 80 + 40𝑞
𝑀𝐶 80 + 40𝑞
𝐸𝑐 = =
𝐴𝐶 4500 + 80 + 20𝑞
𝑞
4500
𝐸𝑐 = 1 => 20𝑞 = => 𝑞 = 15(𝐶𝑅𝑆)
𝑞
𝑞 > 15, 𝐸𝐶 > 1(𝐷𝑅𝑆)
𝑞 < 15, 𝐸𝑐 < 1(𝐼𝑅𝑆)

Page 3 of 18
c) (6 Points) Suppose we have the following production function q = min {6L, 30K}. Prices for K and L
are 30 and 6 respectively. First find and graph the equation for the long run cost function. Then find and
graph the equation for the short run cost function for a fixed capital of 10.

Solution:

Long Run (5 Points):

𝑞
=> 6𝐿 = 𝑞 => 𝐿 =
6
𝑞 LRTC
=> 30𝐾 = 𝑞 => 𝐾 =
30
𝐿𝑅𝑇𝐶 = 𝑞 + 𝑞 = 2𝑞

q
Short Run (3 Points):

If K = 10, the only efficient production is Q = 30K = 300, which will need Q = 300 = 6L => L = 50 labor.
This efficient production will cost (TC = 6*50 + 30*10 = 600). There will be no other efficient production
so cost function will not be defined.

Page 4 of 18
d) [5 Points] The short run production curve for a firm is shown in the following figure. On the lower
diagram, graphically derive the APL and the MPL.

q
q

Page 5 of 18
e) [6 Points] In a perfectly competitive market, there are 100 firm split equally between the
following short run cost functions:

𝐶1 (𝑞1 ) = 24q21 + 20q1 + 2500

𝐶2 (𝑞2 ) = 8q22 + 80q 2 + 3000

Find the total short run market supply curve and graph it.

Solution:

𝐶1 (𝑞1 ) = 24q21 + 20q1 + 2500

SRMC = 48q1 + 20, 𝑆𝑅𝐴𝑉𝐶 = 24𝑞1 + 20
𝑆𝑅𝑀𝐶 = 𝑆𝑅𝐴𝑉𝐶(𝑞1 = 0, 𝑝 = 20 − shoutdown point)
𝑃 = 48q1 + 20(if P ≥ 20)
𝐶2 (𝑞2 ) = 8q22 + 80q 2 + 3000
SRMC = 16𝑞2 + 80, 𝑆𝑅𝐴𝑉𝐶 = 8𝑞2 + 80
𝑆𝑅𝑀𝐶 = 𝑆𝑅𝐴𝑉𝐶(𝑞2 = 0, 𝑝 = 80 − shoutdown point)
𝑃 = 16𝑞2 + 80(if P ≥ 80)

Market supply:
𝑃 20
𝑞1 = 48 − 48 (𝑖𝑓𝑃 ≥ 20)
𝑃 80
𝑞2 = − (𝑖𝑓𝑃(≥ 80)
16 16

𝑄=0 (𝑃 < 20)

𝑃 20
𝑄 = 50( − ) = 1.04P-3.125 (20 < 𝑃 < 80)
48 48
𝑃 20 𝑃 80
𝑄 = 50( − ) + 50( − ) = 4.17P-270.8 (𝑃 ≥ 80)
48 48 16 16

80

20

Page 6 of 18
f) [6 Points] The long-run cost function of a firm in a perfectly competitive market is given by
C(q) = 1000q-36q2+0.4q3, where q is firm output. Market demand is given by

Qd = 10,000-2.9P

Find the long-run equilibrium values of output per firm, price, & the number of firms in the market.
Use a graph to demonstrate your solution.

Solution:

In long run equilibrium assuming identical firms we have:

1) P = MC
2) AC = MC
3) Qd = Qs = nq

P = MC = 1000 – 72Q + 1.2q2

AC = 1000 – 36Q + 0.4q2
1), 2) => AC = MC => q = 45 => p = 190
3) Qd = 10,000-2.9*45 = 9449 = n*45 => n = 210

Graph (2 Points)

Page 7 of 18
g) [6 Points] A production is characterized by q = (L1/2 + K1/2)2. Suppose Let w = 8 and r = 10.
Suppose in the short run capital is fixed at 49 units. What would be producer surplus if the market
price is 4?

Solution:

L = [q0.5 - 7]2
𝟐
=> 𝑻𝑪 = 𝟖[𝒒𝟎.𝟓 − 𝟕] + 𝟒𝟗𝟎
𝟕
𝑷 = 𝑴𝑪 = 𝟖 [𝟏 − 𝒒𝟎.𝟓 ]
𝟐
𝑽𝑪 = 𝟖[𝒒𝟎.𝟓 − 𝟕]

We know that in the short run fixed cost is sunk therefore:

P = 4 > q = 196
VC = 392
PS = TR - VC = 4×196 – 392 = 392

Page 8 of 18
h) (6 Points) In the long-run equilibrium of a competitive market, the market supply and demand
are:

Supply: P = 200 + 2Q
Demand: P = 2000 – 8Q,

where P is dollars per unit and Q is rate of production and sales in hundreds of units per day. One
firm in this market has a marginal cost of production expressed as:

MC = 200 + 30q.

Determine the economic rent that the typical firm enjoys and then briefly explain what Economic
rent means?

Solution:

Supply = Demand

200 + 2Q = 2000 – 8Q
Q = 180 (hundred per day)
P = 200 + 2(180) = $560 / unit

MC = 560 = 200 +30q

q = 12 (hundred per day)
PS = Economic Rent = (560-200)*12/2 = 2160

Economic rent: return to firm specific advantage (in labour, capital, location, etc)

Page 9 of 18
 Question-2 [20 Points] A consumer has the following utility function U=ln(8I) where I is the income. She
is currently employed with an annual wage of $100,000. However, she might be fired and if so then she
will have to find a second job that pays only $40,000 a year. The probability of him being fired is 40%. (p
= 0.40)

Note: Approximate to three digits.

a) [8 Points] Depict the utility of this consumer on the following diagram. Calculate the expected utility
for this consumer and identify it on the graph. Demonstrate that her utility of expected is higher than her
expected utility.

13.592
13.318

13.226

13.676

40000 76000 100,000

𝐸(𝐼) = 0.6 × 100,00 + 0.4 × 40,000 = 76,000

𝑈(𝐸(𝐼)) = ln(8 × 76,000) = 13.318
𝐸(𝑈) = 0.6 × ln(8 × 100,000) + 0.4 × ln (8 × 40,000) = 13.226

Page 10 of 18
b) [4 Points] An insurance company is offering full insurance in the case of him being fired. What is the
maximum that the consumer will pay for the insurance?

Solution:

𝐸(𝑈) = 13.226 = ln(8 × 𝐶𝐸)

𝑒 13.226
𝐶𝐸 = = 69,314.5
8
Since this is a full insurance E(I) = 100,000, therefore:

𝑅𝑃 = 100,000 − 69,314.5 = 30,685.5

Which is the maximum that the individual will pay for full insurance.

c) [4 Points] Now suppose that the insurance company is offering a partial insurance of $15,000 (in the
case she is fired he will receive a payment of $15,000 from the insurance company in addition to what she
earns) for a premium of $4,000. Would the consumer insure herself?

Solution:

With the insurance the expected Utility is:

𝐸(𝑈) = 0.6 × ln(8 × (100,000 − 4000))

+ 0.4 × ln(8 × (40,000 + 15,000 − 4000)) = 13.299

Which is higher than without => Will take the insurance.

Page 11 of 18
d) [4 Points] So far we have assumed that the probability of losing the job is 40%. Now suppose that is not
necessarily the case. What would be the maximum probability such that she is indifferent between insuring
and not insuring herself if she is offered the insurance as described in part (c).

Solution:

𝐸(𝑈)𝑤𝑖𝑡ℎ = (1 − 𝑝) × ln(8 × (100,000 − 4000))

+ 𝑝 × ln(8 × (40,000 + 15,000 − 4000)) = 13.552 − 1.326𝑝
𝐸(𝑈)𝑤𝑖𝑡ℎ = (1 − 𝑝) × ln(8 × (100,000)) + 𝑝 × ln(8 × (40,000)) = 13.592 − 1.609𝑝
𝐸(𝑈)𝑤𝑖𝑡ℎ =𝐸(𝑈)𝑤𝑖𝑡ℎ𝑜𝑢𝑡
13.552 − 1.326𝑝 = 13.592 − 1.609𝑝
𝑝 = 0.1439

Page 12 of 18
Question-3 [15 Points] Suppose that the production function for chairs is given by:

𝑞 = 4𝐾𝐿2 − 3𝐿3

where q is the number of chairs produced per year, K is the machine-hours of capital, and L is the man-
hours of labor.

a) [5 Points] Suppose that K = 1,500: Find average productivity of labor (APL) and the marginal
productivity of labor (MPL). At what level of labor does APL reach its maximum? What is the level of
output at this point?

Solution:

APL = 4 K L − 3L2
MPL = 8 K L − 9 L2
APL = MPL
4 K L − 3L2 = 8 K L − 9 L2
6 L = 4 K = 6000

APL is maximized when L = 1,000

L = 1,000, K = 1,500 => q = 3,000,000,000

b) [5 Points] Continuing to assume that K = 1,500: graph the APL and MPL curves on the space below.
Make sure to identify the points at which MPL = 0, the point where the output is maximized and the points
where APL and MPL are equal?

̅ 𝐿 − 9𝐿2 = 0 𝐿 = 0, 𝐿 = 1333.3
𝑀𝑃𝐿 = 8𝐾

1000 1333.3

Page 13 of 18
 c) [5 Points] Find MRTS. Does MRTS exhibit standard diminishing marginal returns to inputs? Graph
the isoquant of q = 20. (Note: Identify at least two points on it)

Solution:

q = 4 KL2 − 3L3
MPL 8KL − 9 L2 8K − 9 L
MRTS = = =
MPK 4 L2 4L
MRTS exhibits standard characteristics (i.e. declining) only if 8K-9L > 0, K> (9/8)L.
Assume q =20,
If L=1 then K=23/4 = 5.75, if L=2 then K= 2.75.

5.75
q = 20

2.75

Inefficient Production (When K< (9/8) L, MPL<0 & MRTS<0)

L
1 2

Page 14 of 18
Question-4 [10 Points] A firm faces the following production function:
0.75 0.25
q =20(K-10) (L)

a) [5 Points] Find the expression for short run total cost, short run variable cost, and short run marginal
cost. Assume that the rental cost of capital is 5 and the wage is 1 and that in the short run, capital is fixed
at 16. Identify when the average cost is minimized and graph the marginal cost and the average cost.
b) [5 Points] Find the long run cost function. Draw the firm’s expansion path.

Solution:

a)

𝐾̄ = 16
̄ − 10)0.75 (𝐿)0.25
𝑞 = 20(𝐾
𝑞 4 𝑞4
=> 𝐿 = ( ) =
56.57 10240000
𝑞4
𝑆𝑅𝑇𝐶 = 𝑤𝐿 + 𝑟𝐾̄ = + 80
10240000
4
𝑞
𝑆𝑅𝑉𝐶 =
10240000
4
𝑆𝑅𝑀𝐶 = 𝑞3
10240000

AVC = MC =>

𝑞3 80 4 3 80
+ = 𝑞 3 => 𝑞3 = => 𝑞 𝑆𝐷 = 128.56 => 𝑃 𝑆𝐷 = 0.83
10240000 𝑞 10240000 102400000 𝑞

Page 15 of 18
 b)

(𝐾 − 10) 𝑤 1
𝑀𝑅𝑇𝑆 = = =
3𝐿 𝑟 5
3𝐿
𝐾= + 10
5
0.75 0.25
3𝐿 0.75
𝑞 = (𝐾 − 10) 𝐿 => 𝑞 = ( ) (𝐿)0.25 = 0.68𝐿
5
𝐿 = 1.47𝑞, 𝐾 = 0.88𝑞 + 10

𝑇𝐶𝑙𝑜𝑛𝑔𝑡𝑒𝑟𝑚 = 𝑤𝐿 + 𝑟𝐾 = 1.47𝑞 + 5(0.88𝑞 + 10) = 5.87𝑞 + 50

Expansion Path
K=3L/5+10
10

Page 16 of 18
Question-5 [13 Points]: Suppose you are given the following information about a particular
industry:
𝑄 𝐷 = 45,000 − 800𝑃
𝑄 𝑆 = 3,700𝑃
𝑞2
𝐶(𝑞) = 1000 +
100

Where the two equations represent industry demand and supply and the next stands for a typical
firm cost structure. Assume that all firms are identical, and that the market is characterized by
perfect competition.

a) (4 Points) Would you expect to see entry into or exit from the industry in the long run?
Explain. What effect will entry or exit have on market equilibrium?
b) (6 Points) What is the lowest price at which each firm would sell its output in the long run? Is
profit positive, negative, or zero at this price? Explain. What is the lowest price at which each
firm would sell its output in the short run? Is profit positive, negative, or zero at this price?
Explain.

Solution:

a)
𝑄 𝐷 = 𝑄 𝑆 => 𝑃 = 10
𝑞
𝑀𝐶 = 𝑃 = 10 = => 𝑞 = 500
50
5002
𝜋 = 500 × 10 − (1000 + ) = 1500
100

Since profit is > 0 firms will have incentive to enter. As a result, the market quantity will
increase and the market price will fall.

b) The minimum price can be found by equating the marginal cost with the average cost:

𝑞 1000 𝑞
𝑀𝐶 = , 𝐴𝐶 = +
50 𝑞 100
𝑞
=> 𝑞 = 223.6 => 𝑃 = 𝑀𝐶 = = 4.47
50

The firm will not sell for any price below 4.47. The long-run equilibrium price is therefore $4.47, and
at a price of $4.47, each firm’s economic profit equals zero because P = AC.

𝑞 𝑞
𝑀𝐶 = , 𝐴𝑉𝐶 =
50 100
𝑀𝐶 = 𝐴𝑉𝐶 => 𝑞 = 0 => 𝑃 = 0

Page 17 of 18
The firm will sell for any positive price, because at any positive price, marginal cost is above average
variable cost. Profit is negative if price is below minimum average cost, or as long as price is below $4.37.
Profit is zero if price is exactly $4.47, and profit is positive if price is greater than $4.47.

Page 18 of 18