Economics 2100
Problem Set 3
Due 3pm on Thursday, September 18, 2025 (submit on Canvas)
Show all work for full credit. A subset of questions from this homework will be selected and graded.
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problem set.
Question 1. Philly Pretzel Company is a monopoly producer of Philly pretzels. The demand
for Philly pretzels is D(p) = 150 − 30p and the cost of producing pretzels is C(q) = q 2 /10.
1. Compute the marginal revenue (in terms of q).
Solution:
The marginal revenue is M R(q) = 5 − q/15.
q
Justification: The inverse demand function is p = 5 − 30
. We can write the revenue
as a function of q:
R(q) = q(5 − q/30).
The marginal revenue is
dR(q)
M R(q) = = 5 − q/15.
dq
2. Compute the marginal cost (again in terms of q). What type of returns to scale does Philly
Pretzel Company have?
Solution:
M C(q) = q/5, and Philly Pretzel Company has decreasing returns to scale.
Justification: Marginal cost is the first derivative of the cost function:
dC(q)
MC = = q/5.
dq
The returns to scale is characterized by the second derivative of the cost function:
d2 C(q)
= 1/5 > 0.
dq 2
As the second derivative is positive, it is decreasing returns to scale.
3. Compute the profit-maximizing price and quantity of pretzels.
Solution:
p∗ = 4.375, q ∗ = 18.75.
Justification: The profit maximizing quantity can be solved by equating the marginal
revenue to the marginal cost:
5 − q/15 = q/5 ⇒ q ∗ = 75/4 = 18.75.
Global optimality is guaranteed as the marginal revenue is decreasing in q and the
marginal cost is increasing in q.
The profit maximizing price is
p∗ = 5 − q ∗ /30 = 4.375.
4. What profit does Philly Pretzel Company earn at this profit-maximizing price?
Solution:
(q ∗ )2
π ∗ = p∗ · q ∗ − 10
= 46.875.
5. What is consumer surplus at this profit-maximizing price?
Solution:
CS ∗ = 5.86
Justification:
Z q∗ Z 18.75
∗ q ∗ q
CS = (5 − − p )dq = (5 − − 4.375)dq
0 30 0 30
Z 18.75
q q2
= (0.625 − )dq = 0.625q − |18.75 = 5.86.
0 30 60 0
6. Now suppose that pretzels are taxed by $1 per pretzel. Compute the profit-maximizing price
and quantity of pretzels given this tax. Compare your answers to those in part (3) and give
economic intuition for how they changed.
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Solution:
p∗∗ = 4.5, q ∗∗ = 15. p∗∗ > p∗ and q ∗∗ < q ∗ .
Justification: With unit tax of $1, the new profit maximization problem is
q q2
max q(5 − ) − − q.
q 30 10
The first order condition is
q q
4− − = 0 ⇒ q ∗∗ = 15.
15 5
4
The second order condition holds as − 15 < 0. The new profit-maximizing price is
q ∗∗
p∗∗ = 5 − = 4.5.
30
When a unit tax is imposed, the margin faced by the monopolist decreases. The mo-
nopolist responds by producing a smaller quantity, and the price rises accordingly. As a
result, part of the unit tax is passed on to consumers.
7. Compute Philly Pretzel Company’s profit when there is a $1 per pretzel tax. Compare your
answer to part (4) and give economic intuition for how it changed.
Solution:
π ∗∗ = 30. The profit decreases by 16.875.
Justification:
(q ∗∗ )2
π ∗∗ = p∗∗ · q ∗∗ − − q ∗∗ = 30.
10
The profit decreases by π ∗ − π ∗∗ = 16.875. Note that this decrease is smaller than the
tax payment that would have been incurred at the original profit-maximizing quantity,
18.75. The reason is that the monopolist reoptimizes its output and shifts part of the
unit tax onto consumers.
8. Compute consumer surplus when there is a $1 per pretzel tax. Compare your answer to part
(5). Are consumers better or worse off under the tax? Why?
Solution:
CS ∗∗ = 3.75. Consumer surplus decreases by 2.11.
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Justification:
Z q ∗∗ Z 15
∗∗ q ∗∗ q
CS = (5 − − p )dq = (5 − − 4.5)dq
0 30 0 30
Z 15
q q2 ∗
= (0.5 − )dq = 0.5q − |15 0 = 3.75 < 5.86 = CS .
0 30 60
Consumers are worse off under the tax as the quantity sold decreases and the price
increases.
9. Compute the tax revenue that the government earns under the $1 per pretzel tax.
Solution:
T axRev = $1 · q ∗∗ = $15.
10. Challenge: consider a tax t per pretzel. What tax t maximizes tax revenue to the govern-
ment? How does the government’s tax rate decision related to the classic margin vs. volume
trade-off of firms?
Solution:
The tax revenue maximizing unit tax t is 2.5.
Justification: For an arbitrary t, the monopolist’s profit maximization problem is
q q2
max q(5 − )− − t · q.
q 30 10
The first order condition gives us:
q q 15
5− − − t = 0 ⇒ q(t) = (5 − t).
15 5 4
The second order condition is the same as before.
15
Expecting that the monopolist is going to sell q(t) = 4
(5 − t), the government’s tax
revenue maximization problem is
15
max t · (5 − t).
t 4
The first order condition is
15
(5 − 2t) = 0 ⇒ t∗ = 2.5.
4
The second order condition holds as the second derivative of the tax revenue function
is −7.5 < 0. Note that the government’s tax revenue maximization problem has similar
trade-off to the classic margin vs. volume trade-off of firms. The government has an
incentive to raise t in order to collect more tax revenue per unit sold, but it also has an
incentive to lower t to induce a higher volume of transactions.
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Question 2. Nike uses labor (L) and thread (K) to make Eagles hats. Suppose the production
function for the production of hats is
(
0, if L < 1,
q= 1/2 1/2
K (L − 1) , if L ≥ 1,
where q is the quantity of hats (in thousands) produced from L days of labor and K tons of thread.
1. Graph the isoquants for two positive values of q (these do not have to be mathematically
precise).
Solution:
60 q = 2.0
q = 2.5
50
40
L
30
20
10
0
0 0.5 1 1.5 2
K
Justification: For any q > 0, the production function satisfies q = K 1/2 (L − 1)1/2 . We
can express L as a function of K given q, which is
q2
L=1+ .
K
The above graphs illustrate the isoquant curves with q = 2 and q = 2.5.
2. Suppose w is the price of labor and r is the price of thread. Solve for the cost-minimizing
choices of labor and thread to produce q > 0 thousands of hats. Write the cost function
C(q) (note that it will also depend on w and r).
Note that since the isoquants are convex, the FOC is sufficient for solving the cost mini-
mization problem and you do not need to check the SOC (we will discuss this Monday in
lecture).
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Solution:
( ( (
0, q=0 0, q=0 0, q=0
K∗ = p w L∗ = pr C(q) = √
r
q, q > 0 1 + w q, q > 0 w + 2 rw q, q > 0
Justification: The cost-minimization problem for q > 0 is
min rK + wL
K,L
s.t. q = K 1/2 (L − 1)1/2 .
q2
Rearranging the constraint gives L = 1 + K
. Substituting into the objective yields an
unconstrained single-variable problem:
q2
min rK + w 1 + .
K K
The first-order condition is
r
wq 2 ∗ w
r− 2 =0 ⇒ K = q.
K r
Then r
∗ q2 r
L = 1+ ∗ = 1+ q.
K w
Therefore, the cost function for q > 0 is
q q √
C(q) = rK ∗ + wL∗ = r w
r
q + w 1 + r
w
q = w + 2 rw q.
The cost-minimizing combination of inputs for q = 0 is trivially (0, 0), leading to C(0) =
0.
3. Suppose w = 1 and r = 2. What are the cost-minimizing inputs for quantities q = 1, q = 2,
and q = 3? Note that q = 2 is the average of q = 1 and q = 3. How does the cost-minimizing
choice of inputs for q = 2 compare with the average of the cost-minimizing inputs for q = 1
and q = 3?
Solution:
The cost-minimizing inputs with w = 1 and r = 2 are given by
q K L
1 0.707 2.414
2 1.414 3.828
3 2.121 5.243
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The cost-minimizing inputs for q = 2 is the same as the average of the cost-minimizing
inputs for q = 1 and q = 3.
Justification: Plugging in r = 2 and w = 1 to (K ∗ , L∗ ) derived in Part 2 gives
√
r
1
K∗ = q, L∗ = 1 + 2q.
2
Note that both inputs are linear in q, which means that the cost-minimizing inputs for
q = 2 is equal to the average of the cost-minimizing inputs for q = 1 and q = 3.
4. What is the resulting cost function at w = 1 and r = 2? What returns to scale does it have?
Solution:
The resulting cost function is
(
0 q = 0,
c(q) = √
1 + 2 2q q > 0.
The technology displays constant returns to scale.
Justification: The solution is obtained by plugging the w = 1 and r = 2 in the cost
function. For q > 0, the cost function is linear in q. This implies constant returns to
scale as c′′ (q) = 0.
5. Suppose there is 10% inflation in the wage rate and the price of labor rises to w = 1.1. The
price of thread stays the same at r = 2. What are the cost-minimizing inputs for quantities
q = 1, q = 2, and q = 3?
Solution:
The cost-minimizing inputs with w = 1.1 and r = 2 are given by
q K L
1 0.742 2.348
2 1.483 3.697
3 2.225 5.045
Justification: Plugging in r = 2 and w = 1.1 to (K ∗ , L∗ ) derived in Part 2 gives
r r
1.1 2
K∗ = q, L∗ = 1 + q.
2 1.1
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6. How does this inflation change the capital-labor ratio at the level of inputs used to produce
each of these quantities (note: the capital labor ratio corresponds to K/L). Provide economic
intuition for your answer.
Solution:
Capital-labor ratio increases due to wage rate inflation.
Justification: The following table summarizes the capital-labor ratio for w = 1 and
w = 1.1, using the cost-minimizing inputs calculated in Part 3 and 5:
q w = 1 w = 1.1
1 0.293 0.316
2 0.369 0.401
3 0.405 0.441
When labor becomes relatively more expensive, the firm reoptimizes its input combina-
tion - using less labor and more threads to produce the same output. This adjustment
raises the capital-labor ratio.
7. What is the cost of producing q = 1, q = 2, and q = 3 after the wage inflation? Does this
10% wage inflation lead greater than 10%, less than 10% or equal (10%) inflation in the cost
of hats? Provide economic intuition for your answer.
Solution:
q w = 1 w = 1.1 ratio
1 3.41421 3.48324 1.02022
2 4.82843 4.96648 1.02859
3 6.24264 6.44972 1.03317
The 10% wage inflation leads to less than 10% inflation in the cost of production.
Justification: The cost function after the wage inflation is
(
0 q = 0,
c(q) = √
1.1 + 2 2.2q q > 0.
Plugging in q = 1, 2, 3 into the cost function derived in Part 4 and 7 gives the costs
summarized in the above table. Note that although there is 10% wage inflation, the
total cost increases by less than 10%. This is because the producer adjusts the capital-
labor ratio and use more threads, which is now a relatively cheaper input.
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