Problem Set #6: Cost Curves, Firm and Industry Supply, Market Equilibrium

Microeconomics I
The problems marked with an asterisk (∗ ) will be given higher priority in the seminars.

Profit Maximization, Cost Minimization

1. (∗ ) Suppose that work (L) and capital (K) can be combined to produce Y units of
output as represented by the following production function: Y = 30K + 10L. The
firm wants to produce 600 units of output.

(a) Draw the isoquant that corresponds to this level of production (600 units) in
the space (L, K) (that is, in a graph where L is on the horizontal axis and K
is on the vertical one).
(b) Analyze how L and K can be substituted while producing Y units: How many
units of K can be replaced by a unit of L without changing output? How many
units of L can be replaced by a unit of K without changing output? Does your
answer depend on the initially employed quantities employed L and K?
(c) Suppose the price (r) of capital is 1000e (per machine per week). What
combination of inputs will the firm employ if the weekly wage for each worker
is 400e?
(d) Suppose the price of capital is still 1000e (per machine per week). What
combination of inputs will the firm employ if the weekly wage for each worker
is 300e?

1
Cost Curves

2. Consider the following hypothetical total cost curves (CT (Y )):

Consider the following hypothetical average cost curves (AC(Y ), in red) and marginal
cost curves (M C(Y ), in yellow):

(a) For each of the Figures 1 to 4, show whether the cost curve corresponds to
a technology of decreasing, constant, or increasing returns to scale. Explain
your answer.
(b) For each of the Figures 5 to 8, show whether the average cost curve corresponds
to a technology with increasing, constant or decreasing returns to scale.
(c) Some of the last four graphs are impossible since they do not respect the
relation between marginal and average cost. Which ones are these and explain
why they are not possible?

2
3. (∗ ) The short run cost curve of a firm is C(Y ) = 1000 + 40Y 2 .

(a) Find the variable cost function, V C(Y ), and the fixed cost function, F C. Draw
these in a graph with Y on the horizontal (and the cost, expressed in e’s, on
the vertical) axis.
(b) Find the short run average cost function, AC(Y ), and the average fixed cost
function, AF C(Y ) and the average variable cost function, AV C(Y ). Draw
these curves in a new graph with Y on the horizontal (and the cost, expressed
in e’s, on the vertical) axis.
(c) Find the short run marginal cost curve, M C(Y ). Draw this curve in the
graph of part (b), and show that M C(Y ) passes through the minimum of the
average cost curve, AC(Y ), and through the minimum of the average variable
cost curve, AV C(Y ).
(d) Now draw the short run marginal cost curve, M C(Y ), in a new graph again
with Y on the horizontal axis (and cost expressed in e, on the vertical). Show
that the variable cost V C(Y ), can be computed as the area below the marginal
cost curve, M C(Y ), until the production level Y . (Hint: the area of a triangle
is 1/2 of the product of the base with the height).

4. (∗ ) Consider the following cost curve of a firm, C(Y ) = 1000Y − 30Y 2 + Y 3 , where
Y is the number of units of output.

(a) Find the equation that defines the average cost, AC(Y ). What is the minimum
efficient scale for this firm?
(b) In what range of production does the firm’s underlying production technology
exhibit increasing returns to scale (also called economies of scale)? In what
range does it exhibit decreasing returns to scale (also called diseconomies of
scale)?
1 1
5. (∗ ) A firm has a production function of the form y = f (x1 , x2 ) = x1 3 x2 3 .

(a) Draw some isoquants for this production function.

(b) Obtain the (long run) cost function and graphically represent the marginal
cost and the average cost curves for w1 = w2 = 10.
(c) Obtain the short-run cost function for x2 = 100 and represent graphically the
curves AC, AVC, AFC and MC for w1 = w2 = 10.
(d) Obtain the (long run) supply curve for this firm and draw it in the picture of
part (b).
(e) Obtain the short-run supply curve and draw it in the picture of part (c).
(f) How do your results of parts (b) and (c) change if the production function
2 2
changes to y = f (x1 , x2 ) = x1 3 x2 3 ?
(g) How do all your results in (a)–(e) change if the production function changes
2
to y = f (x1 , x2 ) = min{2x1 , 5x2 } 3 ?

3
Firm and Industry Supply and Market Equilibrium

6. Consider the long-run cost function given by c(y) = y + 4y 2 + 1.

(a) Find the average cost, AC(y).

(b) Find firms long-run supply function.
(c) Suppose that market demand is given by D(p) = 36 − 2p. All firms have
identical long-run cost functions. How many firms enter in the long-run?
(d) What is the long-run equilibrium price and quantity.

7. A profit-maximizing firm produces gadgets (Y ) using machines (K) and workers

(L). Weekly production is given by the production function Y = 5L1/2 K 1/2 . In the
short run, capital is fixed at the level (K̄ =) 16 machines. The price per week of a
machine (r) is 625e, and the weekly salary (w) is 400e.

(a) Derive the equation defining the short run cost function of the firm, C(Y ), the
short run average cost, AC(Y ), and the average variable cost, AV C(Y ).
(b) If the fixed cost is a sunk cost (that is, it is inevitable and irrecoverable even
if the firm produces zero), what is the shutdown price of the firm (pt ), that is,
the lowest price below which the firm prefers to shut down? How many units
of output Y will the firm want to produce in the short run if the market price
p is below the shutdown price pt ?
(c) How many units of output Y will the firm produce in the short run when the
market price p is above the shutdown price pt that you computed in part (b)?
(d) Based on your answers in (b) and (c), write down the short run supply curve
Y (p), where p is the market price. Suppose there are 40 identical firms in this
market. What will be the short run industry supply curve, Y S (p)?
(e) Suppose that the aggregate demand in this market is given by Y d (p) = 7.500−
10p. Given that the supply curve for this industry, Y S (p), is the one you
computed in part (d), what will be the equilibrium market price for one gadget?
How many gadgets will each one of the 40 firms produce? What will be the
profits of each one of the 40 firms?
(f) At the market equilibrium, compute the price elasticity of the demand and
supply of gadgets. [Hint: The elasticity at a specific point of a curve or
p
function can always be computed using the following formula: ε = ∂Y ∂p Y
]. Is
demand/supply at this point, elastic, inelastic or of unitary elasticity?
(g) For the equilibrium computed in part (f), compute the consumers’ surplus, the
producers’ surplus and the total surplus. The total surplus is also referred to
as the total gains from trade of this market.

8. In a market you have the following supply and demand curves:

D(p) = 10 − 5p and S(p) = 2 + 8p.

(a) Characterize the equilibrium in this market and represent it graphically.

(b) At the equilibrium price in (a), what is the consumer and the producer surplus?

4
(c) Suppose now the government imposes a quantity tax. The producers have to
pay t to the government for every unit that they sell (excise tax). Explain how
this affects the supply of the good and show it graphically. Determine the new
equilibrium price. Compute the loss in the consumer and producer surplus.
(d) In the long run all firms have constant average costs. Who pays for the tax in
this case?