Economics 2100

Problem Set 2
Due 3pm on Thursday, September 11, 2025 (submit on Canvas)

Show all work for full credit. A subset of questions from this homework will be selected and graded.
Please follow the guidelines on the formatting and uploading of solutions described in the first
problem set.

1. You are an author and are about to sign a contract with a book publisher. Under the terms
of the contract the publisher has sole authority to set the price. The only issue is what
percentage of the revenue you receive. Is it always the case that you would want as high a
percentage as possible?
To make things concrete suppose the demand for the book as a function of its price p is
D(p) = 5, 000(3 − p). The unit cost of production, distribution, and advertising for the book
is $1. Let α ∈ (0, 1) denote the fraction of the revenue that the author receives.

(a) Compute the publisher’s profit maximizing price as a function of α for α < 2/3. Is it
increasing or decreasing as a function of α? Give intuition for your.

Solution:
The profit maximizing price of the publisher as a function of α is p∗ = 4−3α
2(1−α)
.
Justification: The publisher’s profit function is

Π(p) = (1 − α)pD(p) − q
= 5, 000[(1 − α)(3 − p)p − (3 − p)]
= 5, 000(3 − p)[(1 − α)p − 1]
= 5, 000[−3 + (4 − 3α)p − (1 − α)p2 ].

The publisher will choose p to maximize his profit (note that we can ignore the
5,000 factor, since it is present in all terms and so cancels out). The FOC is
4 − 3α
4 − 3α − 2(1 − α)p = 0 =⇒ p∗ =
2(1 − α)

The second-order condition holds, −2(1 − α) < 0, so this is indeed the profit-
maximizing price as a function of α.
The optimal price is increasing in α.
The intuition is that for higher α, the publisher retains a smaller fraction of the
revenue, and so each copy sold is less valuable. Consequently, the reduction in
demand from higher prices is less costly to the publisher.
Observe that the upper bound of 2/3 on α is needed to ensure the price is below
the choke price of 3.
 (b) What happens if α > 2/3? Hint: what is the relationship between the choke price and
marginal cost?

Solution:
When α ≥ 2/3, the money the publisher receives from any sale (if there was one)
at the choke price is less than marginal cost, and so positive sales would require the
publisher to set a price that yields less money than the cost of production, and so
the publisher would lose money. So, the publisher does not sell any books.

(c) Vary α between 0 and 2/3 and plot the author’s payment from the publisher (using
Wolfram Alpha for example). What does this tell you about the author’s preferred α?

Solution:
Since the author takes as given that the publisher will set the profit-maximizing
price, the author prefers α to be somewhere between 0 and 2/3, rather than an α
as large as possible. This is because when α is very high, revenue begins to fall and
the author receives less payment. The author’s optimal value of α is approximately
0.455. See the plot below.

Rev auth

0 0.455 2 α
3

2. Tasty Baking Company is the only producer of Tastykakes in Pennsylvania. The demand
(measured in millions of packets) for Tastykakes in Pennsylvania is given by
D1 (p) = 36 − p,
where p is the price per snack.

(a) Suppose Tasty Baking Company’s cost function for Tastykakes is C(q) = 2q 2 . Does
this technology display increasing, constant, or decreasing returns to scale?

Solution:
This technology has decreasing returns to scale.
d2 C(q)
Justification: The marginal cost is increasing, as dq 2
= 4 > 0.

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(b) What price maximizes the profits for the monopolist from sales in Pennsylvania?

Solution:
The profit-maximizing price is $30 per jar.
Justification:The monopolist’s profit is Π = p·q−C(q) = p·(36−p)−2(36−p)2 =
−3p2 + 180p − 2592. The FOC is −6p + 180 = 0, giving us p = 30. The SOC is
−6 < 0, so this is indeed the profit-maximizing price.

Tasty Baking Company also sells Tastykakes in the other states. The demand for Tastykakes
in other states is
D2 (p) = 70 − 8p.
Assume that Tasty Baking Company must sell Tastykakes at the same price in all states.

(c) What is the choke price for each demand curve?

Solution:
The choke price of D1 (p) is $36 and the choke price of D2 (p) is $8.75.
Justification: The choke price is found by setting the demand to 0. D1 (p) =
36 − p = 0 =⇒ p = 36 and, similarly, D2 (p) = 70 − 8p = 0 =⇒ p = 8.75.

(d) If the price of Tastykakes is $5, what is the total demand across PA and other states
combined? What about if the price is $10?

Solution:
The total demand at a price of $5 is 61 million and at a price of $10 is 26 million.
Justification: In Pennsylvania, the demand at a price of $5 is 31 million. In
other states, the demand at a price of $5 is 30 million. Therefore, the total demand
at a price of $5 is 61 million.
In Pennsylvania, the demand at a price of $10 is 26 million. In other states, the
demand at a price of $10 is 0 because 10 exceeds their choke price. Therefore, the
total demand at a price of $10 is 26 million.

(e) Write the aggregate (total) demand curve for Tastykakes in Pennsylvania and other
states combined. Hint: there will be two cases, one for prices above the choke price
for other states and one for prices below the choke price for other states. Make sure
that you do not add negative demand when the price is above the choke price for other
states but below hte choke price for PA.

Solution:

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 The aggregate (total) demand curve for Tastykakes in Pennsylvania and other states
is:

 106 − 9p if 0 ≤ p < 8.75

DT otal (p) = 36 − p if 8.75 ≤ p < 36

0 if p ≥ 36


Justification: To find the aggregate demand curve, we must carefully add the
demand curves while paying attention to the choke prices. The demand curve for
other states has the smaller choke price, so the aggregate demand is D1 (p) + D2 (p)
for p < 8.75. For any p ≥ 8.75, the demand from other states is 0, and the aggregate
demand curve is simply D1 (p). Note that there is no demand for p ≥ 36, as this is
the choke price for Pennsylvania.

(f) What is the profit maximizing price for the monopolist for sales across all states?
Hint: to maximize profit with a piecewise demand function (i.e., a demand function
with cases), break up the optimization problem into cases for each part of the demand
function, find the solution for each case, and then compare these solutions to see which
yields the highest profit.

Solution:
The profit-maximizing price is $30 per jar.
Justification: The demand function for all of the United States is given by

 106 − 9p if 0 ≤ p < 8.75

DT otal (p) = 36 − p if 8.75 ≤ p < 36

0 if p ≥ 36


Graphically,

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 p
36

30

20

10 DT otal (p)

DP (p)

DO (p)
0 Q
0 10 20 30 40 50 60 70 80 90 100 110

To maximize profit with a piecewise demand function, we proceed as we did for

maximizing revenue: break up the optimization problem into cases for each part of
the demand function, find the solution candidates from each case, and then compare
the candidates to see which maximizes the monopolist’s profit.

Case 1: 0 ≤ p < 8.75

In this case, the monopolist’s profit is

Π = p · q − C(q) = p · (106 − 9p) − 2(106 − 9p)2

= −171p2 + 3922p − 22472.

The FOC is 3922 − 342p = 0, giving p = 11.47. This is not within the boundaries
of this case. Therefore, because 11.47 > 8.75, the optimal price choice within the
boundaries of this case is 8.75, with profits (approximately) -$1246.69 million (recall
that q is in millions of jars). As such, the monopolist will not produce in this case.

Case 2: 8.75 ≤ p < 36

This is case in which Tasty Baking Company is only making sales in Pennsylvania.
We have already solved for the Pennsylvania’s profit maximizing price. Since that
price of $30 is above the choke price for the rest of the United States, this is the
solution for case 2, with profits of $108 million.

Case 3: p ≥ 36
There cannot be a profit-maximizing price in this case because demand is 0 at all
prices greater than $36.

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 Comparing the solution candidates from Case 1 and Case 2, we see that the solution
candidate from case 2, p = 30, is the profit-maximizing price.

Return to the case where Tasty Baking Company only sells Tastykakes in Pennsylvania
but it can produce Tastykakes using a different technology. This “star” technology has the
following cost structure: (
25 + 3q, q > 0,
C ∗ (q) =
0, q = 0.

(g) What price maximizes the profits from Pennsylvania sales when the monopolist is using
the star technology?

Solution:
The profit-maximizing price is $19.5 per jar.
Justification:The monopolist’s profit is Π = p · q − C ∗ (q). Now we break up the
optimization problem into cases for each part of the cost function, find the solution
candidates from each case, and then compare the candidates to see which maximizes
the monopolist’s profit.

Case 1: q = 0
This case is trivial, and Π = 0 million.

Case 2: q > 0
In this case, the monopolist’s profit is Π = p · (36 − p) − (25 + 3 · (36 − p)) =
−p2 + 39p − 133. The FOC is −2p + 39 = 0, yielding p = 19.5 and q = 16.5. The
quantity q is within the bounds, so this is a solution. So Π = 247.25 million.

Comparing profit from the two cases, the optimal price is p = 19.5.

(h) How much money is Tasty Baking Company willing to pay to be able to use the star
technology rather than the original cost technology (with costs C(q)) if it is only selling
Tastykakes in Pennsylvania?

Solution:
Tasty Baking Company is willing to pay at most $139.25 million.
Justification: From the previous solutions, the profit when using the star tech-
nology is $247.25 million, and the profit when using the original technology is $108
million. Hence Tasty Baking Company is willing to pay 247.25 − 108 = 139.25
million dollars for the new technology.

(i) By how much does using the star technology (rather than the original technology)
change consumer surplus in Pennsylvania?

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 Solution:
Consumer surplus increases by $118.125 million.
Justification: The consumer surplus as a function of the price in Pennsylvania
is: Z 36
1
CS(p) = (36 − p̃)dp̃ = (36 − p)2 .
p 2
Under the original technology, the price is 30 and the consumer surplus is CS(30) =
18. Under the star technology, the price is 19.5 and the consumer surplus is
CS(19.5) = 136.125. As such, using the star technology rather than the original
technology improves the consumer surplus by $118.125 million.
Visually, observe the following graph:
p

36
A
30
B
19.5

DP
Q
6 16.5

Under the original technology, the consumer surplus is region A. Under the new
technology, the consumer surplus is region A + B. The change in consumer surplus
is therefore (A + B) − A = B, region B.

(j) Challenge (not graded): Suppose Tasty Baking Company can use both technologies to
produce Tastykakes. Denote by q † the production using the original technology so that
q ∗ = q−q † is produced using the star technology. What is the cost-minimizing allocation
of production of q across the two technologies (i.e., what is C(q) = minq† C(q † )+C ∗ (q −
q † ))? How does this possibility change the profit-maximizing price when selling to
Pennsylvania only?

Solution:
The optimal allocation of q across technologies is
(
q if 0 ≤ q < 0.75 + √5 ,
q† = 2
0.75 if 0.75 + √52 ≤ q.

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and (
0, q < 0.75 + √5
q∗ = 2
q − 0.75, q ≥ 0.75 + √5 .
2
This gives the cost function:
(
2q 2 , q < 0.75 + √5
2
C(q) =
3q + 23.875, q ≥ 0.75 + √5 .
2

With this cost function, the profit-maximizing price is $19.5 and the profits are
$248.375 million.
When q = 0.75 + √52 , setting q † = q or q † = 0.75 minimizes costs.
Justification:
The cost function as a function of both q and q † is
(
q2, if q † = q,
C(q; q † ) =
2(q † )2 + 25 + 3(q − q † ), if q † < q.
Minimizing C(q; q † ) over q † < q (and so temporarily ignoring the fixed cost of the
star technology), the first order condition is
4q † − 3 = 0 =⇒ q † = 0.75.
But using the star technology only makes sense if the cost savings cover the fixed
costs, i.e.,
5
2q 2 ≥ 2(0.752 ) + 25 + 3(q − 0.75) = 23.875 + 3q ⇐⇒ q ≥ 0.75 + √ .
2
For q < 0.75 + √52 , only the dagger technology is used, and so q † = q.
The cost function is illustrated below.
C†
$

C∗ C

0.75 0.75 + √5 q
2

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Plugging the cost-minimizing allocation into the cost function, the cost function
will be (
2q 2 , q < 0.75 + √52
C(q) =
3q + 23.875, q ≥ 0.75 + √52 .
First, assume 0 ≤ q < 0.75 + √52 . The profit for just selling to Pennsylvania is given
by:
Π = p · (36 − p) − 2(36 − p)2 .
From part (b), we got an optimal price of $30, yielding a production of 6 million,
which fails the assumption that 0 ≤ q < 0.75 + √52 ≈ 4.29. Therefore, they must
choose q = 0.75+ √52 in this case, with price p = 35.25− √52 , and profits of π ≈ 99.18.
Now, assume that q ≥ 0.75 + √52 . From part (g), we know that the optimal price
when selling only to Pennsylvania is $19.5 since the FOC is the same. This implies
sales of 16.5 million, which satisfies the assumption that q ≥ 0.75 + √52 . This gives
profits π = 248.375 million.
Therefore, when both technologies can be used, the optimal price if Tasty Baking
Company only sells to Pennsylvania is $19.5.

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