ISET, Second Miniterm 2015

Microeconomics 2
Final Exam
Please provide brief but thourough answers to the questions below. You are allowed to use one-page
of handwritten information during the exam, however, it is forbidden to communicate with each other or
use any electronic devices. If the question sounds confusing reread them, they all have simple solutions.
Good luck!

Problem 1 [7 points] Firm produces according to function F (K; L) = (KL)1=2

and faces market prices PK = 4 and PL = 2: Find the values of K and L that
minimise the cost of producing 2 units of output.
Solution: Solving for
maxPY (KL)1=2
K;L

PK K

PL L

gives

so

PY
2

L
K

1=2

PY
2

K
L

1=2

= PK
= PL

L
PK
=
() 2L = 4K () L = 2K
K
PL

on the other hand

so K =

2 = (KL)1=2 () 4 = LK

p
2 and L = 2 2:

Problem 2 [7 points] A rm has a cost function given as T C = y 3 8y 2 +21y+50.

What is the price below which the perfectly competitive rm does not supply any
output in the short run. (Hint: What is the lowest end of the supply function?)
Solution: The competitive rm produces according to the rule M P = M C.
At the same time it would not want to produce when the prce is below the

average variable costs. We know that M C = AV Cmin , thus we need to look

for the minimum of the average variable costs. Hence,
AV C = y 2

8y + 21

AV C 0 = 2y

y = 4
AV Cmin = 42

8 4 + 21 = 5

so if the price is bellow 5, the producer will prefer to shut down even in the
short run.
Problem 3 Suppose that you produce cars with xed costs of 10 and variable costs
of 2Q + Q2 . The price of one car is given by P = 6.
a. [3 points] Write down the cost function and compute marginal and average
costs.
Solution: The cost functions are as follows:
T C = Q2 + 2Q + 10
10
AC = Q + 2 +
Q
AV C = Q + 2
M C = 2Q + 2
b. [2 points] Find the prot-maximising output level Q.
Solution: As M C = M R(= P ), then 2Q + 2 = 6, Q = 2:
c. [3 points] If the price goes up, to say P = 7, the rm will choose to produce
more. Explain why.
Solution: Increase in price of the product means increase in marginal revenue. Previousely the rm decided to produce one unit of output less when
the marginal cost was above the marginal revenue. Now with higher marginal
revenue they can produce that one (or many) extra units.
d. [5 points] In the long-run (still assume price level P = 6 and the same cost
structure) will the rm choose to quit the market, stay in the market or invest
2:
in R&D? The price of R&D is 5 and it reduces the variable costs to Q2 :
Solution: The prot in the long run is
=p Q

TC

Without R&D, that is

22 + 2 2 + 10 =

=6 2

Thus theyll prefer to quit the market, if the choice is between quiting or
staying. However, with R&D:
MC = Q
Q = 6
= 6 6

22 + 2 2 + 10 + 5 = 12

So the rm will decide to stay in the market and invest in R&D.

Problem 4 [7 points] Suppose that the cost function is given by
c (w; y) = y (w1 w2 )1=2 :
Derive the conditional factor demand functions x (w1 ; w2 ; y) and the production
function y = y (x1 ; x2 ) :
Solution: According to Shephards lemma
@c (w; y)
y
x1 (w1 ; w2 ; y) =
=
@w1
2

w2
w1

y
@c (w; y)
=
x2 (w1 ; w2 ; y) =
@w2
2

w2
w1

some rearrangements yield

w2
=
w1

2x1
y

w2
=
w1

2x2
y

combining RHS of the two we get

2x1
y

2x2
y

(2x1 )2 (2x2 )2 = y 2 y 2
(4x1 x2 )2 = y 4
0:5
y = 2x0:5
1 x2

1
2

1
2

Problem 5 [6 points] Suppose the construction rm has a cost function as

c (w; y) = y min fw1 ; w2 g
What can we infer about the production function and the conditional factor demands of that rm?
Solution: This corresponds to production function that uses imputs as perfect substitutes. So a linear function y = x1 + x2 ; and any a ne transformation will t the cost function. The conditional factor demands look like:
x1 (w; y) =

y
0

if w1 < w2
if w1 > w2

Problem 6 A cost-minimising rm uses production function

f (L; K) = minfL0:5 ; K 0:5 g
L is labour and K is capital. Assume that the rm is a price-taker in the input
markets, i.e. it pays w for each unit of labour it hires and r for each unit of capital
(where w and r are given), and faces no costs other than those from labour and
capital.
a. [5 points] Assuming that the rm can freely choose both labour and capital, derive expressions for the cost-minimising conditional input demands,
L (r; w; q) and K (r; w; q).
Solution: f (L; K) = minfL0:5 ; K 0:5 g is a perfect complements production
function, so we know that we will always be producing at L = K. Using this,
Q = f (L; K) = minfL0:5 ; K 0:5 g = minfL0:5 ; L0:5 g = L0:5
so
L (r; w; Q) = Q2
K (r; w; Q) = Q2

(1)

b. [3 points] Conrm that the conditional input demand functions are homogeneous of degree zero in w and r:
Solution: To conrm the homogeneity of degree zero:
L ( r; w; Q) = Q2 =
and same for K ( r; w; Q) =

L (r; w; Q)

K (r; w; Q).

c. [4 points] What happens to the conditional demand for labour if there is an

increase in the wage rate, assuming that r and q remain the same? Explain
in one sentence why your answer makes intuitive sense.
Solution: From equation (1) we get that L (r; w; Q) and K (r; w; Q) are independent of the input prices r and w. Hence, there no change in input quantity should be expected from a change in input price. Intuitively, given the
perfect complement production function, producers cannot substitute away
from labor when its price w increases.
Problem 7 Consider a monopsonistic rm that produces a good, with price py =
1, using the following production function: y(L) = 4L 2L3 and operating in a
market where the (inverse) labour supply is given by w (L) = L2 :
a. [4 points] Write down the prot maximisation problem of the monopsonistic
rm and state the rst order necessary condition(s).
Solution: With p = 1, the monopsonist rms prot maximisation problem
can be written as
max
L

= p y(L)

CL (L)

s:t:
y (L) = 4L

2L3

CL (L) = w (L) L
w(L) = L2
After substitutions this can be reduced to = (4L 2L3 )
Our rst-order condition for prot maximisation is

L2 L = 4L

3L3 :

@ !
=0
@L
that can be calculated as 4

9L2 = 0:

b. [3 points] Find the equilibrium employment and wage rate.

Solution: From the solution of FOC 4
wage is w (L) = L2 = 4=9:

9L2 = 0 =) L = 2=3 and the

c. [3 points] Explain why in a monopsonistic market marginal cost of labor

M CL (L) is above wage w(L) for any L.
Solution: The reason M CL lies above the supply curve is that, for buying
an additional unit of labor, the monopsonist must pay a higher wage not only

to the additional (marginal) unit of labor but also to all the units that it has
hired before.
Problem 8 [7 points] Each extra worker produces an extra unit of output up to six
workers. After the sixth worker, no additional output is produced. Draw the total
product of labor, average product of labor and marginal product of labor curves.
Solution:

Problem 9 [4 points] There is a lemma that states: For any convex production set
Y
RL with 0 Y; there is a convex, constant-returns production set Y 0 RL+1
such that Y = y RL : (y; 1) 2 Y 0 : What is the main microeconomics usage
of that lemma?
Solution: In essence, the lemma implies that in a competitive, convex setting, there may be little loss of conceptual generality in limiting ourselves to
constant returns technologies in most of the analysis. Thus, even if the data
shows that the technology seemingly displays decreasing returns, we can assume that there is a missing input (e.g. the entrepreneural skill, that couldnt
have changed for the time of the analysis) in the equation and in total it can
sum up to constant returns.
Problem 10 [3 points] Suppose that a production set Y has the shutdown property
and the no free lunch property (i.e., Y \ Rn+ f0g: at least one of the goods must
be used as an input and it is possible to produce nothing with no imputs), and
nonincreasing returns to scale. Does that imply that Y is convex? (Hint: Think of
a couterexample.)
Solution: Consider the following counter example where Y is the production
set given by the single-input single-output production function
f (z) =

z 1=2
z

if z 2 [0; 1]
if z 1

This is represented in Figure 1. The production set is below the curve of the
production function. It is easy to see that it is not convex but that it satises
nonincreasing returns to scale.

Problem 11 [6 points] Show analytically that the marginal cost is equal to average
cost when the average cost is in its minimum.
Solution: AC =

TC
q ; MC

@T C
@q :

So, to nd the AC in its minimum

@T C
TC !
@AC
@ T C (q)
@q q
=
=
=0
@q
@q
q
q2
@T C
TC
@T C
q = T C ()
=
@q
@q
q

Problem 12 [6 points] During the marvelous eleventhy-rst year after the establishment of the Country of Dystopia the annual economic growth rate was registered to be -50 per cent. Assume that the production followed a Cobb-Douglas form:
yt = At lt1 kt ; with = 1=2; where At stands for the level of productivity (the
level of general knowledge in the country) at time t, lt is the size of population at
time t, and kt shows the size of the physical capital. Knowing that the population
lt grew 10 per cent and kt decreased 10 per cent, calculate how much dumber (less
smart) the population of the glourious Country of Dystopia became during that
year.
Solution: Taking the logarithm of the production function and the derivative
with respect to time, we arrive at
gy = gA + (1
50 = gA + (1
gA =

50

) gl + gk
:5) 10 + :5 ( 10)

Multiple choice questions

(only one correct answer)

[3 points each]
1. If Q = K 2 L2 the M PL is
(a) constant
(b) diminishing
(c) increasing
(Correct. However, it still does not say what it is increasing
in. It does increase with L and K, but it does not increase in time or
wages.)
(d) not enough information to determine
2. As long as marginal cost is below average cost, average cost will be
(a) falling
(Correct. As long as each next input costs less than then the
average, the new average is falling.)
(b) rising.
(c) constant.
(d) changing in a direction that cannot be determined without more information.
3. Suppose pigs (P ) can be fed corn-based feed (C) or soybean-based feed (S)
such that the production function is P = 2C + 5S. If the price of corn
feed is $4 and the price of soybean feed is $5, what is the cost minimising
combination of producing P = 200?
(a) C = 100
(b) S=40
(Correct. The pig production employs a production function
that has inputs as perfect complements. Obviously using only soybeanbased feed costs less than any of the alternatives.)
(c) C = 50; S = 20
(d) C = 20; S = 50
4. Regardless of market structure, all rms

(a) maximize prot by setting marginal revenue equal to marginal cost.

(Correct. Follows from the rst order necessary condition that marginal
prot should be zero. Answer in b. is wrong as many rms produce
identical prodcts. Answer is c. is almost correct, they certainly can
charge any arbitrary price, but that wouldnt be optimal.)
(b) produce a dierentiated product.
(c) have the ability to set price.
(d) All of the above.