COMM 220

Analysis of Markets
Practice Problems, Winter 2010

Chapter 2: The basics of Supply and Demand

1. American Mining Company is interested in obtaining quick estimates of the supply and demand curves for coal. The rms research department informs you that the elasticity of supply
is approximately 1.7, the elasticity of demand is approximately -0.85, and the current price
and quantity are $41 and 1,206, respectively. Price is measured in dollars per ton, quantity
the number of tons per week.
(a) Estimate linear supply and demand curves at the current price and quantity.
(b) What impact would a 10% increase in demand have on the equilibrium price and quantity?
(c) If the government refused to let American raise the price when demand increased in (b)
above, what shortage is created?
2. In a city with a medium sized population, the equilibrium price for a city bus ticket is $1.00,
and the number of riders each day is 10,800. The short-run price elasticity of demand is -0.60,
and the short-run elasticity of supply is 1.0.
(a) Estimate the short run linear supply and demand curves for bus tickets.
(b) If the demand for bus tickets increased by 10% because of a rise in the world price of oil,
what would be the new equilibrium price of bus tickets?
(c) If the city council refused to let the bus company raise the price of bus tickets after the
demand for tickets increases (see (b) above), what daily shortage of tickets would be
created?
(d) Would the bus company have an incentive to increase the supply in the long run given
the city councils decision in (c) above? Explain your answer.
3. The U.S. Department of Agriculture is interested in analyzing the domestic market for corn.
The USDAs sta economists estimate the following equations for the demand and supply
curves:
Qd = 1; 600

125P

Qs = 440 + 165P
Quantities are measured in millions of bushels; prices are measured in dollars per bushel.
(a) Calculate the equilibrium price and quantity that will prevail under a completely free
market.
(b) Calculate the price elasticities of supply and demand at the equilibrium values.
(c) The government currently has a $4.50 bushel support price in place. What impact will
this support price have on the market? Will the government be forced to purchase corn
under a program that requires them to buy up any surpluses? If so, how much?

Chapter 3&4: Consumer Behavior and Demand

1. Jane lives in a dormitory that oers soft drinks and chips for sale in vending machines. Her
utility function is U = 3SC, where S is the number of soft drinks per week and C the number
of bags of chips per week. Soft drinks are priced at $0.50 each, chips $0.25 per bag.
(a) Write an expression for Janes marginal rate of substitution between soft drinks and
chips.
(b) Use the expression generated in part (a) to determine Janes optimal mix of soft drinks
and chips.
(c) If Jane has $5.00 per week to spend on chips and soft drinks, how many of each should
she purchase per week?
2. Janice Doe consumes two goods, X and Y. Janice has a utility function given by
the expression:
U = 4X 0:5 Y 0:5
The current prices of X and Y are 25 and 50, respectively. Janice currently has
an income of 750 per time period.
(a) Write an expression for Janices budget constraint.
(b) Calculate the optimal quantities of X and Y that Janice should choose, given
her budget constraint. Graph your answer.
(c) Suppose that the government rations purchases of good X such that Janice
is limited to 10 units of X per time period. Assuming that Janice chooses
to spend her entire income, how much Y will Janice consume? Construct
a diagram that shows the impact of the limited availability of X. Is Janice
satisfying the usual conditions of consumer equilibrium while the restriction
is in eect?
(d) Calculate the impact of the ration restriction on Janices utility.
3. Natasha derives utility from attending rock concerts (r) and from drinking colas (c) as follows:
U (c; r) = c0:9 r0:1
(a) If the price of cola (Pc) is $1 and the price of concert tickets (Pr) is $30 and Natashas
income is $300, how many colas and tickets should Natasha buy to maximize utility?
(b) Suppose that the promoters of rock concerts require each fan to buy 4 tickets or none at
all. Under this constraint and given the prices and income in (a), how many colas and
tickets should Natasha buy to maximize utility?
(c) Is Natasha better o under the conditions in (a) or (b)? Explain your answer.
4. The following data pertain to products A and B, both of which are purchased by Madame X.
Initially, the prices of the products and quantities consumed are: PA = $10; QA = 3; PB =
$10; QB = 7: Madame X has $100 to spend per time period. After a reduction in price of
B, the prices and quantities consumed are: PA = $10; QA = 2:5; PB = $5; QB = 15. Assume
that Madame X maximizes utility under both price conditions above. Also, note that if after
the price reduction enough income were taken away from Madame X to put her back on the
original indierence curve, she would consume this combination of A and B: QA = 1:5; QB = 9
2

(a) Determine the change in consumption rate of good B due to (1) the substitution eect
and (2) the income eect.
(b) Determine if product B is a normal, inferior, or Gien good. Explain.
5. Suppose that the demand for artichokes (Qa) is given as: Qa = 120 - 4P
(a) What is the point price elasticity of demand if the price of artichokes is $10?
(b) Suppose that the price of artichokes increases to $12. What will happen to
the number of artichokes sold and the total expenditure by consumers on
artichokes?
(c) At what price if any is the demand for artichokes innitely elastic?

Chapter 6&7: Production and Cost

1. Fill in the gaps in the table below
Input
0
1
2
3
4
5
6

Output
0
150

Marginal Product

Average Product

200

200
760
150
150

Answer:
Input
0
1
2
3
4
5
6

Output
0
150
200 2 = 400
x = 600
760
x = 910
x = 150 6 = 900

Marginal Product

(150 0)=(1 0) = 150

(400 150)=(2 1) = 250
(x 400)=(3 2) =200
(760 600)=(4 3) = 160
(x 760)=(5 4) =150
(900 910)=(6 5) = 10

Average Product

150=1 = 150
200
600=3 = 200
760=4 = 190
910=5 = 182
x=6 =150

2. Does the following production function exhibit increasing, decreasing, or constant returns to
scale? include supporting calculations
Q = KL0:5
Solution:
For any

> 0;
f ( K; L) = ( K)( L)0:5 = K

Therefore, the production function exhibits IRS

0:5 0:5

1:5

[KL0:5 ] =

1:5

3. A rms marginal product of labour is 3, and its marginal product of capital is 9. If the rm
adds one unit of labour, but does not want output to change, calculate how much it should
change capital.
4. You manage a plant that mass produces engines by teams of workers using assembly machines.
The technology is summarized by the production function
Q = 5KL
where
M PL = 5K
and
M PK = 5L
where Q is the number of engines per week, K is the number of assembly machines, and L
is the number of labour teams. Each assembly machine rents for $10,000 per week and each
team costs $5000 per week. Engine costs are given by the cost of labour teams and machines,
plus $2000 per engine for raw materials. Your plant has a xed installation of 5 assembly
machines as part of its design.
(a) Determine the total cost function for your plant; that is, how much would it cost to
produce Q engines? (Hint: determine an algebric expression for total cost as a function
of output)
(b) Determine an algebric expression for average total cost and marginal cost
(c) Calculate the number of teams required to produce 250 engines. Calculate the average
cost per engine
(d) Is the rm minimizing cost at its current level of output? (Hint: No calculations are
required)
Solution:
(a) From the given information, we have
T C = 5000L + 10000K + 2000Q
Remember, we need to nd TC as a function of Q: First, use the fact that K = 5 (xed
as given); therefore, we have
T C = 50; 000 + 5000L + 2000Q
and
Q = 5KL = 25L
Now we need to express L in terms of Q and plug it back into the cost function to get
rid of L: From the production function, we have
L=

Q
25

back into the total cost function yields

T C = 50; 000 + 5000

Q
+ 2000Q
25

Simplify
T C = 50; 000 + 2200Q
4

(b)
AT C =

TC
50; 000
=
+ 2200
Q
Q

MC =

dT C
= 2200
dQ

(c) Using the production function

Q = 5(5)L
For Q = 250; we have
250 = 25L
Therefore, L = 10 teams. The AC per engine is found using the formula
AT C =

TC
50; 000
=
+ 2200
Q
Q

AT C =

50; 000
+ 2200 = 2400
250

For Q = 250

(d) Recall that the cost-minimization condition is

w
M PL
=
M PK
r
or

5000
1
5K
=
=
5L
10000
2

or
L = 2K
That is, the number of teams should be twice the number of assembly machines. Since
the rm is using L = 10 and K = 5 (xed), then we conclude that the rm is minimizing
cost at the current level of output
5. A paint manufacturing company has the production function (Q) shown below.
The rm faces a price of labour of $15 per unit, and a price of capital of $10 per
unit
Q = KL2
where
M PL = 2KL
and
M PK = L2
(a) Determine the COMBINATION of labour and capital that minimizes the
cost of producing ANY given level of output
(b) Calculate the cost minimizing usage of the two inputs necessary to produce
10,000 units, the current level of output.
(c) Calculate the minimum cost to produce the current output
(d) Suppose the rm increases output to 20,000 units. Calculate the cost minimizing usage of the two inputs to produce this new level of output. Calculate
the minimum cost to produce the new level of output
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(e) Does this production function exhibit economies or diseconomies of scale?

Explain.
Solution:
(a)
M PL
PL
=
M PK
PK
2KL
15
=
L2
10
or

2K
3
= =) 4K = 3L
L
2

or

4
L= K
3
So, the combination is that for each 1 unit of labour, we use 4/3 units of capital.
(b) We have
4
L= K
3
and
10000 = KL2

(1)
(2)

Plug (1) into (2) yields

4
16K 3
10000 = K( K)2 =
3
9
10;
000
9
K3 =
= 5625
16
Therefore,
K = 56251=3 = 17:78
and

4
L = (17:78) = 23:71
3

(c)
T C = 15L + 10K = 15(23:71) + 10(17:78) = 533:45
(d)
K = 22:41;

L = 29:88

T C = 15L + 10K = 672:3

(e) We measure economies of scale using the Cost output Elasticity, which measures the
percentage change in cost due to an increase in output by 1 percent as
"c =
where
%4C =

%4C
26
=
= 0:3 < 1
%4Q
100

20; 000 10; 000

10; 000

and
%4Q=

672:3 533:45
533:45

100 = 100%

100 = 26%

since
"c < 1 =) Economies of scale
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6. Duane breeds parrots for a living. He has discovered that the production function for parrot
chicks (Q) is:
Q = K 1=2 L1=2 ;
where K is capital (for example nest boxes, cages and the like) and L is parrot food. The
price of K is $8 and the price of L is $2.
(a) What type of production function is this?
(b) Does this production function exhibit constant, increasing or decreasing returns to scale?
Explain.
(c) What is the average product of capital?
(d) Does capital obey the law of diminishing returns? Explain.
(e) Suppose that Duane wants 144 parrot chicks, how much K and L should be employed to
minimize costs, and what is the cost of producing 144 parrot chicks?
(f ) Suppose that Duane is faced with the same problem as in (f) except that he has a xed
amount of K. In fact, K = 16. How much L should be employed to minimize costs, and
what is the total cost?
7. The cost of producing 600 small berglass sailboats per year, and the cost of producing sails
and ttings necessary to make the boats seaworthy in a single plant, are together $780,000.
If produced in separate plants, the boat cost $540,000, and the sails and ttings would cost
$180,000. From this information, what can be learned about (1) economies of scale and (2)
economies of scope in the production of sailboats, sails, and ttings? Perform any necessary
calculations and explain.

Chapter 8&9: The Analysis of Competitive Markets

1. The elected o cials in a west coast university town are concerned about the
exploitative rents being charged to college students. The town council is contemplating the imposition of a $350 per month rent ceiling on apartments in the
city. An economist at the university estimates the demand and supply curves as:
QD = 5600

8P

QS = 500 + 4P;
where P = monthly rent, and Q = number of apartments available for rent. For
purposes of this analysis, apartments can be treated as identical.
(a) Calculate the equilibrium price and quantity that would prevail without the
price ceiling.
(b) Calculate producer and consumer surplus at this equilibrium (sketch a diagram showing both).
(c) What quantity will eventually be available if the rent ceiling is imposed?
Calculate any gains or losses in consumer and/or producer surplus.
(d) Does the proposed rent ceiling result in net welfare gains? Would you advise
the town council to implement the policy?

2. The demand and supply functions for basic cable TV in the local market are given as:
QD = 200; 000

4; 000P

QS = 20; 000 + 2; 000P:

Calculate the consumer and producer surplus in this market. If the government implements
a price ceiling of $15 on the price of basic cable service, calculate the new levels of consumer
and producer surplus. Are all consumers better o? Are producers better o?
3. The market demand and supply functions for pork are:
QD = 2; 000

500P

QS = 800 + 100P:
To help pork producers, the U.S. Congress is considering legislation that would put a price
oor at $2.25 per unit. If this price oor is implemented, how many units of pork will the
government be forced to buy to keep the price at $2.25? How much will the government spend
in total? How much does producer surplus increase?
4. The market for semiskilled labor can be represented by the following supply and demand
curves:
LD = 32000

4000W

LS = 8000 + 6000W;
where L = millions of person hours per year, and W = the wage in dollars per hour.
(a) Calculate the equilibrium price and quantity that would exist under a free market. What
impact does a minimum wage of $3.35 per hour have on the market?
(b) The government is contemplating an increase in the minimum wage to $5.00 per hour.
(c) Calculate the impact of the new minimum wage on the quantity of labor supplied and
demanded.
(d) Calculate producer surplus (laborerssurplus) before and after the proposed change.
(e) Comment on the net eect of the proposed change upon workers as a whole and on
individual workers. How does this price oor dier from an agricultural support price?
(f ) Is the policy e cient from an economists viewpoint?
5. A country which does not tax cigarettes is considering the introduction of a $0.40 per pack tax.
The economic advisors to the country estimate the supply and demand curves for cigarettes
as:
QD = 140; 00025; 000P
QS = 20; 000 + 75; 000P;
where Q = daily sales in packs of cigarettes, and P = price per pack. The country has hired
you to provide the following information regarding the cigarette market and the proposed
tax.
(a) What are the equilibrium values in the current environment with no tax?

(b) What price and quantity would prevail after the imposition of the tax? What portion of
the tax would be borne by buyers and sellers respectively?
(c) Calculate the deadweight loss from the tax. Could the tax be justied despite the deadweight loss? What tax revenue will be generated?
6. The total and marginal cost functions for a typical soft coal producer are:
T C = 75; 000 + 0:1Q2 ;
where Q is measured in railroad cars per year. The industry consists of 55
identical producers. The market demand curve is:
QD = 140; 000

425P;

where P is the price per carload. The market can be regarded as competitive.
(a) Calculate the short run equilibrium price and quantity in the market. Calculate the quantity that each rm would produce. Calculate producer surplus,
consumer surplus, and total surplus at the equilibrium values. Calculate the
rms prot (or loss).
(b) The Federal government is considering the imposition of a $15 per carload
tax on soft coal. Calculate the short-run equilibrium price and quantity
that would exist under the tax. What portion of the tax would be paid
by producers and what portion by consumers? Calculate the producer and
consumer surplus under the tax and analyze the e ciency consequences of
the tax. Calculate the rms prot (or loss) under the tax. Could the tax
be justied despite its e ciency implications?
7. The market demand and supply functions for cotton are:
QD = 10
QS = 38P

0:04P
20

Calculate the consumer and producer surplus. To assist cotton farmers, suppose
a subsidy of $0.10 a unit is implemented. Calculate the new level of consumer
and producer surplus. Did the increase in consumer and producer surplus exceed
the increased government spending necessary to nance the subsidy?

Chapter 16: General Equilibrium and Economic E ciency

1. Sarah and Jane are two representative individuals living in an economy that produces two
goods, x and y: The market determined price of good x is $10 and of good y is $20. Current
outputs are 58 units of x and 36 units of y: Janes current income is $600, and Sarahs income
is $700. Sarahs and Janes utility functions and marginal utilities are given by the following:
USarah (x; y) = 50x0:4 y 0:6
and
UJane (x; y) = 100x0:5 y 0:5

(a) Write an algebric expression for Sarahs marginal rate of substitution of x for y: Simplify
your answer
(b) Write an algebric expression for Janes marginal rate of substitution of x for y: Simplify
your answer
(c) Calculate the quantities of x and y that Sarah should consumer to maximize her utility
(d) Calculate the quantities of x and y that Sarah should consumer to maximize her utility
(e) Write the condition(s) for equilibrium in this exchange economy. Show numerically that
the values you calculated in parts (c) and (d) satisfy the equilibrium condition(s)
2. Explain the dierence between partial equilibrium and general equilibrium analysis.
3. Explain the concept of input e ciency. State the condition for its existence, and show that
it exists if the input market is perfectly competitive. Illustrate your answer with a diagram.
4. Show that the allocations of two goods, X and Y, between two consumers, A and B, are Pareto
e cient if the marginal rate of substitution of Y for X is the same for the two consumers.
5. Two individuals, A and B, are free to engage in trade of clothing and food. Initially, A has
12 units of clothing and 9 units of food, and B has 8 units of clothing and 11 units of food.
The individuals have the following utility functions in clothing C and food F:
UA = 0:15QC QF
UB = 0:08QC QF
where QF represents units of food, QC represents units of clothing, and U represents utility.
Determine if a mutually benecial trade is possible between A and B. If so, who would trade
for what?
6. On planet Economus, the countries Blib and Flib can produce the amounts of string and
rope indicated in the table below with one unit of land. The country of Blib has 20 units
of land available while the country of Flib has 10 units of land. Does either country have
an absolute advantage? Which country has a comparative advantage in string production?
Which country has a comparative advantage in rope production? Is it possible for the two
countries to benet from trade?
Country String Rope
Blib
10
20
Flib
25
10
7. Germany and France can produce the amounts of wine and beer indicated in the table below
with one unit of land. Each country has 10 units of land. Does either country have an absolute
advantage? Which country has a comparative advantage in beer production? Which country
has a comparative advantage in wine production? Is it possible for the two countries to benet
from trade?
Country Beer Wine
France
2
4
Germany 10
1

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Chapter 5: Uncertainty and attitudes towards risk

1. Describe Larry, Judy and Carol s risk preferences. Their utility as a function of income is
given as follows
Larry: UL (I) = 10I:
Judy: UJ (I) = 3I 2 :
Carol: UC (I) = 20I.
Answer:
Larrys marginal utility of income is 5I. As income increases, his marginal utility of income
diminishes. This implies that Larry is risk-averse. Judys marginal utility of income is 6I.
As income increases, her marginal utility of income increases. This implies that Judy is a
risk-lover. Carols marginal utility of income is 20. As income increases, her marginal utility
of income is constant. This implies that Carol is risk-neutral.
2

w
2. Richard is a stock market day trader. His utility of wealth function is U (w) = 4 1;000;000
:
Richard has seen a recent upward trend in the price of Yahoo stock. He feels that there is a
30% chance the stock will rise from $175 per share to $225. Otherwise, he believes the stock
will settle to about $150 per share. Richards current wealth is $1.75 million. Assume that
if Richard purchases the stock, he will use his entire wealth. Given his risk preferences, will
Richard buy Yahoo?

Answer: Richard will purchase the stock if his expected utility from owning the stock exceeds
his current utility of wealth. His currently utility of wealth is: U(w = $1,750,000) = 4(1.75)2
= 12.25.
Richards expected utility from owning the stock is: EV[U(w)] = 0.3 4(2.25)2 + 0.7 4(1.5)2=
0.3(20.25) + 0.7(9)= 12.375. Since Richards expected utility of wealth from owning the stock
exceeds his utility of wealth with certainty, Richard will buy the stock.

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