QUANTITATIVE MICROECONOMIC THEORY ECON301 Fall 2011 Professor Mulligan Second Examination (Answers) 1.

(10 points) Assume that a perfectly competitive firm produces its output subject to the following production function: q = 10K0.5L0.5. In the short-run K equals 16. The wage rate is 2 and rental rate is 10. a. (5 points) Derive the equation for the short-run cost curve. Show your work. b. (5 points) Derive the equation for the firms short-run supply curve. Show your work. Answer: q = 10K0.5L0.5 = 10(4)L0.5 = 40L0.5 => L = q2/100 => C = wL + rK = 2L + 10(16) = 2(q2/1600) + 160 = q2/800 + 160. SMC = dC/dq = 2q/800 = q/400 = P => q = 400P. AVC = q/800. As a result, minimum average variable cost is 0 when q equals 0. 2. (15 points) Assume that a perfectly competitive firm produces its output subject to the following production function: q = 20K0.5L0.75. The wage rate equals 2 and the rental rate is 4. a. (10 points) Use the Lagrangian method to derive the equation for the firms long-run expansion path. Show your work. b. (5 points) Does this production function have the property of constant returns to scale? Provide a formal proof that supports your answer. Answer: = 2L + 4K (20K0.5L0.75 q). /L = 0 = 2 (20)(0.75)K0.5L-0.2.5 = 2 (15)K0.5L-0.2.5 /K = 0 = 4 (20)(0.50)K-0.5L0.7.5 = 4 (10)K-0.5L0.7.5 / = 0 = 20K0.5L0.75 q. From the first two first derivatives we have 4/2 = [(10)K-0.5L0.7.5]/[ (15)K0.5L-0.2.5] = 2 = (2/3)L/K => K = L/3. This production function has the property of increasing returns to scale. The formal proof should follow the example shown in Solved Problem 6.2 on page 172. 3. (10 points) Assume that the government imposes a franchise tax (that is, lump sum tax) equal to T on all firms in a competitive market. a. (5 points) Explain what effect the tax has on the typical firms short-run cost curves and shut-down point. b. (5 points) Explain what effect the franchise tax has on the typical firms output in long-run equilibrium. Answer: See Solved Problem 7.2 on pages 197 and 198. The franchise tax increases the average fixed and average cost curves in the same way that an increase in fixed tax would. It has no effect on marginal cost or average variable cost. In the short run this results in a higher shut

down price. In the long run the firm now minimizes its long run average cost at a larger output. Note that the curves do not shift up parallel to the previous curve. 4. (15 points) Assume in the long run that a firm uses 400 units of labor and 400 units of capital to produce output q* when the market wage is $20 and the rental rate is $50. Assume further that the marginal product of labor is 40 and the marginal product of capital is 80 when L is 400 and K is 400. Assume further that the isoquants for the production function are strictly convex. a. (5 points) Is this firm minimizing its long-run cost of producing q*? Explain. b. (5 points) Draw a graph consistent with the assumptions given for this problem. c. (5 points) If the firm is not minimizing its cost of producing q*, what adjustment should it make in order to minimize its cost? Explain. Answer: MPL/w = 40/20 = 2 > MPK/r = 80/50 = 1.6. As a result, the firm is not minimizing its long run cost. It should use more labor and less capital to produce q*. Your graph should look something like Figure 7.5 on page 202 with the firm currently producing its output at a point such as y when it should be at point x. 5. (15 Points) Assume that the market demand equation for a competitive market is Q = 1500 50 P. Each firms long-run cost function is as follows: C = 0.5q2 10q + 200. a. (5 points) How much will each firm produce in long-run equilibrium? Show your work. b. (5 points) What is the long-run equilibrium price? Show your work. c. (5 points) How many firms will there be in long-run equilibrium? Show your work. Answer: AC = 0.5q 10 + 200/q. MC = q 10. In the long run the firm produces at minimum AC where AC equals MC => 0.5q 10 + 200/q = q 10 => 200/q = 0.5q => q2 = 400 => q* = 20. Since P = MC => P* = q* - 10 = 20 10 = 10. Q* = 1500 50(P*) = 1500 50(10) = 1000. n* = Q*/q* = 1000/20 = 50. 6. (10 points) Assume that a firm produces its output in the short run subject to the short-run production function q = f(L). This production function has the property of positive and increasing marginal product up to L* and positive but decreasing marginal product for L > L*. a. (5 points) Draw a graph of the marginal and average product curves for this production function based on the information given. b. (5 points) What is the relationship between short-run marginal cost and short-run average variable cost at the output level where average product reaches its maximum value? Explain your reasoning.

Answer: See figure 6.1 on page 159 for the graph. See pages 194 and 195 for the relationship among the cost and production curves. Note that MC = w/MPL and AVC = w/APL. MPL = APL at maximum APL. As a result, MC = AVC when MPL = APL. 7. (15 points) Assume that the market demand equation is Q = 100 P and the market supply equation is Q = P. a. (5 points) Assume that the government uses a deficiency payments program to support a price of 60. Calculate the total cost to the government of the deficiency payments program. b. (5 points) Calculate the deadweight loss due to the deficiency payments program in part a. Show your work. c. (5 points) Assume that the government decides to use a per unit subsidy instead of the deficiency payments program. What must the subsidy per unit equal in order for the government to accomplish the same market result? Explain. Answer: Without any government program the market equilibrium price and quantity both equal 50. At the support price of 60 the firms will supply 60 units. The market will clear at a price of 40. As a result, the government will have to pay the firms 20 per unit (that is, 60 40). Since 60 units are sold, the total cost is 20(60) = 1200. See the graph on page 300 for this type of problem. Area F is the deadweight loss. In this case the deadweight loss equals 0.5(60 50)(10) + 0.5(50 40)(10) = 0.5(60 40)(10) = 100. If the government used a subsidy instead, the subsidy would equal the difference in the market price and the support price: 60 40 = 20. 8. (10 points) Assume that the equations for market demand and supply are the same as in question 7. Assume, however, that the government implements a price support of 60 by agreeing to purchase whatever output consumers do not buy at the support price. a. (5 points) Calculate the cost to the government of maintaining the support price. b. (5 points) Calculate the dead-weight loss to society of this program. Answer: The graph for this problem is similar to figure 9.8 on page 298. The government will buy the difference in the quantity produced and the quantity demanded in the market at the price of 60 => 60 40 = 20. The price paid is the support price of 60. The overall cost is 60 (20) = 1200. The deadweight loss is the sum of areas C, F, and G in figure 9.8. As a result, the loss in this case is 1100.