ECON 425 - 100 SOLUTIONS FOR PRACTICE QUESTIONS FOR EXAM #1

1) Suppose the market for potatoes can be expressed as follows:

Supply: QS = −20 + 10p
Demand: QD = 400 − 20p
Solve for the equilibrium price and quantity.

Answer: Equate the RHS of the supply equation to the RHS of the demand equation: −20 +
10p = 400 − 20p. Rearrange: 30p = 420 or p = 14. Plug this into either S or D to get Q:
Q = 400 − 20(14) = 120.

2) Suppose there are 1000 identical wheat farmers. For each, Total Cost TC =10 + q2.
(a) Derive the short-run market supply curve.
If the market demand is Q = 600,000 − 100p.
(b) Derive the short-run equilibrium Q, q, and p.
(c) Does the typical firm earn a short-run profit?

Answer: For each MC = 2q and AVC = q. Thus MC > AVC for all levels of output.
The firm sets p = 2q or q =0.5p. Since there are 1000 firms each producing q, market
supply equals Q = 500p. The firm’s supply is q = 0.5p; market supply is Q = 500p.
Market equilibrium can be found as 500p = 600,000 − 100p, or 600p =600,000, so p =1,000
and Q = 500,000.
q = 0.5p = 500. Short-run Profit = (500* 1,000) − (250,000) = 250,000.
Each firm earns a profit.

Figure 1

3) Figure 1 shows the long-run cost curves for

a typical firm in a competitive market. If the
number of firms is unrestricted and input
costs are constant, derive the long-run
market supply curve.
Answer: The long-run market supply curve is
horizontal at a price of $10 per unit.
4) Suppose a price taking firm has the following total cost function TC = 100 + 2q2. If price
equals $20, what is the firm’s output decision? What are its short-run profits?

Answer: MC = 4q. Since price taker, set 20 = 4q, or q = 5.

Profit = (20 * 5) − (100+ 50) = -50.Therefore, profits is -$50.

5) Assume the market demand for wheat may be written as

Q = 45 − 2p + 0.3Y + 1pb
where Y refers to income and pb refers to the price of barley. Assuming that wheat and
barley both sell for $1, and income is $20, calculate demand elasticity for wheat.

Answer: First, solve for Q = 45 − 2(1) + .3(20) + 1(1) = 50.

Then price elasticity = −2(1/50) = −0.04.

6) Suppose the demand for pizza in a small isolated town is p = 10 – Q. There are only two
firms, A and B, and each has a cost function TC = 2 + q. Determine the Cournot
equilibrium. Determine the equilibrium quantities of each if firm A is the Stackelberg
leader.

Answer: Firm A’s profit is π = [10 – (qA+ qB)]qA – 2 – qA.

Maximizing with respect to its own output yields qA = 4.5 – qB/2.
Similarly, firm B’s best response is qB = 4.5 – qA/2.
The equilibrium occurs when both firms produce 3 units, since qA = 4.5 – (4.5 – qA/2)2
solves to make qA=3 and then you can get qB = 3. Price is 10 − 3 − 3 = 4.

Knowing the best response, firm A substitutes this into demand and maximizes its profit.
π = [10 – qA − (4.5 – qA/2)]qA – 2 − qA. Maximizing with respect to qA yields qA = 4.5.
Firm B responds by producing 2.25.
7) Suppose two firms, A and B, are simultaneously considering entry into a new market. If
neither enters, both earn zero. If both enter, they both lose 100. If one firm enters, it gains
50 while the other earns zero. Set up the payoff matrix for this game and determine if any
pure Nash equilibria exist. Can you predict the outcome?

Figure 3
Answer: See Figure 3. There are two Nash
equilibria; either firm A is a natural monopoly or
firm B is a natural monopoly. It is difficult to
predict the outcome since the firms decide
simultaneously. If firm A has the opportunity to
choose first, it will enter, and firm B will not.

Figure 2

8) Figure 2 shows the payoff for two firms,

A and B, that must each choose to produce
either an advanced computer or a basic
computer. Determine the dominant
strategies for each firm (if any) and the
Nash equilibria (if any).

Answer: Neither firm has a dominant strategy. Each firm is better off doing the opposite of
its rival. There are two Nash equilibria. Either firm A makes the basic computer and firm B
makes the advanced, or firm A makes the advanced computer and firm B makes the basic.