PROBLEMS

1) A firm's total cost function is given by the equation:

TC = 4000 + 5Q + 10Q2.
(1) Write an expression for each of the following cost concepts:
a. Total Fixed Cost
b. Average Fixed Cost
c. Total Variable Cost
d. Average Variable Cost
e. Average Total Cost
f. Marginal Cost
(2) Determine the quantity that minimizes average total cost. Demonstrate that the predicted
relationship between marginal cost and average cost holds.

SOLUTION:
PART (1)
a. TFC  4000
b. 4000
AFC 
Q
TVC  TC  TFC
c.
TVC  5Q  10Q 2
d. TVC 5Q  10Q 2
AVC    5  10Q
Q Q
TC 4000  5Q  10Q 2
e. ATC  
Q Q
f. MC  5  20Q

PART (2)
ATC is minimized where MC is equal to ATC.
Equating MC to ATC
4000  5Q  10Q 2
 5  20Q
Q
4000  5Q  10 2  5Q  20Q 2
4000  10Q 2
Q 2  400
Q  20
ATC is minimized at 20 units of output. Up to 20, ATC falls, while beyond 20 ATC rises.
MC should be less than ATC for any quantity less than 20. For example, let Q = 10:
MC = 5 + 20(10) = 205
4000  510  1010
2
ATC   505
10
MC is indeed less than ATC for quantities smaller than 20.
MC should exceed ATC for any quantity greater than 20.
For example, let Q = 25:
MC = 5 + 20(25) = 505
4000  525  1025
2
ATC   415
25
MC is indeed greater than ATC for quantities greater than 20.

1
2) The manufacturing of paper products causes damage to a local river when the manufacturing
plant produces more than 1,000 units in a period. To discourage the plant from producing more
than 1,000 units, the local community is considering placing a tax on the plant. The long-run
q2
cost curve for the paper producing firm is: C  q, t    tq, where q is the number of units of
1500
paper produced and t is the per unit tax on paper production. The relevant marginal cost curve
q
is: MC  q, t    t. If the manufacturing plant can sell all of its output for $2, what is the firm's
750
optimal output if the tax is set at zero? What is the minimum tax rate necessary to ensure that
the firm produces no more than 1,000 units? How much are the firm's profits reduced by the
presence of a tax?

SOLUTION: In the absence of a tax, we know the plant will maximize profits where marginal
cost is equal to the price (given average costs exceed the market price). That is,
q
MC  q, 0     0   2  q  1,500. Thus, without a tax, we know the plant will produce at a level
750
that will cause damage to the river. The firms profits at this level are:
 1,500 
2

  2 1,500     0 1,500    1,500. To ensure that the plant doesn't go beyond 1,000 units
 1,500 
of production, the community needs to make sure the firm's marginal cost is equivalent to the
1000 1 2
market price at 1,000 units or less. That is, MC 1000, t    t  2  t  2  1  . A tax of 2 3
750 3 3
or greater will ensure the plant will not produce beyond 1,000 units. If we set the tax rate at
2 , the firm's profits will   2 1, 000    1, 000   2 1, 000    666 2 .
 2

3 Implementation of a tax
 1,500 3  3
equal to 2/3 will result in profits declining by 55.6%.

3) Assume the market for tortillas is perfectly competitive. The market supply and demand
curves for tortillas are given as follows: P = .000002QS and P = 11 - .00002QD
The short run marginal cost curve for a typical tortilla factory is:MC = .1 + .0009Q
a) Determine the equilibrium price for tortillas.
b) Determine the profit maximizing short run equilibrium level of output for a tortilla
factory.
c) At the level of output determined above, is the factory making a profit, breaking-even, or
making a loss? Explain your answer.
d) Assuming that all of the tortilla factories are identical, how many tortilla factories are
producing tortillas?

SOLUTION:
a) The equilibrium price is the price at which the quantity supplied equals the quantity
demanded. Therefore, 0.000002Q = 11 - .00002Q
Q = 500,000 and P = 1

b) The profit maximizing short run equilibrium level of output for a tortilla factory is found
where marginal revenue equals marginal cost. For a perfectly competitive firm, marginal
revenue equals price. Therefore,
P = MC
1 = .1 + .0009Q and Q = 1,000

2
c) Given the information provided, it cannot be determined whether the firm is making a
profit or a loss, because total cost cannot be determined from marginal cost.

d) Since Q = 500,000 and Q = 1,000, there must be 500 firms.

4) Marge's Hair Salon uses 15 hair dryers to produce 10 units of output per period. Marge's
15q 2
short-run cost function is: C  q, K    12 K , where q is the number of units produced and K is
K
the number of hair dryers Marge leases. Marge's long-run cost function is: CLR  q   26.8q. If
Marge used 4 fewer hair dryers in the short-run, would short-run average total costs increase or
decrease?

SOLUTION:
 15 10 2 
  12 15  
 15 
Currently, Marge's short-run average costs are: SRATC 10,15      28.00. If
10
Marge uses 4 fewer hair dryers in the short run, her short-run average total costs become:
 15 10 2 
  12 11 
 11 
SRATC 10,11     26.84. If Marge uses 4 fewer dryers and produces 10 units,
10
here short-run average total costs decrease. Marge's long-run average costs are:
CLR  q  26.8q
LRAC    26.8. We see that Marge's long-run average costs are constant.
q q

5) The market for wheat consists of 500 identical firms, each with the total and marginal cost
functions shown:
TC = 90,000 + 0.00001Q2
MC = 0.00002Q,
where Q is measured in bushels per year. The market demand curve for wheat is Q
= 90,000,000 - 20,000,000P, where Q is again measured in bushels and P is the price per
bushel.
a. Determine the short-run equilibrium price and quantity that would exist in the market.
b. Calculate the profit maximizing quantity for the individual firm. Calculate the firm's
short-run profit (loss) at that quantity.
c. Assume that the short-run profit or loss is representative of the current long-run prospects
in this market. You may further assume that there are no barriers to entry or exit in the
market. Describe the expected long-run response to the conditions described in part b. (The
TC function for the firm may be regarded as an economic cost function that captures all
implicit and explicit costs.)

SOLUTION:
a) Market supply is horizontal sum of individual firm supply (firms MC curve).
Firm's TC = 90,000 + 0.00001Q2
MC = 0.00002Q = P.
Solve for Q in terms of P to express as supply curve
P = 0.00002Q and Q = 50,000P

3
Market supply curve is horizontal sum of firm supply curve or N-times the firm supply curve
(N is the number of firms).
QS = 500(50,000)P and QS = 25,000,000P

equate QS and QD to determine price and quantity

25,000,000P = 90,000,000 - 20,000,000P
45,000,000P = 90,000,000
P = $2.00 and Q = 25,000,000P =>> Q = 25,000,000(2) and Q = 50,000,000

b) To determine the firm's output, equate price and marginal cost - Firm's MC = 0.00002Q.
P = 2 = 0.00002Q and Q = 100,000
Firm's  = TR – TC
TR = 2.00(100,000)
TR = 200,000

TC = 90,000 + 0.00001Q 2
TC = 90,000 + 0.00001(100,000) 2
TC = 190,000
 = 200,000,000 - 190,000 = 10,000

c) Firms are earning economic profit so we would expect entry to occur, causing the market
supply curve to shift rightward. As the market supply curve shifts rightward, price falls, which
in turn causes each firm to reduce its output. This will continue until we reach long-run
equilibrium at zero profit.

6) The long-run cost function for LeAnn's telecommunication firm is: C  q   0.03q 2 .
A local
telecommunication tax of $0.01 has been implemented for each unit LeAnn sells. This implies
the marginal cost function becomes: MC  q, t   0.06q  t. If LeAnn can sell all the units she
produces at the market price of $0.70, calculate LeAnn's optimal output before and after the
tax. What effect did the tax have on LeAnn's output level? How did LeAnn's profits change?

SOLUTION:
The profit maximizing output level is where the market price equals marginal cost (providing
the price exceeds the average variable cost). To determine the optimal output level, we need
to first equate marginal cost to the market price. That is,
2
MC  q, 0   0.06q   0   P  0.7  q  11 . The average variable cost at this output level is:
3
 2  2  2 2
AVC 11   0.03 11   0.35. Since P  AVC 11  , LeAnn will maximize profits at 11 units.
 3  3  3 3
2  2 
2

LeAnn's profits are:   Pq  C  q   0.70 11   0.03 11    4 .

1
 3    3   12
With the tax, LeAnn's optimal output level requires:
MC  q, 0.01  0.06q   0.01  P  0.7  q  [Link] average variable cost at this output level is:
AVC 11.5   0.03 11.5   .01  0.355. Since P  AVC 11.5  , LeAnn will maximize profits at 11.5

units. LeAnn's profit with the tax is:   Pq  C  q   0.70 11.5  0.03 11.5  0.0111.5  3.9675.
2

The tax reduces LeAnn's output and profit.