Problem Set-Unit D Answers

February 2021

Question 1
In this question we will consider the short-run equilibrium in a market for some good y for the case of perfect
competition. Suppose each producer has a production function given by y = Lα M β K γ , where L is the amount of
labour, M denotes the amount of intermediate inputs and K = K is the fixed level of capital. We assume that
α + β < 1. Moreover, a firm can avoid paying for capital if it chooses to shut down.

1. Let ω and q be the wage rate of labour and price of intermediate inputs, respectively. Set up
the firm’s cost minimization problem and obtain the levels of L(ω, q, y, K) and M (ω, q, y, K) that
minimize cost.
Let r be the rental rate of capital. The cost minimization problem is

min ωL + qM + rK subject to Lα M β K γ ≥ y
L,M

Set up the Lagrangean:

Λ(L, M, K, λ) = ωL + qM + rK + λ(y − Lα M β K γ )
We will consider the solutions such that the constraint is binding (i.e. Lα M β K γ = y). The first order conditions
are:
∂Λ(·) γ
= ω − λαLα−1 M β K = 0
∂L
∂Λ(·) γ
= q − λβLα M β−1 K = 0
∂M
∂Λ(·) γ
= Lα M β K − y = 0
∂λ
Divide the first equation above by the second:
αM ω βω
= →M = L
β L q αq

(1)

Substituting this expression into our constraint yields to:

 β ω β γ
y = Lα L K
αq
Solving for L:
1
! α+β β
!− α+β
y βω
L= γ
K αq

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 Finally, substituting expression for L into equation (1) implies:
1
! α+β β
!− α+β 1
! α+β α
! α+β
βω y βω y βω
M= γ →M = γ
αq K αq K αq

2. Analyze how the optimal amount of intermediate inputs (M (ω, q, y, K)) changes with the wage
rate (ω). Explain the intuition behind your result. From the expression for cost minimizing level of M
found above, we can see that
∂M
>0
∂ω
In order to understand why this is the case note that M and L can be substituted (not perfectly, of course) for
each other (due to Cobb-Douglas production function). Hence, when price of L goes up, the desired production
level can be sustained by decreasing the level of L and increasing M . Hence, this is the usual substitution
effect.
3. Obtain a firm’s cost function and analyze how cost changes with the desired level of output
The function is:
c(ω, q, r, y) = ωL(ω, q, y, K) + qM (ω, q, y, K) + rK
Substituting the cost minimizing levels of L and M yields to:
1 "
! α+β β
!− α+β α #
! α+β
y βω βω
c(ω, q, r, y) = γ ω +q + rK
K αq αq

As can be seen from the expression above, cost increases with the level of output.

4. Let p be the price level of y. Write down expressions for firm’s average and marginal costs. What
is firm’s supply curve? Plot marginal cost, average cost and supply curve on the same graph.
Marginal cost is given by:
1 " β
!− α+β α #
1−(α+β) ! α+β ! α+β
∂c(·) y α+β 1 βω βω
= γ ω +q
∂y α+β K αq αq

In addition, the average cost is given by:

1 "
! α+β β
!− α+β α #
! α+β
c(ω, q, r, y) 1−(α+β) 1 βω βω K
= y α+β γ ω +q +r
y K αq αq y

As each firm operates in a perfectly competitive market, it takes price as given. Therefore, an individual firm’s
supply function is determined by p = M C. Moreover, a firm will choose to operate in the market, as long as
it can cover its average cost. Hence, an individual firm’s supply function is the part of marginal cost above
average cost
1 " β
!− α+β α #
1−(α+β) ! α+β ! α+β
∂c(·) y α+β 1 βω βω ∂c(·) c(ω, q, r, y)
p= = γ ω +q if ≥
∂y α+β K αq αq ∂y y

On the graph, supply curve is the part of the M C above AC.

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AC, M C, p

M C( ∂c(·)
∂y )

AC( c(ω,q,r,y)
y )

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5. Suppose that there are N > 1 suppliers in the market. Find the industry supply function.
Rearrange the above supply function:
" α+β
# 1−(α+β)
p(α + β)
y=
Ω
1 "
! α+β β
!− α+β α #
! α+β
1 βω βω
where Ω = K
γ ω αq +q αq

The market supply function is the sum of the N individual supply functions:
" α+β
# 1−(α+β) " α+β
# 1−(α+β)
N
X p(α + β) p(α + β)
YS = =N
i=1
Ω Ω

6. Now consider the demand side of this market. Suppose there are C > 1 consumers, each with
utility function U (y, x) = y µ x1−µ , where x is a numeraire good (i.e. price of x is one). Moreover,
suppose consumers are heterogeneous in their income levels, which each of them having income
level denoted by Ic , c = 1, . · · · , C. Solve a consumer’s utility maximization problem and find the
market demand function for y.
An individual consumer’s utility maximization problem is:

max y µ x1−µ subject to py + x ≤ Ic

y,x

Again we will focus on solutions such that the constraint binds (in fact it will always bind for such a utility
function). Set up the Lagrangian:

Λ(y, x, λ) = y µ x1−µ + λ(Ic − py − x)

Take the first order conditions:

∂Λ(·)
= µy µ−1 x1−µ − λp = 0
∂y
∂Λ(·)
= (1 − µ)y µ x−µ − λ = 0
∂x
∂Λ(·)
= Ic − py − x = 0
∂λ
Solving for y yields to individual demand function given by:
Ic
yc = µ
p

Given the individual demand function, the market demand function is obtained by summing over individual
demand functions:
C PC
D
X Ic
Y = yc = µ c=1
c=1
p

7. Solve for equilibrium market price and quantity of y.

In order to solve for equilibrium price and quantity, we need to equate demand and supply:

YS =YD
" α+β
# 1−(α+β) PC
p(α + β) c=1 Ic
→N =µ
Ω p

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 Solving the above expression for p yields to:
" P #1−(α+β) " #−(α+β)
C
∗ c=1 Ic α+β
p = µ
N Ω

In order to obtain the equilibrium quantity, p∗ can be substituted into demand or supply functions. Solving
for equilibrium quantity yields to:
" C
#(α+β) " #α+β
∗
X
1−(α+β) (α + β)
Y = µ Ic N
c=1
Ω

8. Suppose that income of some consumer c increases exogenously. What is the impact of this
change on the equilibrium market price and quantity in the market for y?
PC
An increase in the income of consumer c will increase aggregate income c=1 Ic . As both market price and
quantity increase in aggregate income, this change will push up both equilibrium price and quantity.
9. Let C = 10 and suppose that the government is worried about income inequality among consumers
and decides to transfer some amount of income from certain consumers to others. More precisely,
suppose that the government taxes each consumer c = 6, 7, · · · , 10 by a fixed amount F < Ic
and pays each consumer c = 1, 2 · · · , 5 exactly F . What is the impact of this redistribution on
equilibrium market price and quantity in the market for y?
Lets first analyze the change in aggregate income after this policy is implemented. Consider consumers c =
6, 7, · · · , 10. The total income of these consumers after the policy is
10
X
Ic − 5F
c=6

Income of consumers c = 1, 2 · · · , 5 after the policy is:

5
X
Ic + 5F
c=1

Thus the aggregate income after the policy is implemented is:

10
X 5
X 10
X 5
X 10
X
Ic − 5F + Ic + 5F = Ic + Ic = Ic
c=6 c=1 c=6 c=1 c=1

Thus, the aggregate income remains unchanged. What matters for market equilibrium price and quantity is aggregate
income. As it remains unchanged, market price and quantity will remain unchanged as well.

Question 2
Consider a perfectly competitive market for some good q. Each firm’s long-run total cost is given by LRT C(q) =
1 3 2 d
6 q − 3q + 20q. In addition, the market demand function is given by q (p) = 1100 − 50p.

1. Find each firm’s long run supply function.

In a perfectly competitive market each firm takes market price as given. The necessary condition for profit
maximization implies
p = MC
Thus, given that
dLRT C(·) 1
MC = = q 2 − 6q + 20
dq 2

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 An individual firm’s long-run supply function is
1 2
p= q − 6q + 20
2

2. What is the equilibrium quantity that each firm produces in the long-run?
In the long-run each firm makes zero profits, which means marginal cost equals long-run average cost. Given
that the long-run average cost is LRTqC(q) = 61 q 2 − 3q + 20, we have:

1 2 1
q − 6q + 20 = q 2 − 3q + 20
2 6
Solving the above for q > 0 implies that each firm produces q ∗ = 9 in the long-run.
3. Find the long-run equilibrium price and number of firms in the market.
For equilibrium price, plug q ∗ = 9 into individual firm’s supply function:
81
p∗ = − 54 + 20 = 6.5
2
In order to find the number of firms in the market, consider the demand function. At price p∗ = 6.5 total
demand is
q d = 1100 − 50 × 6.5 = 775
Given that each firm supplies 9 units, the total number of firms, n, must be:

n × 9 = 775 → n = 86.1 ≈ 86

4. Now suppose that the market demand changes to q d (p) = 2200 − 50p. How does the long-run
equilibrium market price change? Is there any change in the long-run equilibrium number of
firms?
Note that the total cost function of an individual firm remains unchanged, which means the marginal cost and
average cost functions remain unchanged as well. Hence, in the long-run, each individual firm will still supply
9 units and equilibrium market price will be 6.5, as before.
However, as market demand has shifted up (only intercept increased), the total quantity demanded will go up.
That is, at p∗ = 6.5, the total amount demanded becomes:

q d = 2200 − 50 × 6.5 = 1875

This implies that the total number of firms now becomes:

n × 9 = 1875 → n = 208.3 ≈ 208

Question 3
Consider a firm, called WXM, which operates in a perfectly competitive market. The short-run total cost is given
by SRT C(q) = 40 + 10q + 0.1q 2 , where q is the amount of output produced. We will assume that all fixed costs are
sunk.

1. Find WXM’s short-run supply curve. Plot the supply curve alongside with short-run average
cost and marginal cost curves.
In a perfectly competitive market firms take price as given and maximize profits. The necessary condition for
profit maximization is P = M C. Moreover, a firm will be willing to supply if price is such that it can cover
short-run average variable costs.

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Given the total cost, marginal cost is:

dSRT C(·)
MC = = 10 + 0.2q
dq
In addition, the average variable cost function is given by:

SRAV C(q) = 10 + 0.1q

SRAV C(q) reaches its minimum at q = 0. Hence, the minimum price at which the firm is willing to participate
is pM IN = 10 + 0 = 10. Given the necessary condition for profit maximization, WXM’s short-run supply
funciton is:
P = 10 + 0.2q if P > 10

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AC, M C, P

SM C
Profit

20
SRAC

50 q

2. Suppose that the market price is 20 per unit. How many units does WXM produce to maximize
its profits? Calculate WXM’s profits and show it on the graph that you drew in previous part.
Given the supply function found above, at P = 20 WXM produces

20 = 10 + 0.2q → q = 50

Hence, WXM’s profit is:  

π = 20 × 50 − 40 + 10 × 50 + 0.1 × 502 = 210