BAYLOR UNIVERSITY HANKAMER SCHOOL OF BUSINESS DEPARTMENT OF ECONOMICS

ECO 5315 Problem Set #2 Solutions Jim Garven Fall 2008 Solutions for assigned problems from Chapter 3 (problems 2, 6, 10, 12 on pp. 122-125) 2. The Johnson Robot Company's marketing officials report to the company's chief executive officer that the demand curve for the company's robots in 2004 is P = 3,000 40Q where P is the price of a robot and Q is the number sold per month. a. Derive the marginal revenue curve for the firm. Since P = 3,000 400Q, TR = PQ = (3,000 400Q)Q = 3,000Q 40Q2. Therefore marginal revenue MR = dTR / dQ = 3, 000 80 Q . b. At what prices is the demand for the firm's product price elastic? The firms product is price elastic for prices higher than the price at which there is unitary elasticity. Therefore, in order to determine the answer to this question, I solve the following equation for P: dQ P = = 1. dP Q Since P = 3, 000 40 Q Q =
P = 3, 000 P dQ P = .025. Therefore, = .025 = 1 40 dP Q

Q . Substituting this into the P = 3,000 40Q equation, I find that there is unitary 40 price elasticity when P = 1,500. Thus, there will be price-elastic demand for prices exceeding $1,500.

c. If the firm wants to maximize its dollar sales volume, what price should it charge? Maximizing dollar sales volume is the same as maximizing total revenue. The first-order condition involves setting marginal revenue equal to 0 and solving for Q:

3,000 80Q = 0 Q = 375. Substituting Q = 375 back into the P = 3,000 40Q equation, I find that the revenue maximizing price for the Johnson Robot Company is P = $1,500. 6. The Hanover Manufacturing Company believes that the demand curve for its product is P=5Q where P is the price of its product (in dollars) and Q is the number of millions of units of its product sold per day. It is currently charging a price of $1 per unit for its product. a. Evaluate the wisdom of the firm's pricing policy. Note that total revenue TR = PQ = (5 - Q)Q = 5Q Q2, which implies that marginal revenue MR = dTR/dQ = 5Q 2Q. At P = 1, Q = 4, which implies that MR = 3. Since marginal revenue is negative, this implies that the price is too low; the Hanover Manufacturing Company would increase revenues by increasing the price and selling fewer units! Therefore, the firms current pricing policy is not prudent. b. A marketing specialist says that the price elasticity of demand for the firm's product is -1.0. Is this correct? No, while dQ/dP = 1, dQ/dP (P/Q) = 1(1/4) = -1/4 at P = 1. 10. Market researchers at the Lawrence Corporation estimate that the demand function for the firm's product is Q = 50P 1.5 I 0.5 where Q is the quantity demanded, P is the product's price, and I is per capita disposable income. The marginal cost of the firm's product is estimated to be $10. Population is assumed to be constant. a. Lawrence's price for its product is $20. Is this the optimal price? Why or why not? In order for this to be an optimal price, it must be the case that the marginal revenue, when evaluated at P = $20, is equal to marginal cost, which is $10. From equation (3.16) dQ P on page 103, MR = P (1 + 1/ ) , where = . Differentiating Q = 50P 1.5 I 0.5 with dP Q respect to P, I find that Q / P = 75P 2.5 I 0.5 . Substituting this into the equation for the
Q / P 75P 2.5 I 0.5 P = 1.5P 1P P = price elasticity of demand, I obtain = 1.5 0.5 50 P I Q = -1.5. Thus, MR = P (1 + 1/ ) = $20(1 + 1/ ( 1.5)) = $6.67. Since marginal revenue is less than marginal cost, price should be increased and quantity decreased.

b. According to equation (3.18) on p. 111 of the textbook, the optimal (profit maximizing) price is: MC P= . 1 + 1 Since = -1.5, this means that the optimal price is P =
10 = $30. Note that if P 1 + 1/ ( 1.5)

= $30, then MR = P (1 + 1/ ) = $30(1 + 1/ ( 1.5)) = $10 = MC ; i.e., I have maximized profit! 12. The Schmidt Corporation estimates that its demand function is Q = 400 - 3P + 4I + 0.6A where Q is the quantity demanded per month, P is the product's price (in dollars), I is per capita disposable income (in thousands of dollars), and A is the firm's advertising expenditures (in thousands of dollars per month). Population is assumed to be constant. a. During the next decade, per capita disposable income is expected to increase by $5,000. What effect will this have on the firm's sales? Since Q / I = 4, an increase in per capita disposable income in the amount of $5,000 will increase Q by 20 units. b. If Schmidt wants to raise its price enough to offset the effect of the increase in per capita disposable income, by how much must it raise its price? Since Q / P = 3, increasing price by 20/3 = $6.67 will have the effect of fully offsetting the effect of the $5,000 increase in per capita disposable income.
c. If Schmidt raises its price by this amount, will it increase or decrease the price elasticity of demand? Explain. Make sure your answers reflect the fact that elasticity is a negative number.

An increase in per capita disposable income will cause a parallel shift of the demand curve to the right. For example, suppose that initially, I = $20 and A = $25. Then Q = 435 3P P = 145 1 3 Q . With the $5,000 increase in per capita disposable income, the demand curve would become P = 151.67 1 3 Q . Since the price elasticity of demand

dQ P P = 3 , a price increase will cause to become a larger negative value (i.e., dP Q Q

demand will become more price elastic) since a positive price change coupled with a corresponding demand decrease causes the P/Q ratio to increase. Essentially, the effect of a price increase under these circumstances involves moving up a linear demand curve, which implies an increasingly elastic demand for the product.
Solutions for assigned problems from Chapter 7 (problems 2, 6, and 8 on pp. 282-285)

2. On the basis of a regression analysis like those in Chapter 5, the Washington Company finds that its production function is log Q = 1.50 + 0.76 log L + 0.24 log K where Q is its daily output, L is the number of workers employed per day, and K is the number of machines used per day. The Washington Company's product is sold in a competitive market at a price per unit of $10. The firm cannot influence the wage of workers or the price of machines. a. If the wage of a worker is $30 per day, how many workers per unit of output should the firm hire? Taking the antilog of the production function,1 I obtain:
Q = e 1.5 L0.76 K 0.24

In order to answer this question, one must know the margin revenue product for labor, TR Q MRPL = . Since the product price is $10, this corresponds to marginal revenue Q L TR Q (i.e., MR = = $10). Next, I calculate the marginal product of labor MPL = = Q L
0.76e 1.5 L0.24 K 0.24 = Q 0.76e 1.5 L0.76 K 0.24 0.76 Q . Therefore, MRPL = 7.60 . = L L L

Since the marginal expenditure for labor, MEL = $30, I set MRPL = MEL and solve for the number of workers per unit of output that the firm should hire: 7.60 b. What percentage of the firm's revenues is spent on labor? Why?
Q L* 7.6 = 30 = . L Q 30

In ECO 5315 (and in economics more generally), we typically work with natural logarithms. Therefore, when the authors use the notation log Q, they really mean ln Q. The antilog of the natural logarithm is the number e. See equations 7.17 and 7.18 in the textbook (p. 275) for another example of this.
1

Note that PQ = $10, whereas PL = $30. Therefore, I rewrite the expression for the L* 7.6 .76PQ PL L* = = = 0.76 = 76 percent. Q 30 PL PQ Q c. Will this percentage vary depending on the daily wage of a worker? Why or why not? Although the number of units of L hired is a function of the price of labor PL (see part b), the total wage bill as a fraction of the firms revenues (i.e.,
PL L* ) is not. PQ Q

6. According to the chief engineer at the Zodiac Company, Q = AL K , where Q is the output rate, L is the rate of labor input, and K is the rate of capital input. Statistical analysis indicates that = 0.8 and = 0.3. The firm's owner claims the plant has increasing returns to scale. a. Is the owner correct? Yes. Note that in the equation for Q, and represent output elasticities. Specifically, = 0.8 implies that a 1 percent increase in labor will increase output by 0.8 percent, whereas = 0.3 implies that a 1 percent increase in capital will increase output by 0.3 percent. Therefore, increasing both L and K by 1 percent will cause output to go up by more than 1 percent. b. If were 0.2 rather than 0.3, would she be correct? No. In this case, there would be constant, not increasing returns to scale. If = 0.8 and = 0.2, this means that increasing both L and K by 1 percent will cause output to go up by 1 percent. c. Does output per unit of labor depend only on and ? Why or why not? Output per unit of labor = Q/L = APL = AL 1K , which also depends on A, K, and L. The average product of labor ( APL ) is a function of L because the marginal product of L ( MPL = Q / L = AL 1K ) is not constant (in fact, the MPL = APL ). The average product depends on K because as K increases, Q increases, so holding L constant, Q/L increases. Finally, A scales the Q, and so if A goes up, Q/L goes up proportionately. 8. The owner of the Hughes Car Wash believes that the relationship between the number of cars washed and labor input is Q = -0.8 + 4.5L - 0.3L2 4

where Q is the number of cars washed per hour and L is the number of people employed per hour. The firm receives $5 for each car washed, and the hourly wage rate for each person employed is $4.50. The cost of other inputs like water is trivial; hence, they are ignored. a. How many people should be employed to maximize profit? MRPL = P MPL = 5(4.5 - 0.6L) = 22.5 3L. Since the marginal expenditure for labor, MREL = 4.5, it follows that 22.5 3L = 4.5 L* = 6. b. What will be the firms hourly profit? Profit () = TR TC. For L* = 6, TR = 5(-0.8 + 27 10.8) = $77, and TC = 4.5L = 4.5(6) = 27, so = $50. c. Is this relationship between output and labor input valid for all values of L? Why or why not? No. The production function does not make sense for L less than 0.18 or more than 14.82 because output becomes negative in those cases.