PM Exercise Solutions Session 1-6 CH 2-10

Firms, Prices & Markets Timothy Van Zandt
© August 2006
Chapter 2
Supply, Demand, and Markets
SOLUTIONS TO EXERCISES
Exercise 2.1. Suppose a market for commercial water purification systems has 13 buyers with the following
valuations (in €1000s), from highest to lowest:
Buyer 1 2 3 4 5 6 7 8 9 10 11 12 13
Valuation 57 54 51 48 45 42 39 36 33 30 27 24 21
These valuations are graphed in Figure E2.1 and again in Figure E2.2.
a. What is the total valuation of the first 5 buyers? Illustrate this as the area under the valuation curve in Fig-
ure E2.1.
Solution: Total valuation is 57 + 54 + 51 + 48 + 45 = 255. See Figure E2.1.
Figure E2.1
€
(1000s) 57
54
Valuations
51
48
45
42
39
36
33
30
27
Total valuation
24
of first 5 buyers
21
18
15
12
9
6
3
1 2 3 4 5 6 7 8 9 10 11 12 13
Buyer
Firms, Prices & Markets • Solutions for Chapter 2 (Supply, Demand, and Markets) 2
b. Suppose the price is 43. How much is the demand? How much is the total expenditure? How much is
the surplus of each of the buyers? How much is the total consumer surplus? Illustrate the demand, the total
expenditure, and the consumer surplus using the valuation curve in Figure E2.2.
Solution: Demand is 5. Total values are as follows:
Expenditure = 43 × 5 = 215,
Consumer surplus = Valuation − Expenditure = 255 − 215 = 40.
See Figure E2.2.
Figure E2.2
€
(1000s) 57
54
Valuations
51
48 Consumer
45
surplus
42
39
36
33
30
27
24
21 Total expenditure
18
15
12
9
6
3
1 2 3 4 5 6 7 8 9 10 11 12 13
Buyer
Exercise 2.2. This exercise asks you to show the effect of a tax by working with the seller’s price Ps (not
including the tax) and shifting the demand curve.
a. Figure E2.3 shows a demand and supply curve. Show the equilibrium price and quantity. Illustrate also the
producer surplus and consumer surplus.
Figure E2.3
$ Equilibrium without tax
900
800
700 s(P)
600
Consumer
500
surplus
400
∗
P300
200
Producer surplus d(P)
100
10 20 30 40 50 60 70 80 90 100
Q∗ Q
Solution: See Figure E2.3.
b. Suppose a tax of €200 is imposed. Let the vertical axis measure the price received by sellers. Redraw the
demand curve on Figure E2.4 as a function of the seller’s price. Illustrate the new equilibrium price and quantity
as well as the deadweight loss.
Figure E2.4
$ Equilibrium with tax
900
800
700 Τ s(P)
600 Deadweight loss
500
400
300
Ps
200
d(P)
100
10 20 30 40 50 60 70 80 90 100
QΤ Q∗ Q
ˆ s)
d(P
Exercise 2.3. Suppose there are 8 buyers with valuations 2, 3, 3, 4, 5, 5, 7, and 8.

a. Graph the valuations as points on the axes in Figure E2.5, from highest to lowest.
Solution:
Figure S1
$
8
1 2 3 4 5 6 7 8
Q
b. Suppose the market price is $4.50. How many buyers will purchase at this price? Connect the points on your
graph so that it becomes a demand curve, and illustrate the quantity purchased when the price is $4.50.
Solution: Four buyers will purchase, because this is the number of buyers whose valu-
ations exceed $4.5.
Figure S2
$
8
5
P = 4.5
4
demand d(P)
3
1 2 3 4 5 6 7 8
Q
c. What is the total valuation of the buyers who would purchase when the price is $4.5? Illustrate this as the
area of a region on your graph.
Solution: The total valuation of the “top” four buyers is 8 + 7 + 5 + 5 = 25.
Figure S3
$
8
4
Total valuation
3
of first 4 buyers
2
1 2 3 4 5 6 7 8
Q
d. What is the total expenditure by those who purchase? What is the total surplus? Illustrate these as the areas
of regions on your graph.
Solution: Total expenditure is 4.5 × 4 = 18. Total consumer surplus is 25 − 18 = 7.
Figure S4
$
8
6 Consumer
surplus
5
P
4
2 Total expenditure
1 2 3 4 5 6 7 8
Q
Exercise 2.4. Consider a market with the following demand and supply curves:
Demand: d(P) = 50 − (1/2)P ,
Supply: s(P) = −10 + P .
a. Compute the equilibrium price and quantity.
Solution: We find the equilibrium price by solving
d(P) = s(P) ,
50 − (1/2)P = −10 + P ,
60 = (3/2)P ,
40 = P .
We find the quantity by putting the price into either the demand or the supply curve (at the
equilibrium price, these are equal). For example, Q = d(40) = 50 − (1/2)40 = 30.
b. Graph the demand and supply curves on Figure E2.6. Illustrate on the graph the equilibrium price and quan-
tity, the consumer surplus, and the producer surplus.
Figure E2.6
P
100
90
d(P)
80
70
s(P)
60 Consumer surplus
50
P∗ 40
30 Producer surplus
20
10
5 10 15 20 25 30 35 40 45 50
Q∗ Q
c. Calculate the consumer surplus and the producer surplus. [You are calculating the areas of two triangles.
Remember: area of a triangle = (1/2)(base × height).]
Solution: The triangle of the consumer surplus has base 30 and height 60. Hence, con-
sumer surplus is (30 × 60)/2 = 900.
The triangle of the producer surplus has base 30 and height 30. Hence, producer surplus
is (30 × 30)/2 = 450.
Exercise 2.5. Consider the demand and supply curves from Exercise 2.4. Assume a per-unit tax of 15 is
imposed. You are to find the price the buyers pay (including the tax), the price the sellers receive (net of the tax),
and the quantity transacted. Some of the questions require that you graph curves within Figure E2.7.
Figure E2.7
P
100
90
d(P)
80
70
Deadweight loss s(P)
60 Consumer surplus
Pb 50
40
Tax revenue
Ps
30
20
d Τ (Ps )
10
Producer surplus
5 10 15 20 25 30 35 40 45 50
QΤ Q
a. You should find the new equilibrium values by shifting the demand curve. What is the demand d Τ (Ps ) as a
function of the price (net of tax) received by the sellers?
Solution: The new demand at the net-of-tax price Ps is same as the old demand when
the price is P = Ps + 15 (since Ps + 15 is the total amount that the buyers pay). Thus, the
shifted demand curve is
d Τ (Ps ) = d(Ps + 15) = 50 − (1/2)(Ps + 15) = 42.5 − (1/2)Ps .
b. Graph this function and the original demand curve d(P) on Figure E2.7. In which direction does the demand
curve shift by 15?
Solution: See Figure E2.7. The demand curve shifts DOWN by 15.
(With linear demand, it also looks like the demand curve shifted to the left. However,
(a) the amount of this shift is not the amount of the tax and (b) with non-linear demand, the
curve would shift down by 15 but would not shift left by a fixed amount.)
c. Calculate the equilibrium price paid by buyers (including the tax), price received by sellers (net of tax), and
quantity.
Solution: We find the price Ps received by sellers by solving
d Τ (Ps ) = s(Ps ) ,
42.5 − (1/2)Ps = −10 + Ps ,
52.5 = (3/2)Ps ,
35 = Ps .
The price Pb paid by buyers is 15 more than this: Pb = 50. The quantity transacted is
d(50) = s(35) = 25.
d. Illustrate the equilibrium on the graph. Show the regions that correspond to (a) producer surplus, (b) consumer
surplus, (c) tax revenue, and (d) deadweight loss.

© August 2006
Chapter 3
Consumer Choice and Demand
Exercise 3.1. Consider the U.S. demand Q for minivans (measured in hundred thousands of units) as a func-
tion of the price P of minivans (measured in thousands of dollars), the price Ps of station wagons (measured
in thousands of dollars), the price Pg of gasoline (measured in dollars), and per capita income I (measured in
thousands of dollars). Suppose the demand function is linear, as follows:
Q = 12 − 0.6P + 0.2Ps − 3Pg + 0.2I. (E3.1)
Based on the form of this demand function (instead of on your prior knowledge about the minivan market), answer
the following questions.
a. Are minivans normal goods?
Solution: Yes: the coefficient on I is positive and hence demand rises with income.
b. Are minivans and station wagons substitutes or complements?
Solution: Substitutes, because the coefficient on Ps is positive and hence demand for
minivans rises with the price of station wagons.
c. Are minivans and gasoline substitutes or complements?
Solution: Complements, because the coefficient on Pg is negative and hence demand for
minivans falls when the price of gasoline rises.
Exercise 3.2. Consider the demand function for minivans shown in Exercise 3.1. What is the demand curve
when the price of station wagons is $16K, the price of gasoline is $3 per gallon, and per capita income is $25K?
Solution: Q = 12 − 0.6P + (0.2 × 16) − (3 × 3) + (0.2 × 25) = 11.2 − 0.6P.
Exercise 3.3. Market research revealed that the market demand function for home exercise equipment is
Q = 2400 − 2P − 15Pv ,
where P is the price of exercise equipment and Pv is the price of exercise videos. The current price of exercise
equipment is 300 and the current price of exercise videos is 20.
a. Given these prices, calculate the own-price elasticity of demand for exercise equipment.
Solution: One way to solve this problem is to plug in Pv = 20 to obtain the demand
curve, which is linear, and then use our formula E = P/(P̄ − P) for the elasticity of a linear
demand curve at price P. Plugging in Pv = 20 yields Q = 2100 − 2P. The choke price is
P̄ = 1050. Elasticity when P = 300 is 300/(1050 − 300) = 0.4.
b. Are exercise videos and exercise equipment complements or substitutes?
Solution: Videos and equipment are complements, because a higher price for videos
makes demand for equipment go down.
Firms, Prices & Markets • Solutions for Chapter 3 (Consumer Choice and Demand) 2
c. Suppose the price of exercise videos increases to 40. Does the own-price elasticity of demand increase or
decrease?
Solution: If instead Pv = 40, the demand curve is Q = 1800 − 2P and the choke price
is 900. Hence, elasticity when P = 300 is 300/(900 − 300) = 0.5. Demand has become
more elastic.
Exercise 3.4. What will be the effect (increase or decrease) of the following events on the demand for French
wine? Be sure to distinguish between shifts of the demand curve and movements along the curve.
a. A decrease in the price of French wine.
Solution: Demand increases. This is a movement along the demand curve.
b. A new study linking longevity with moderate amounts of red wine.
Solution: Demand increases at any given price. This is a shift (to the right) of the de-
mand curve.
c. An increase in the price of California wine.
Solution: The price of Californian wine is likely to rise, causing demand for French
wine to increase (because these goods are substitutes). This is a shift in the demand curve.
d. A severe drought in the wine-growing regions of France.
Solution: The restriction in supply is likely to cause the price to rise. This reduces
demand, via a movement along the demand curve.
Exercise 3.5. Calculate the price elasticity at current prices in the following examples. If you do not have
enough information, say so.
a. The firm’s demand curve is Q = 2000 − 5P, and the firm’s output is 500.
Solution: When output is 500, the price is P = 300. The choke price of this demand
curve is 400. Therefore, using the formula E = P/(P̄ − P) for the elasticity of a linear
demand curve, we have E = 300/(400 − 300) = 3.
b. The firm’s demand curve is Q = 5P−1.55 ; the firm’s price and output are unobserved.
Solution: This is a constant elasticity demand curve. The elasticity is 1.55 at any price.
Exercise 3.6. (Valuation) A newspaper poll in Columbus showed that two thirds of the voters rated an ex-
cellent school system as one of the city’s important assets. However, in an election the voters turned down a school
bond issue. Does this mean the poll was faulty or that voters are irrational?
Solution: No. This exercise illustrates the difference between marginal and total valu-
ation. The voter behavior indicates that the marginal value of an extra dollar on schooling
is less than the marginal value of an extra dollar on other consumption. However, the total
valuation of the school system could be much higher than the amount the district spends.
Exercise 3.7. (Inferior goods) It has been observed that the amount consumed of the services of domestic
servants declined in most Western countries during the first half of the 20th century, while per capita income was
increasing. Does this mean that domestic servants are an inferior good?
Solution: A good is an inferior good if, other things kept constant, demand falls as
income rises. In this case, the price of domestic servants was rising as fast as per capita
income, or even faster because of the rise of the middle class. Hence, another explanation
is that, for the wealthy who hired domestic servants, the price of domestic servants was
rising compared to their wealth and so the decline in the use of domestic servants was a
price effect rather than an income effect. Furthermore, new substitute goods (household
appliances) were developed. A cross-sectional study of households with different incomes
would probably show that servants are a luxury good.
Exercise 3.8. (Elasticity) The 23 January 1992 issue of The Economist stated that, owing to a wet spring,
truffle production in France was expected to reach 16 tons—up from the previous year’s production of 8 tons. The
price of truffles, which reached $690/pound in the previous year, was expected to fall to approximately $290/pound
this year.
a. Assuming that the demand function for truffles has not changed, what is the arc elasticity of demand for this
price change?
Solution: The formula for arc elasticity is

change in demand change in price
− .
avg. of demand before and after avg. of price before and after
Hence, the arc elasticity with respect to this change in prices (rounded to two decimal
places) is
16 − 8 290 − 690
− = .82.
(8 + 16)/2 (690 + 290)/2
b. Do you think that truffle producers are happy about the good truffle-growing weather?
Solution: Unhappy (assuming that happiness is measured by profits). Revenues have

fallen from
($690/pound) × (8 tons) × (2000 pounds/ton) = $11.04 M
to
($290/pound) × (16 tons) × (2000 pounds/ton) = $9.28 M .
Yet presumably costs did not fall but rather rose due to the increased production. Hence,
average profits of the producers are lower.
Exercise 3.9. (Elasticity, shifts in demand) Table E3.1 shows actual data about the prices of Model T touring
cars in different years and the sales volumes at those prices.
Table E3.1
Year Retail price Sales volume
1908 850 5,986

1909 950 12,292
1910 780 19,293
1911 690 40,402
1912 600 78,611
1913 550 182,809
1914 490 260,720
1915 440 355,276
1916 360 577,036
a. Assuming that these data represent points on a fixed demand curve, calculate the arc elasticity of demand by
comparing the data (i) for the years 1910 and 1911 and (ii) for the years 1915 and 1916.
Solution: (i) From 1910 to 1911, arc elasticity is

40, 402 − 19, 293 690 − 780
− = 5.78.
(19, 293 + 40, 402)/2 (780 + 690)/2
(ii) From 1915 to 1916, arc elasticity is

577, 036 − 355, 276 360 − 440
− = 2.38.
(577, 036 + 355, 276)/2 (440 + 360)/2
b. Give two reasons why we might not want to consider these data to be points on a fixed demand curve.
Solution:
1. Demand depends not only on the price of the Model T, but also on the prices of other
goods, on income, and on consumer tastes. These may have changed between 1908
and 1916. In particular, demand for the recently introduced automobile depended on
the infrastructure of roads and gas stations that were being developed.
2. The good is a durable good; hence demand depends not only on the current price but
also on the expected future prices and on past prices. This is particularly important in
this market because the Model T had been introduced recently and stocks had not built
up to their steady-state levels.
Commentary A suitable answer could consist of two reasonably different examples of what
I grouped into the first reason.
© August 2006
Chapter 4
Production and Costs
Exercise 4.1. Suppose that the costs of a large newspaper company consist of
1. workers and machines who print the newspaper;
2. newsprint and ink; and
3. reporters/editors/typesetters who prepare the content.
For each of the listed costs, determine if is a long-run fixed cost. You can answer this by examining the
following scenario: the newspaper decides to keep the same quality newspaper (i.e., sell the same product) while
cutting its circulation in half. A long-run fixed cost is one that could never be reduced without changing the quality
of the product and hence that is not linked to the size of circulation.
Solution: The workers and machines for printing the paper can eventually be reduced—
perhaps by half—when the number of copies printed is cut in half. The same is true for the
newsprint and ink. These are not long-run fixed costs.
The wages of the reporters, editors, and typesetters cannot be reduced without changing
the quality of the product. Their tasks are unaffected by the size of the circulation.
Exercise 4.2. Recall the example of a large newspaper company from Exercise 4.1. The costs of the company
are:
1. workers and machines who print the newspaper;

2. newsprint and ink; and
3. reporters/editors/typesetters who prepare the content.
Which costs are fixed in the short run, that is, which cannot be adjusted quickly even if the firm shuts down (but
meets its financial obligations rather than entering into bankruptcy)? This is a question of degree, not a black-and-
white categorization, so it is better to give a qualitative discussion of how long it would take to reduce or increase
each input.
(In Exercise 4.1, you identified the long-run fixed costs. Remember that this question about short-run fixed
costs bears no direct relationship to Exercise 4.1.)
Solution: Newsprint and ink can be reduced (or increased) very quickly, e.g., within
weeks, depending on the contracts the newspaper has with suppliers. Their costs are not
fixed in the short-run.
Machines will likely take a long time to sell off, depreciate, or redeploy, e.g., six months
or more (similarly for buying and installing machines). Hence, their costs are fixed in the
short run.
The time it takes to lay off or fire employees—whether workers who print the newspaper
or the reporters, editors, and typesetters—is probably in the middle, e.g., from one to six
months, depending on the country and labor contracts (similarly for hiring new workers).
Their wages may or may not be defined as short-run fixed costs, depending on the time
horizon by which one defines the “short run”.
Firms, Prices & Markets • Solutions for Chapter 4 (Production and Costs) 2
Exercise 4.3. A firm may develop software for blocking pop-up windows. The software is to be sold on a
subscription basis, giving users access to regular updates that are needed to adapt to changing tactics of advertisers.
The product has the following costs:
1. Initial development of software: $10 million.

2. Development of updates: $200K per month.
3. Distribution costs (e.g., payment processing): $4 per customer per year.
a. Decision problem 1: You have not yet decided to develop the software and enter the market, but you are
putting together a business plan to decide whether to do so and what price to charge. What are the long-run fixed
costs? What are the sunk costs?
Solution: Costs (1) and (2) are long-run fixed costs. There are no sunk costs.
b. Decision problem 2: You have already developed the product and have been operating for a year. A new
competitor has entered the market, shifting your demand curve. You are now deciding how to adjust your pricing
and whether to shut down. What are the long-run fixed costs? What are the sunk costs?
Solution: Cost (1) is a sunk cost; cost (2) is a long-run fixed cost.
Note: All prior operating expenses, such as the distribution costs and update develop-
ment costs incurred in the first year of operation, are also trivially sunk costs. When we
say that cost (2) is a long-run fixed cost, we are referring to the future update development
costs needed to continue operating.
Exercise 4.4. Consider the following cost function:
c(Q) = 100 + 10Q + Q2 .
a. What are the formulas for the fixed cost, variable cost, average cost, and marginal cost?
Solution:
FC = 100 ;
vc(Q) = 10Q + Q2 ;
ac(Q) = 100/Q + 10 + Q ;
mc(Q) = 10 + 2Q .
b. At what output level Qu is average cost lowest?
Solution: One way to solve this is to find the quantity at which AC = MC. We solve
100/Q + 10 + Q = 10 + 2Q, or 100 = Q2 . Hence, Qu = 10.
c. What is the minimum average cost ACu ?
Solution: ACu = ac(Qu ) = 100/10 + 10 + 10 = 30.
Solution:
Exercise 4.5. Suppose a firm has a fixed cost as well as increasing marginal cost and thus has a U-shaped
average cost curve. Suppose that its marginal cost increases by a fixed amount ∆MC at all output levels—for
example, a per-unit tax is imposed on the firm’s output. Based only on this information, what can you say about
how Qu and ACu change? A graph can help you figure out the answer and should be used to illustrate your it.
Solution: I use on values after the increase in marginal cost.

Both the average cost curve and the marginal cost curve shift up by exactly ∆MC.
Therefore:
1. The quantity at which the two curves intersect does not change: Q̂u = Qu ,
u
= ACu + ∆MC.
2. The value at their intersection point increases by ∆MC: AC
You are expected to draw freehand curves with these to properties. That is all.
For my own graph in Figure S1, I have used c(Q) = 125 + 2Q1.5 and ∆MC = 10.
Figure S1
€ AC = dashed curves
MC = solid curves
40 After tax: higher curves (shifted up by 10)
35
30
⎧ u
⎪ AC 25
⎪
⎪
⎨
∆MC 20
⎪
⎪
⎪
⎩
ACu 15
10
5 10 15 20 25 30 35 40 45 Q
Qu = Q̂u
Exercise 4.6. Suppose a firm has a fixed cost as well as increasing marginal cost and thus has a U-shaped
average cost curve. Suppose that its fixed cost increases by ∆FC—for example, the government imposes a yearly
license fee to operate in the market or there is an increase in the firm’s R&D cost. Based only on this information,
what can you say about how Qu and ACu change? A graph can help you figure out the answer and should be used
to illustrate it.
Solution: I use on values after the increase in the fixed cost.

The MC curve does not change at all. The AC curve shifts up. This is all we need
to understand that the quantity at which the MC and AC curve intersects must increase:
Q̂u > Qu . (This is the main difference compared to Exercise 4.5 and the most interesting
u > ACu .
part of this exercise.) Of course, the minimum average cost has to go up also: AC
That conclusion and its graphical illustration are all I am expecting. However, we can
say more about the shift in ACu . The AC curve shifts up by (∆FC)/Q, an amount that
decreases with Q (so the AC curve does not shift up by a fixed amount). At Qu , the average
cost would increase by (∆FC)/Qu . The new average cost is actually lower than the average
cost at Qu (since Q̂u minimizes average cost whereas QU does not. So the increase in
minimum average cost is less than (∆FC)/Qu : AC u < ACu + (∆FC)/Qu .
You are expected to give a freehand drawing that illustrates the first paragraph. My own
examples assumes c(Q) = 125 + 2Q1.5 and ∆FC = 91.
Figure S2
€ AC = dashed curves (“after curve” is the higher one)
MC = solid curve (no change)
40
35
30
25
u 20

AC
ACu 15
10
5 10 15 20 25 30 35 40 45 Q
Qu Q̂u
Exercise 4.7. Figure E4.1 shows the AC and the MC curves of a manufacturing firm. Without any further
information, can you tell which one is which?
Figure E4.1
€
Q
Solution: Since one of these is the AC curve, AC is decreasing. This can only happen
when MC < AC. Therefore, the top curve is the AC curve and the bottom curve is the MC
curve.
Exercise 4.8. Consider the following cost function:
c(Q) = 144 + 3Q + Q2 .
a. What are the formulas for the fixed cost, variable cost, average cost, and marginal cost?
Solution:
FC = 144 ;
vc(Q) = 3Q + Q2 ;
ac(Q) = 144/Q + 3 + Q ;
mc(Q) = 3 + 2Q .
b. At what output level Qu is average cost lowest?
Solution: We solve
AC = MC ,
144/Q + 3 + Q = 3 + 2Q ,
144/Q = Q ,
144 = Q2 ,
Q = 12 .
c. What is the minimum average cost ACu ?
Solution: ACu = ac(Qu ) = 144/12 + 3 + 12 = 27.

© August 2006
Chapter 7
Explicit Market Segmentation
Exercise 7.1. Explicit market segmentation tends to be more common in the sale of services (e.g., discrimina-
tion by income for universities and by age for air transportation services) than in the sale of manufactured goods.
Why do you think this is so?
Solution: There are two reasons:

Most significant: Arbitrage is typically easy with manufactured goods; one person can
buy the good and then trade it to another person for whom the price would be higher if
purchased directly from the firm. Services are typically delivered personally, and hence it
is easier to verify that the purchaser is actually the person who consumes the good.
Also: owing to the personal relationship with the customer, it is easier to observe per-
sonal characteristics that are related to the customer’s taste and upon which prices can de-
pend.
© August 2006
Chapter 8
Implicit Market Segmentation (Screening)
See text for background information for Exercises 8.1–8.4. Note constant MC = € 300.
Exercise 8.1. (Uniform pricing) Suppose you decide to offer only unrestricted tickets. There are only two
prices you might charge (depending on the values of B and L). What are they? For each of the two prices, (i)
describe who purchases the tickets and (ii) write your profit as a function of B and L.
Solution: Either €1000, in which case only business travelers purchase tickets, or €600,
in which case all travelers purchase tickets. My profit when charging the high price is
B × 700; my profit when charging the low price is (B + L) × 300.
Exercise 8.2. (Benchmark: Explicit market segmentation) Suppose your airline can perfectly price dis-
criminate.
a. What products do you offer (unrestricted, restricted, both, or neither), and what price(s) do you charge each
market segment?
Solution: I should charge each customer his valuation for the product he values the most
(since my cost of the two products is the same). Hence, I offer only unrestricted tickets. I
charge business travelers €1000 and leisure travelers €600.
b. What is your total profit as a function of B and L?
Solution: My per-unit profit is €700 for each business traveler and €300 for each leisure
traveler, so my total profit is (B × 700) + (L × 300).
Exercise 8.3. (Screening) Suppose you offer both restricted and unrestricted tickets, with the intention that
the business travelers buy the unrestricted ticket and the leisure travelers buy the restricted ticket. Note that the
business travelers are willing to pay more than the leisure travelers for both types of tickets. The important fact
is that the extra amount the business travelers are willing to pay for the unrestricted ticket is more than the extra
amount the leisure travelers are willing to pay.
a. What would happen if you attempted to extract all the surplus by setting the price of the unrestricted ticket
equal to the business travelers’ valuation (€1000) and the price of the restricted ticket equal to the leisure travelers’
valuation (€500)?
Solution: The business travelers prefer to buy the restricted ticket. This ticket costs
€500 and is worth €600; hence the business traveler’s surplus is €100. In contrast, buying
the unrestricted tickets gives the business traveler zero surplus.
b. The binding parts of the participation and self-selection constraints are:

1. you must not set the price of restricted tickets so high that the leisure travelers prefer not to travel at all;
2. you must not set the price of unrestricted tickets so high that the business travelers prefer to buy restricted
tickets.
Identify these constraints by name.

Firms, Prices & Markets • Solutions for Chapter 8 (Implicit Market Segmentation (Screening)) 2
Solution: (1) is the participation constraint of leisure travelers; (2) is the self-selection
constraint of the business travelers.
c. Calculate your optimal prices.
Solution: I set the price of the restricted ticket to the leisure traveler’s valuation of €500.
I set the price of the unrestricted ticket to the highest amount such that the business travelers
are still willing to purchase these tickets, i.e., to €400 more than the price of the restricted
ticket, or €900.
d. Calculate the profit (given the optimal prices) as a function of B and L.
Solution: (B × 600) + (L × 200).
Exercise 8.4. (Comparison) You have thus narrowed your options down to three potentially good ones:
A. sell only unrestricted tickets at a high price to business travelers only;

B. sell only unrestricted tickets at a lower price to all travelers;
C. sell unrestricted tickets to business travelers and restricted tickets to leisure travelers at the prices you obtained
in Exercise 8.3.
The optimal prices you obtained for options A, B, and C do not depend on the numbers of business and leisure
travelers. However, the ranking of the options does. The purpose of this exercise is to see this relationship.
a. Suppose there are 50 business travelers and 50 leisure travelers. Calculate your profit for each of the three
options and find which option has the highest profit.
Solution: Option C is best:
Option Profit
A 50 × 700 = 35,000
B 100 × 300 = 30,000
C (50 × 600) + (50 × 200) = 40,000
b. Suppose there are 99 business travelers and 1 leisure traveler. How do the profits of the three options compare?
Solution: Option A is best:
Option Profit
A 99 × 700 = 69,300
B 100 × 300 = 30,000
C (99 × 600) + (1 × 200) = 59,600
c. Suppose there are 99 leisure travelers and 1 business traveler. How do the profits of the three options compare?
Solution: Option B is best:
Option Profit
A 1 × 700 = 700
B 100 × 300 = 30,000
C (1 × 600) + (99 × 200) = 20,400
d. Fix the total number of customers at 100, so that B is the percentage that are business travelers and L is the
percentage that are leisure travelers. On a single graph, plot the profit as a function of B (for B between 0 and
100) for each of the three options. (For each option, profit as a function of B is a line and hence is easy to draw
by hand.) For each option, identify the region on the graph (i.e., the range of values of B) for which that option
yields the highest profit.
Solution:
Option Profit as a function of B Shown in graph as
A 700B dotted line
B 100 × 300 = 30, 000 solid line
C B × 600 + (100 − B) × 200 = 20, 000 + 400B dashed line
See Figure S1.
Figure S1
Profit A
60000 C
50000
40000
30000 B
20000
10000
% Bus. travelers (B)
10 20 30 40 50 60 70 80 90
B best C best A best
Exercise 8.5. You are in charge of sales for a symphony that has a mini-season of two concerts, one featuring
music by Wagner and the other featuring new music by John Harbison. Some in the potential audience like old
music much more than contemporary, others like both equally, and others like contemporary much more than old
music. You must decide how to price the individual tickets and the series in order to maximize profit.
We make some simplifying assumptions: The symphony has a very large concert hall relative to its popularity
and hence capacity constraints are not an issue; all seats are equally desirable; and the marginal cost of each
concertgoer is zero. Hence, the symphony’s goal is to maximize revenue.
Assume the market is highly segmented, with only three types of customers. There is one customer of each
type (which is equivalent to assuming there are equal numbers of each type). The valuations of these customers
for each of the two concerts are as shown in Table E8.1
Table E8.1
Valuation
Type of
customer Wagner Harbison
A 50 5
B 40 40
C 5 50
A customer may go to one or both of the concerts. A customer’s valuation of a bundle equals the sum of his
valuations of the concerts in the bundle.
a. (Benchmark: Explicit market segmentation) Suppose, hypothetically, that you can perfectly price discrim-
inate. How much should you charge each type of customer for each concert? What is the total revenue?
Solution: I charge each customer his valuation for each concert. For example, type A
pays €50 for Wagner and €5 for Harbison. Each customer buys a ticket for each concert.
Total revenue equals the sum of the valuations: €190.
b. (No bundling) Return to the real situation in which you cannot perfectly price discriminate. Suppose you
sell only individual tickets. What price should you charge for each concert? Who buys tickets? What is the total
revenue?
Solution: €40 for each concert. Types A and B buy Wagner tickets, Types B and C buy
Harbison tickets. Total revenue is 4 × €40 = €160.
c. (Pure bundling) Suppose you offer only the series and do not sell individual tickets. What price should you
charge? Who buys? What is your total revenue?
Solution: €55 for the series. Each customer buys the subscription. Total revenue is
€165.
d. (Mixed bundling) Suppose you sell individual tickets and also the series. What prices should you charge?
What does each type of customer buy? What is the total revenue?
Solution: €50 for individual tickets and €80 for the series. Type A buys a Wagner ticket,
type C buys a Harbison ticket, and type B buys the series. Total revenue is €180.
Exercise 8.6. (Perfect price discrimination) Suppose that you produce an indivisible good at a constant
marginal cost of $14. You have 12 customers, each of whom buys at most one unit of the good. They have the
following valuations:
$10, $12, $15, $16, $17, $19, $22, $22, $25, $26, $27, $30.
a. If you cannot price discriminate, what price should you charge? What is your total profit? (A spreadsheet
may be useful.)
Solution: For each price P (equal to one of the valuations), we calculate:
1. demand Q = the number of customers whose reservation values are at least P;

2. revenue R = P × Q;
3. cost C = 14 × Q;
4. profit Π = R − C.
Price Demand Revenue Cost Profit
A1 10 12 120 168 (48)
A2 12 11 132 154 (22)
A3 15 10 150 140 10
A4 16 9 144 126 18
A5 17 8 136 112 24
A6 19 7 133 98 35
A7 22 6 132 84 48
A8 25 4 100 56 44
A9 26 3 78 42 36
A10 27 2 54 28 26
A11 30 1 30 14 16
A12 31 0 0 0 0
Price of 22 yields highest profit of $48, with sales equal to 6.
b. Take as the status quo your decision in the previous part. The purpose of this part is to demonstrate that the
outcome is not economically efficient. Show that there is a customer who is currently not buying the product and
to whom you could sell the good at a price that would make both you and that customer better off (if you could
identify the customer and if the transaction would not disturb your current sales to other customers).
Solution: There are four customers whose reservation values are above 14 but below
22. These customers do not purchase because their reservations values are below 22. If
we could, for example, arrange to sell the good to one of these customers at a price that is
midway between 14 and his reservation price, then the customer would be better off and
we would make a higher profit.
c. Now suppose that you can perfectly price discriminate (charge each customer a different price). Which cus-
tomers do you sell to, how much do you charge, and what is your total profit?
Solution: We sell to each customer whose reservation value is at least 14, and we charge
each such customer their reservation value. Thus, we sell to 10 customers and receive as
revenue
15 + 16 + 17 + 19 + 22 + 22 + 25 + 26 + 27 + 30 = 219.
Our cost is 14 × 10 = 140, and hence our profit is 219 − 140 = 79.
Exercise 8.7. (Perfect price discrimination) Consider a market in which each customer purchases at most
one unit of an indivisible good. Consider a shift from a monopolist who cannot price discriminate to the same
monopolist with perfect price discrimination. Which customers are better off, worse off, or indifferent?
Solution: With perfect price discrimination, all customers get zero surplus. Without
price discrimination:
• customers who do not purchase get zero surplus and hence are neither better nor worse
off than with price discrimination;
• there are some customers who purchase at their reservation price, and these customers
are also neither better nor worse off;
• however, most of those customers who purchase do so at a price that is below their
reservation value—hence obtaining positive consumer surplus—and these customers
are better off without price discrimination.
Exercise 8.8. (Perfect price discrimination) Zahra, a profit-maximizing entrepreneur, sells an indivisible
product of which each customer buys at most one unit. She produces the good at a constant marginal cost of $5.
Zahra’s market contains many customers, whose diverse valuations she knows.However, she is initially prohibited
by law from price discrimination. She chooses to charge $10, which results in sales to 10,000 customers. She
calculates that these customers obtain a total of $50,000 in consumer surplus. Suppose now that the prohibition
is lifted and so Zahra can engage in perfect price discrimination. Based on this limited information, what can you
say about (a) how many customers she will sell to, (b) what range of prices she will charge, and (c) by how much
her profit will go up? Be as specific as possible and explain your answers. (Note: Do not assume linear demand,
since that would not be in the “limited information” spirit of this question and since the data are not consistent
with linear demand.)
Solution: Zahra will continue to sell to her current 10,000 customers, but she will charge
each one his valuation, thereby appropriating all the customer surplus. If this were the end
of the story, her profit would increase by the $50,000 surplus that is transferred to her from
the customers.
However, Zahra will also sell to customers whose valuations are between her marginal
cost of $5 and $10, charging each one his valuation. She will obtain additional profit from
these customers. Hence, (a) Zahra will sell to more than 10,000 customers, (b) she will
charge prices ranging from $5 up, and (c) her profit will increase by more than $50,000.
Commentary It is tempting to assume that the aggregate demand curve is linear and thereby
derive exact quantities sales and profit under perfect price discrimination. However, the ques-
tion clearly states that you are to answer it “based on this limited information”, which does
not include the shape of the demand curve. Furthermore, demand cannot be linear given the
data: With constant marginal cost of $5 and a profit-maximizing linear price of $10, the choke
price if demand were linear would be $15. But then the average consumer surplus would be
$2.5, for total consumer surplus of $25,000.
Exercise 8.9. (Screening via differentiated products) The purpose of a numerical example like that of Ex-
ercises 8.1–8.4 is to obtain intuition about real-world pricing problems by working through a simple example that
you can “touch and feel”. Imagine that six months after reading this book you find yourself with a real-world pric-
ing problem that is similar—in that you consider offering multiple quality levels and there are two broad market
segments—although without the stark simplicity of our example. Write a brief (e.g., three-paragraph) summary
of the intuition you have obtained from the numerical example. You should think of this summary as a brief memo
or presentation whose purpose is to analyze the problem for your colleagues.
Solution: One possible good answer:

We face a problem of trying to extract revenue from two groups of customers that are
quite different. We have high-end customers who are willing to pay a lot for our product
and we have low-end customers who are willing to pay less for our product. If we could
identify whether a customer is high-end or low-end each time we made a sale, we could
just charge different prices for the two groups of customers. Unfortunately, although we
are aware that there are two groups of customers out there, we cannot tell which customers
are in each group and hence we must charge each customer the same price.
One option is to charge a low price that would be acceptable to most customers; this
would give us a low margin but high volume. Another option is to charge a high price that
would attract mainly our high-end customers; this would give us a high margin but lower
volume. Which of these two options is better depends on the size of the low-end and high-
end markets. For example, if the low-end market is small compared to the high-end market,
then the loss in volume when we charge the high price is relatively small and so a higher
price is better than a low price.
There is also a third option: Our market studies indicate that the low-end are not willing
to pay a high premium for product quality. The high-end customers are the opposite. Sup-
pose we sell a low-quality version of our product, priced to attract the low-end customers.
This price need not be much lower than the price that would attract the low-end customers
to the full-quality product. We could then charge a high premium for the full-quality prod-
uct and still attract most of the high-end customers to this product. As long as there are
enough low-end customers relative to high-end customers, the third option is better than
only offering the full-quality product at a high price and losing sales from the low-end cus-
tomers. As long as there are enough high-end customers relative to low-end customers, the
third option is better than only offering the full-quality product at a low price and foregoing
the higher margins from the high-end customers.
Exercise 8.10. (Bundling) You are a movie distributor with two movies to offer: an arts film called Sorrow
and Loneliness and an action film called Death Machine. You distribute to three theaters: “Supermall Megaplex”,
“Downtown Deluxe”, and “Ethereal Visions”. You know that the amounts each theater would pay for these movies
are as shown in Table E8.2.
Table E8.2
Valuation
Theater Sorrow Death
Supermall $60 $100

Downtown $90 $60
Ethereal $120 $10
(The amount a theater is willing to pay for one of these movies does not depend on whether or not it chooses
to buy the other movie.) Your marginal cost is zero and so your objective is to maximize revenue. In each of the
following problems, you cannot explicitly segment your market.
a. Suppose that you do not bundle. What is the optimal price of Sorrow and what is the optimal price of Death?
What is your total revenue?
Solution: Sorrow: Optimal price is either $60 or $90, both of which give revenue of
$180.
Death: Optimal price is $60, for revenue of $120.
Total revenue: $300.
b. Now suppose that you offer the two movies only as a bundle (pure bundling). What is the optimal price for
the bundle? What is your revenue?
Solution: Willingness-to-pay for bundle:
Theater WTP
Supermall $160
Downtown $150
Ethereal $130
Optimal bundle price is $130. which gives revenue of $390.
c. Suppose you can engage in mixed bundling. What is your optimal pricing strategy? What does each theater
buy? What is your revenue?
Solution: Offer bundle for $150 and Sorrow alone for $120. Do not sell Death by itself.
Supermall and Downtown theaters buy the bundle; Ethereal buys Sorrow.
Total revenue is $150 + $150 + $120 = $420.
Exercise 8.11. (Bundling) You are a monopolist selling two different types of concert tickets, for rock music
and world music. You have zero marginal cost and hence your objective is to maximize revenue. You face three
groups of potential customers, with an equal number of customers in each group. Table E8.3 summarizes the
valuation of each group for each concert.
Table E8.3
Valuation
Type Rock World
A 5 60
B 35 65
C 40 70
a. (Pure bundling): What is the optimal price for the bundle of both tickets? What is your profit?
Solution: The valuations for the bundle are as follows:

Valuation
Type Rock World Bundle
A 5 60 65
B 35 65 100
C 40 70 110
For simplicity, suppose that there is one customer of each type. Otherwise, revenue and
profits are as given, but multiplied by the number of customers of each type.
You might charge 65 and sell 3 tickets, for profit (revenue) of $195, or charge $100 and
sell two tickets for profit of $200, or charge $110 and sell one ticket, for profit of $110. The
best option is to charge $100.
b. (Mixed bundling) Find one mixed bundle pricing strategy that gives you higher profit than your answer for
pure bundling.
Solution: You should be able to guess by looking at the data that you might want to sell
the bundle to these two customers who have a high valuation for it (B and C), and then sell
a “World” ticket to the type A customer. Charge the highest price to A that satisfies his
participation constraint, i.e., $60. Now we need to adjust the price of the bundle to satisfy
the self-selection constraints of types B and C. The problem is that these two customers
could choose the World ticket instead of the bundle. Their surplus if buying the world
ticket is $5 and $10, respectively. We have to lower the price of the bundle so that they get
at least that much surplus by buying the bundle. Thus, we have to lower the price of the
bundle to $95. The overall revenue (profit) is then $250.
© August 2006
Chapter 9
Nonlinear Pricing
Exercise 9.1. A naïve approach to this pricing problem is to set the tariff for 2 units equal to the high types’
valuation ($75) and to set the tariff of 1 unit equal to the low types’ valuation ($35) in order to extract all the
surplus. Explain what would happen if you set prices this way.
Solution: The high-valuation customers would prefer to buy 1 unit (surplus of $10 com-
pared to surplus of $0 when buying 2 units).
Exercise 9.2. Find the optimal screening menu for the following valuations.
Table E9.1
Valuation
Type of
customer 1 unit 2 units
High $40 $80

Low $35 $50
Solution: Sell one unit (to low types) for $35. Sell two units (to high types) for $75.
Exercise 9.3. Suppose the demand curve in Exercise 5.3 is that of a single customer, and let your marginal
cost be 25. Suppose you implement perfect price discrimination with a two-part tariff. What is your usage fee?
What is the entry fee?
Solution: My usage fee is my marginal cost of 25. The customer buys 11 units. His
valuation is 462. He pays 11 × 25 = 275 in usage fees. I set the entry fee to extract the rest
of his valuation: 462 − 275 = 187.
Exercise 9.4. (Nonlinear pricing) You sell a divisible good to two customers, A and B. Their demand curves
are
dA (P) = 3 53 − 25 P , and
dB (P) = 12 − 2P .
One can show that their total valuation curves are therefore
vA (Q) = 9Q − 54 Q2 , and
vB (Q) = 6Q − 14 Q2 ,
respectively. You have a constant marginal cost of 4.

You cannot explicitly segment the market, but nonlinear pricing is possible. Find the optimal menu, using
the following hint: you can achieve efficient trade and extract all the gains from trade. Be sure to check that your
menu satisfies all constraints. Could you achieve the same outcome using a two-part tariff (i.e., the same two-part
tariff for both customers)?
Firms, Prices & Markets • Solutions for Chapter 9 (Nonlinear Pricing) 2
Solution: From the hint:
Trade is efficient ⇒ Each customer consumes the amount he would demand if I charged
my marginal cost (because then marginal valuation equals marginal cost). Hence, customer
A should get dA (4) = 2 units and customer B should get dB (4) = 4 units.
I get all the gains from trade ⇒ I must charge each customer the total valuation for the
quantity he consumes. Thus, I charge vA (2) = 13 for 2 units and vB (4) = 20 for 4 units.
The participation constraints are thus satisfied (each consumer is indifferent between his
designated quantity and not trading at all). We can check that the self-selection constraints
are satisfied, as follows.
1. Customer A’s valuation for 4 units is vA (4) = 16, which is lower than the tariff 20;
hence A prefers 2 units over 4.
2. Customer B’s valuation for 2 units is vB (2) = 11, which is lower than the tariff 13;
hence B prefers 4 units over 2.
A two-part tariff will not work. To achieve efficiency, the usage fee should be 4 (my
marginal cost). The entry fee (same for both customers) must then be set to extract each
customer’s variable surplus. However, at the usage fee of 4, the customers have different
variable surplus:
1. Customer A pays a usage fee of 8 for his two units; to extract all the gains from trade,
the entry fee for this customer should be 13 − 8 = 5.
2. Customer B pays a usage fee of 16 for this four units; to extract all the gains from trade,
the entry fee for this customer should be 20 − 16 = 4.
Thus, there is no common entry fee that extracts all the surplus.
© August 2006
Chapter 10
Competitive Supply and Market Price
Exercise 10.1. Suppose that a firm has no fixed cost and that its marginal cost equals 10 + 2Q. (Its cost curve
is c(Q) = 10Q + Q2 .)
a. Write the equation for the firm’s supply curve. Graph the supply curve with price on the vertical axis.
Solution: Because there is no fixed cost and the marginal cost is increasing, the supply
curve is the solution to P = MC. Solving P = 10 + 2Q yields Q = 12 P − 5. This holds for
P ≥ 10; if instead P < 10 then Q = 0. See Figure S1.
Figure S1
P
50
40 s(P)
30
20
10
2 4 6 8 10 12 14 16 18 Q
b. Calculate the firm’s output and profit when P = 20 and when P = 30. For P = 30, illustrate the output
decision, the cost, and the profit on the graph of the supply curve.
Solution:
Table S1
General P = 20 P = 30
Price P 20 30
Output −5
1
2
P 5 10
Revenue P×Q 100 300
Cost 10Q + Q2 75 200
Profit R−C 25 100
Firms, Prices & Markets • Solutions for Chapter 10 (Competitive Supply and Market Price) 2
These amounts are illustrated in Figure S2 for P = 30.
Figure S2
P
50
40 s(P)
30
Profit
20
10
Cost
2 4 6 8 10 12 14 16 18 Q
Exercise 10.2. Consider the firm in Exercise 10.1 (its variable cost is 10Q + Q2 and its marginal cost is
10 + 2Q), but now suppose it has a fixed cost FC = 100 that can be eliminated by shutting down. Thus, its cost
curve is c(Q) = 100 + 10Q + Q2 , the same as in Exercise 4.4.
a. If the firm does not shut down, how much does it produce?
Solution: Contingent on not shutting down, it has the same supply curve as without the
fixed cost: Q = 12 P − 5.
b. In Exercise 4.4, you calculated the quantity that minimizes the average cost and determined the minimum
average cost. Write these numbers again. For what prices should the firm shut down?
Solution: We calculated Qu = 10 and ACu = 30. The firm should shut down whenever
P < ACu .
c. Graph the average cost curve and the marginal cost curve for quantities between 0 and 20. (using e.g. Excel
or simply by hand). Draw in the supply curve.
Solution: The firm shuts down if P < 30; for prices above 30, the firm’s supply curve
is the one shown in Figure S1. Figure S3 shows the graph of this supply curve.
Figure S3
P
50
40 s(P)
30
AC
20
MC
10
2 4 6 8 10 12 14 16 18 Q
Exercise 10.3. Consider a competitive market with N identical firms. Each firm has the cost curve given in
Exercises 4.4 and 10.2:
c(Q) = 100 + 10Q + Q2 .
The demand curve is

d(P) = 1600 − 20P.
The following steps show you how to find the equilibrium price and equilibrium profit per firm as a function of
N, and then determine how many firms would enter if there were free entry.
a. In order to calculate the equilibrium price when there are N firms, we must find the aggregate supply curve.
Since the firms are identical, aggregate supply is equal to N times the supply of an individual firm. The fixed cost
affects only entry or exit decisions, which we initially take as given. Thus, the individual supply depends only on
marginal cost. In fact, you already found the individual supply curve for this marginal cost in Exercise 10.1. Take
your answer from that exercise, which we denote by si (P), and multiply it by N to get the aggregate supply curve:
s(P) = N × si (P).
Solution: The individual supply curve is si (P) = 12 P − 5. The aggregate supply curve
is thus s(P) = N2 P − 5N.
b. Solve s(P) = d(P) for P to derive the equilibrium price as a function of N.
Solution: We solve
N
P − 5N = 1600 − 20P
2
N
P + 20P = 1600 + 5N
2
NP + 40P = 3200 + 10N
3200 + 10N
P=
N + 40
c. Use a spreadsheet to complete the exercise. You should create the following columns:
1. N, which ranges from 1 to 150.
2. P, calculated from N using the formula in the part b.
3. Qi , the output per firm; this equals si (P).
4. Ri , an individual firm’s revenue; this equals PQi .
5. Ci , an individual firm’s cost including the fixed cost; this equals c(Qi ).
6. Πi , an individual firm’s profit; this equals Ri − Ci .
Scan down the last column. As long as the profit is positive, more firms would enter. If it is negative, firms would
exit. Find the point where the profit is 0 or where it switches from positive to negative. This is the equilibrium
number of firms when there is free entry. What is the price? How much does each firm produce?
Solution: Profit is zero at N = 100. The price is 30. Each firm produces 10 units. See
the following spreadsheet.
N P Qi Ri Ci i N P Qi Ri Ci i
B1 1 78.29 34.15 2,673.41 1,607.44 1,065.97 B76 76 34.14 12.07 412.01 366.35 45.66
B2 2 76.67 33.33 2,555.56 1,544.44 1,011.11 B77 77 33.93 11.97 406.02 362.84 43.18
B3 3 75.12 32.56 2,445.65 1,485.61 960.03 B78 78 33.73 11.86 400.17 359.41 40.76
B4 4 73.64 31.82 2,342.98 1,430.58 912.40 B79 79 33.53 11.76 394.46 356.06 38.41
B5 5 72.22 31.11 2,246.91 1,379.01 867.90 B80 80 33.33 11.67 388.89 352.78 36.11
B6 6 70.87 30.43 2,156.90 1,330.62 826.28 B81 81 33.14 11.57 383.44 349.57 33.87
B7 7 69.57 29.79 2,072.43 1,285.15 787.28 B82 82 32.95 11.48 378.12 346.44 31.69
B8 8 68.33 29.17 1,993.06 1,242.36 750.69 B83 83 32.76 11.38 372.93 343.37 29.55
B9 9 67.14 28.57 1,918.37 1,202.04 716.33 B84 84 32.58 11.29 367.85 340.37 27.47
B10 10 66.00 28.00 1,848.00 1,164.00 684.00 B85 85 32.40 11.20 362.88 337.44 25.44
B11 11 64.90 27.45 1,781.62 1,128.07 653.56 B86 86 32.22 11.11 358.02 334.57 23.46
B12 12 63.85 26.92 1,718.93 1,094.08 624.85 B87 87 32.05 11.02 353.28 331.76 21.52
B13 13 62.83 26.42 1,659.67 1,061.91 597.76 B88 88 31.88 10.94 348.63 329.00 19.63
B14 14 61.85 25.93 1,603.57 1,031.41 572.15 B89 89 31.71 10.85 344.09 326.31 17.78
B15 15 60.91 25.45 1,550.41 1,002.48 547.93 B90 90 31.54 10.77 339.64 323.67 15.98
B16 16 60.00 25.00 1,500.00 975.00 525.00 B91 91 31.37 10.69 335.30 321.08 14.21
B17 17 59.12 24.56 1,452.14 948.88 503.26 B92 92 31.21 10.61 331.04 318.55 12.49
B18 18 58.28 24.14 1,406.66 924.02 482.64 B93 93 31.05 10.53 326.87 316.07 10.80
B19 19 57.46 23.73 1,363.40 900.34 463.06 B94 94 30.90 10.45 322.79 313.63 9.16
B20 20 56.67 23.33 1,322.22 877.78 444.44 B95 95 30.74 10.37 318.79 311.25 7.54
B21 21 55.90 22.95 1,282.99 856.25 426.74 B96 96 30.59 10.29 314.88 308.91 5.97
B22 22 55.16 22.58 1,245.58 835.69 409.89 B97 97 30.44 10.22 311.04 306.62 4.43
B23 23 54.44 22.22 1,209.88 816.05 393.83 B98 98 30.29 10.14 307.29 304.37 2.92
B24 24 53.75 21.88 1,175.78 797.27 378.52 B99 99 30.14 10.07 303.61 302.16 1.44
B25 25 53.08 21.54 1,143.20 779.29 363.91 B100 100 30.00 10.00 300.00 300.00 -
B26 26 52.42 21.21 1,112.03 762.08 349.95 B101 101 29.86 9.93 296.46 297.88 -1.41
B27 27 51.79 20.90 1,082.20 745.58 336.62 B102 102 29.72 9.86 293.00 295.79 -2.80
B28 28 51.18 20.59 1,053.63 729.76 323.88 B103 103 29.58 9.79 289.60 293.75 -4.15
B29 29 50.58 20.29 1,026.25 714.58 311.68 B104 104 29.44 9.72 286.27 291.74 -5.48
B30 30 50.00 20.00 1,000.00 700.00 300.00 B105 105 29.31 9.66 283.00 289.77 -6.78
B31 31 49.44 19.72 974.81 685.99 288.81 B106 106 29.18 9.59 279.79 287.84 -8.05
B32 32 48.89 19.44 950.62 672.53 278.09 B107 107 29.05 9.52 276.64 285.94 -9.30
B33 33 48.36 19.18 927.38 659.58 267.80 B108 108 28.92 9.46 273.56 284.08 -10.52
B34 34 47.84 18.92 905.04 647.11 257.93 B109 109 28.79 9.40 270.53 282.24 -11.72
B35 35 47.33 18.67 883.56 635.11 248.44 B110 110 28.67 9.33 267.56 280.44 -12.89
B36 36 46.84 18.42 862.88 623.55 239.34 B111 111 28.54 9.27 264.64 278.68 -14.04
B37 37 46.36 18.18 842.98 612.40 230.58 B112 112 28.42 9.21 261.77 276.94 -15.17
B38 38 45.90 17.95 823.80 601.64 222.16 B113 113 28.30 9.15 258.96 275.23 -16.27
B39 39 45.44 17.72 805.32 591.27 214.05 B114 114 28.18 9.09 256.20 273.55 -17.36
B40 40 45.00 17.50 787.50 581.25 206.25 B115 115 28.06 9.03 253.49 271.90 -18.42
B41 41 44.57 17.28 770.31 571.57 198.73 B116 116 27.95 8.97 250.82 270.28 -19.46
B42 42 44.15 17.07 753.72 562.22 191.49 B117 117 27.83 8.92 248.20 268.69 -20.48
B43 43 43.73 16.87 737.70 553.19 184.51 B118 118 27.72 8.86 245.63 267.12 -21.49
B44 44 43.33 16.67 722.22 544.44 177.78 B119 119 27.61 8.81 243.11 265.58 -22.47
B45 45 42.94 16.47 707.27 535.99 171.28 B120 120 27.50 8.75 240.63 264.06 -23.44
B46 46 42.56 16.28 692.81 527.80 165.01 B121 121 27.39 8.70 238.19 262.57 -24.39
B47 47 42.18 16.09 678.82 519.87 158.95 B122 122 27.28 8.64 235.79 261.10 -25.32
B48 48 41.82 15.91 665.29 512.19 153.10 B123 123 27.18 8.59 233.43 259.66 -26.23
B49 49 41.46 15.73 652.19 504.75 147.44 B124 124 27.07 8.54 231.11 258.24 -27.13
B50 50 41.11 15.56 639.51 497.53 141.98 B125 125 26.97 8.48 228.83 256.84 -28.01
B51 51 40.77 15.38 627.22 490.53 136.69 B126 126 26.87 8.43 226.59 255.47 -28.87
B52 52 40.43 15.22 615.31 483.74 131.57 B127 127 26.77 8.38 224.39 254.11 -29.72
B53 53 40.11 15.05 603.77 477.15 126.62 B128 128 26.67 8.33 222.22 252.78 -30.56
B54 54 39.79 14.89 592.58 470.76 121.82 B129 129 26.57 8.28 220.09 251.47 -31.37
B55 55 39.47 14.74 581.72 464.54 117.17 B130 130 26.47 8.24 217.99 250.17 -32.18
B56 56 39.17 14.58 571.18 458.51 112.67 B131 131 26.37 8.19 215.93 248.90 -32.97
B57 57 38.87 14.43 560.95 452.64 108.31 B132 132 26.28 8.14 213.90 247.65 -33.75
B58 58 38.57 14.29 551.02 446.94 104.08 B133 133 26.18 8.09 211.90 246.41 -34.51
B59 59 38.28 14.14 541.37 441.39 99.98 B134 134 26.09 8.05 209.94 245.20 -35.26
B60 60 38.00 14.00 532.00 436.00 96.00 B135 135 26.00 8.00 208.00 244.00 -36.00
B61 61 37.72 13.86 522.89 430.75 92.14 B136 136 25.91 7.95 206.10 242.82 -36.73
B62 62 37.45 13.73 514.03 425.64 88.39 B137 137 25.82 7.91 204.22 241.66 -37.44
B63 63 37.18 13.59 505.42 420.67 84.75 B138 138 25.73 7.87 202.37 240.51 -38.14
B64 64 36.92 13.46 497.04 415.83 81.21 B139 139 25.64 7.82 200.56 239.38 -38.83
B65 65 36.67 13.33 488.89 411.11 77.78 B140 140 25.56 7.78 198.77 238.27 -39.51
B66 66 36.42 13.21 480.95 406.51 74.44 B141 141 25.47 7.73 197.00 237.18 -40.17
B67 67 36.17 13.08 473.23 402.04 71.19 B142 142 25.38 7.69 195.27 236.09 -40.83
B68 68 35.93 12.96 465.71 397.67 68.04 B143 143 25.30 7.65 193.56 235.03 -41.47
B69 69 35.69 12.84 458.38 393.41 64.97 B144 144 25.22 7.61 191.87 233.98 -42.11
B70 70 35.45 12.73 451.24 389.26 61.98 B145 145 25.14 7.57 190.21 232.94 -42.73
B71 71 35.23 12.61 444.28 385.20 59.08 B146 146 25.05 7.53 188.58 231.92 -43.35
B72 72 35.00 12.50 437.50 381.25 56.25 B147 147 24.97 7.49 186.97 230.92 -43.95
B73 73 34.78 12.39 430.89 377.39 53.50 B148 148 24.89 7.45 185.38 229.92 -44.55
B74 74 34.56 12.28 424.44 373.62 50.82 B149 149 24.81 7.41 183.81 228.94 -45.13
B75 75 34.35 12.17 418.15 369.94 48.20 B150 150 24.74 7.37 182.27 227.98 -45.71
Exercise 10.4. Consider a competitive market with free entry. Each potential firm has the cost curve given in
Exercises 4.4, 10.2, and 10.3:
c(Q) = 100 + 10Q + Q2 .
The demand curve is

d(P) = 1600 − 20P.
Use the values of Qu and ACu that you calculated for Exercise 4.4 as your starting point.
a. Find the equilibrium price.
Solution: P∗ = ACu = 30.
b. How much does each firm produce?
Solution: Q∗i = Qu = 10.
c. What is the total output?
Solution: Q∗ = d(P∗ ) = 1600 − (20 × 30) = 1000.
d. How many firms are in the market?
Solution: N ∗ = Q∗ ÷ Q∗i = 1000 ÷ 10 = 100.
Exercise 10.5. Consider a competitive industry with free entry and a U-shaped average cost curve. (You may
assume a fixed cost and increasing marginal cost.) Suppose the government imposes a per-unit tax. What happens
to the following?
a. The price of the product.
Solution: I use ˆ to differentiate values after the tax from values before the tax. Denote
the amount of the tax by Τ.
We model the tax as being paid by the firm, so the price of the product includes the tax.
The key step is to recall what we learned in Exercise 4.5. Such a per-unit tax does not
affect the efficient level of production; it raises the minimum average cost by exactly the
amount of the tax. That is: Q̂u = Qu and AC ˆ u = ACu + Τ.
Therefore, our first answer is that the price of the product goes up by Τ.
b. The output of each firm that stays in the market.
Solution: Q∗i = Qu and Q̂∗i = Q̂u . Therefore, output per firm does not change.
c. Total output.
Solution: Since the price goes up, demand goes down.
d. The number of firms in the industry.
Solution: The total output goes down, yet the output per firm remains the same. There-
fore, there must be fewer firms in the market following the tax.
Exercise 10.6. Consider a competitive industry with free entry and a U-shaped average cost curve. (You may
assume a fixed cost and increasing marginal cost.) Suppose the government imposes a yearly license fee on any
firm in the market (the same for all firms, and independent of a firm’s level of output). What happens to the
following?
a. The price of the product.
Solution: I use to denote values after the tax has been imposed; without means the
values when there is no license fee. Denote the value of the license fee by L.
The key step is to recall what we learned in Exercise 4.6. Such a license fee is an
increase in the firm’s fixed cost. The efficient scale of production rises: Q̂u > Qu . ACu also
increases, though by less than L/Qu .
Therefore, our first answer is that the price of the product goes up by less than L/Qu .
b. The output of each firm that stays in the market.
Solution: It increases from Qu to Q̂u .
c. Total output.
Solution: u ).
It decreases from d(ACu ) to d(AC
d. The number of firms in the industry.
Solution: Both total output falls and the output per firm increases. Therefore, the num-
ber off firms must fall.
Exercise 10.7. (Competitive supply) Evaluate: “In a competitive market, a firm sets its price equal to its
marginal cost.”
Solution: No. A competitive firm is a price taker. It sets its quantity (output level) where
its marginal cost equals the price.
Exercise 10.8. (Profit and diseconomies of scale) Evaluate: “A firm in a competitive market without free
entry is better off having diseconomies of scale, because only then can it earn a positive profit in equilibrium.”
Solution: It sounds better to have constant average cost rather than increasing average
cost. Yet we concluded that firms with constant average cost earn zero profit and firms with
diseconomies of scale earn positive profit.
To understand this apparent contradiction, we should remember that the market price
is determined by the market competition of all the firms. Our conclusion is not that it is
better for a firm to have diseconomies of scale, but rather that it is better for the firm to
be in an industry with diseconomies of scale. In the absence of free entry, competition
does not necessarily dissipate all profits. However, if all the firms in the market have the
same constant marginal cost, competition is fierce and drives the price down to the constant
marginal cost.
Exercise 10.9. (The need for patent protection) Suppose that each pharmaceutical company in a compet-
itive drug market knows that, with $100 million of R&D, it can develop a cure for hay fever. The medicine will
cost $20 per dosage to manufacture. However, there is no patent protection and so, once the drug is developed,
any firm can also produce it at $20 per dosage. What will happen?
Solution: Once the drug is developed, the price will be driven down by competition
to the marginal cost. Each firm will earn zero profit, not taking into account sunk R&D
expenditures. Whichever firm invested in the R&D will have made a loss.
Each firm anticipates that this will happen, and hence it does not invest in R&D.
This illustrates why patent protection is important. By providing a temporary monopoly,
it provides firms the incentive to invest in R&D.
Exercise 10.10. (Supply with U-shaped average cost) Assume that your firm operates in a perfectly com-
petitive market. Your total cost function is c(Q) = 100 + Q2 and hence your marginal cost is mc(Q) = 2Q. If the
market price is 60, then how much should you produce and what is your profit?
Solution: There is a fixed cost and increasing marginal cost. Therefore, the cost curve
is U -shaped. We need to find the optimal output ignoring the fixed cost and then determine,
taking into account the fixed cost, whether it is better to shut down.
We find the optimal output ignoring the shut-down option by solving
MC = P
2Q = 60
Q = 30
If we operate, profit is
Π = R −C
= P × Q − c(Q)
= (60 × 30) − (100 + 302 )
= 1800 − 1000 = 800
It is best to operate. The profit is 800.
Exercise 10.11. (Free entry) Consider a perfectly competitive market with free entry. (There are firms and
potential firms with access to the same technology and hence with the same cost curve.) The AC and MC curves
for the common technology are given by
50
ac(Q) = + Q,
Q
mc(Q) = 3Q .
Find the (approximate) equilibrium price and the output of each firm that is active in the market.
Solution: The equilibrium price is the minimum average cost ACu and the output per
firm is the quantity Qu that minimizes this average cost. (These values are approximate
because, depending on the demand curve, they might require there to be 17.6 firms in the
market; rounding of the number of firms would then change the actual price and quantity
per firm by a small amount.)
We find Qu by solving
MC = AC
3Q = 50/Q + Q
2Q2 = 50
Q = 5.
Then ACu = ac(Qu ) = (50/5) + 5 = 15.

Thus, the equilibrium price is 15 and each active firm produces 5.
Exercise 10.12. (Integrating different cost structures) Consider a competitive market in which the firms
are grouped into two sectors, which use different technologies. The technologies cannot be replicated, so firms in
each sector cannot adopt the technology of the other sector and entry possible. (However, there are many firms in
each sector and so each firm behaves competitively).
The two production sectors and the demand for the good have the following properties:
Production Sector A. Each firm in Sector A has the same cost curve, which has a constant marginal cost of
100.
Production Sector B. Each firm in Sector B has the same cost function, which exhibits diseconomies of scale.
The aggregate supply curve for this sector is as follows (we use M to denote “million”):
Price 50 75 100 125 150 175 200
Supply 1M 2M 3M 4M 5M 6M 7M
Demand. The demand curve for this market has these values:
Price 50 75 100 125 150 175 200
Demand 10M 9M 8M 7M 5M 4M 3M
The following questions ask you to determine the competitive equilibrium under various assumptions regard-
ing (i) whether only one of the sectors or both the sectors serve the market and (ii) the presence of taxes.
a. Suppose the market is served only by Sector A. (Sector B does not exist.) What is the equilibrium price?
How much is traded at that price? Do the firms earn a profit? Explain.
Solution: P = 100: Because in an industry in which all firms have no economies of

scale, the competitive equilibrium price equals the constant marginal cost.
Output = demand = 8M, which is the demand when P = 100.
Profit is zero: Because P = MC (competitive equilibrium) and MC = AC (no economies
of scale).
Commentary It is not enough to say that profit equals zero because P = MC.
b. Suppose the market is served only by Sector B. (Sector A does not exist.) What is the equilibrium price?
How much is traded at that price? Do the firms earn a profit?
Solution: P = 150: because this is the price at which supply equals demand.
Output = demand = 5M at this price.
There is positive profit: Firms produce at a point where marginal cost equals price.
Because the sector has diseconomies of scale, the average cost is lower than the marginal
cost. Hence, firms earn positive profit.
c. Suppose the market is served by both sectors. What is the equilibrium? How much is produced by each
sector? Do any of the firms earn a profit?
Solution: The equilibrium price must be 100: below a price of 100, Sector A would
produce nothing, Sector B would produce less then 3M, and the demand would be greater
than 8M; above a price of 100 Sector A would want to produce an infinite amount.
At the price of 100, demand is 8M and Sector B supplies 3M. The output from Sector
A is the difference of 5M.
Firms in Sector A have zero profit; same explanation as in part (a).
Firms in Sector B have positive profit; same explanation as in part (b).
d. Suppose that the market is served only by Sector A and that a $25 (per-unit) sales tax is imposed. What is
the new equilibrium price charged by the firms? How much is produced/consumed at that price? Who “bears the
burden of the tax” (i.e., who pays more than the equilibrium price without the tax)?
Solution: The price received by firms in Sector A must be 100: below 100, these firms
would produce nothing; above 100, these firms would want to produce an infinite amount.
Hence, the price paid by the customers must be 125. Demand at this price is 7M, and so
this is the amount produced by the firms.
The consumers bear the burden of the tax: the tax is 25 and they pay 25 above the no-tax
equilibrium price, whereas firms receive the same with or without the tax.
e. Suppose that the market is served only by Sector B and that a $50 (per-unit) sales tax is imposed. What is
the new equilibrium price charged by the firms? How much is produced/consumed at that price? Who bears the
burden of the tax?
Solution: We need to find a price Pf received by the firms and a price Pc paid by the
consumers whose difference equals the tax of $50, such that the firms supply at Pf equals
the consumers’ demand at Pc . This holds for Pf = 125 and Pc = 175; then supply = demand
= 4M.
The tax is born equally by the consumers and producers; the consumers pay 25 more
than without the tax, whereas the producers receive 25 less than without the tax.
f. Briefly compare your answers about the tax burden in the previous two parts and relate the difference to the
elasticities of supply.
Solution: Keeping the demand curve fixed, the more elastic is supply the more the bur-
den of the tax falls on the customers. In part (d), the supply of Sector A is perfectly elastic
and firms bear no burden of the tax. In part (e), the supply of Sector B has finite elasticity
(hence less elasticity than Sector A) and firms and consumers share the burden of the tax.
© August 2006
Chapter 5
Pricing with Market Power
Exercise 5.1. Suppose you produce minivans at a constant marginal cost of $15K and your demand curve is
d(P) = 16 − 0.6P. (Price is measured in 1000s of dollars and quantity is measured in 100,000s of minivans.) Find
your optimal price and quantity.
Solution: The choke price is 16/0.6 = 80/3; hence your optimal monopoly price is
((80/3) + 15)/2 = 125/6.
Exercise 5.2. What happens if a per-unit tax is imposed on a monopolist’s product? One answer might be:
“Since the monopolist can charge whatever it wants, it will pass the tax on to the consumer.” But this does not
say much, since any firm can charge whatever price it wants. The question is: What price does it want to charge?
Let’s see if we can provide a more informative answer.
When faced with a question like this, one strategy is to start by working out a few simple examples. This
at least illustrates some possibilities. Find out how a per-unit tax changes the price of (a) a firm with constant
marginal cost and linear demand and (b) a firm with constant marginal cost and exponential demand. You can
use the formulas we just presented. You should treat the tax like a per-unit cost borne by the firm. If the firm’s
marginal cost is MC and the tax is Τ, then the firm’s marginal cost after the tax is MC+ Τ. For the case of exponential
demand, use a particular value of B > 1 such as 2 or 3.
Solution: Let PΠ be the price before the tax and let PΤ be the price after the tax.
Linear demand: Q = A − BP. Let P̄ be the choke price. Then PΠ = (MC + P̄)/2 and
the price after the tax is
MC + Τ + P̄ MC + P̄ Τ Τ
PΤ = = + = PΠ + .
2 2 2 2
Therefore, the price goes up by exactly half the tax. The firm does not choose to pass the
entire tax on to the consumer.
Exponential demand: Q = AP−B . Then
B B B
PΠ = MC and PΤ = (MC + Τ ) = PΠ + Τ
B−1 B−1 B−1
Since B > 1, B/(B − 1) > 1. That is, the price goes up by more than the tax. For example,
if B = 3, then B/(B − 1) = 3/2. The price goes up by (3/2)Τ.
This tells us that the price may go up by either more or less than the tax—not very
conclusive, but at least we have learned that it is wrong to think that the firm will simply
raise its price by the tax. Instead, the way the tax is passed on depends on the details of the
demand.
Exercise 5.3. Suppose your firm produces a water purification system that you sell to small businesses. The
demand for this indivisible good is shown in the first two columns of Table E5.1 (money values are in €1000s).
Revenue is calculated for you in the third column. The fourth column shows your cost, and the profit is calculated
in the fifth column. Figure E5.1 is a graph of the demand curve.
Firms, Prices & Markets • Solutions for Chapter 5 (Pricing with Market Power) 2
Table E5.1
Output Price Revenue Cost Profit
0 60 0 0 0
1 57 57 25 32
2 54 108 50 58
3 51 153 75 78
4 48 192 100 92
5 45 225 125 100
6 42 252 150 102
7 39 273 175 98
8 36 288 200 88
9 33 297 225 72
10 30 300 250 50
11 27 297 275 22
12 24 288 300 −12
13 21 273 325 −52
Figure E5.1
P (€1000)
57
54
51
48 Consumer Demand
45 surplus
42
39
36
33
30 Producer surplus Deadweight
27 loss
24
21
18
15
12 Cost of production
9
6
3
1 2 3 4 5 6 7 8 9 10 11 12 13
Q
a. What would your price and quantity be if you maximized total surplus? (Choose the quantity that roughly
equates marginal valuation to marginal cost, remembering that price at a given quantity is the marginal valuation.)
How much is the total surplus?
Solution: You set the price to your constant marginal cost of 25 and supply the demand
at this price. Hence, P = 25 and Q = 11.
The total consumer valuation is the sum of the prices for each of the first 11 points on
the demand curve, starting at the highest price and lowest quantity:
57 + 54 + 51 + 48 + 45 + 42 + 39 + 36 + 33 + 30 + 27 = 462.
The total cost is 11 × 25 = 275. Hence, total surplus is 462 − 275 = 187.
b. What is the profit-maximizing price? What is your profit? How much is the consumer surplus? How much is
the deadweight loss? Illustrate the profit, consumer surplus, and deadweight loss in Figure E5.1. (Your diagram
should look similar to Figure 5.5.)
Solution:
• The maximum profit is €102, achieved by P = 42.

• The total valuation of the 6 units sold is
57 + 54 + 51 + 48 + 45 + 42 = 297.
• The total amount paid by customers for the six units is 6 × 42 = 252.
• Hence, consumer surplus is 45.
• Total surplus is 102 + 45 = 147.
• Deadweight loss is 187 − 147 = 40.
Exercise 5.4. You manage a firm and must make the following decision. There is a good that could be devel-
oped with an R&D investment of 250, after which a patent would be obtained and the good could be produced at
a constant marginal cost of 10. The potential market for this good has the following demand curve:
d(P) = 25 − (1/2)P .
The purpose of this exercise is to formulate a business plan before making the investment.
a. If you were to develop the product, what price would you charge and how much would you sell?
Solution: We have (a) linear demand with a choke price of P̄ = 50 and (b) constant
MC = 10. Thus, using the midpoint pricing rule, I would charge
P = (50 + 10)/2 = 30 .
I can then calculate Q by plugging P into the demand curve:
d(30) = 25 − (1/2)30 = 10 .
b. Calculate your “variable profit”—that is, your profit ignoring the up-front R&D cost.
Solution: My profit ignoring the fixed cost is (P − MC)Q, or
V Π = (30 − 10)10 = 200 .
c. Should you make the investment?
Solution: I check whether variable profit (200) exceeds the fixed cost (250). It does not.
I should not make the investment.
d. Suppose instead the R&D cost is only 100. How would your answers change?
Solution: My price, quantity, and variable profit if I develop the product do not change.
However, I now find that the variable profit exceeds the R&D cost. Hence, I choose to
develop the product.
e. Suppose you initially estimate the R&D cost to be 100 and that you go ahead and develop the product.
However, the R&D cost ends up being 250. How does this affect your pricing when you launch the product or
your decision of whether to actually launch the product?
Solution: This cost is now sunk and it has no effect on my pricing or decision of whether
to launch the product. I charge 30 as planned. Taking into account the sunk cost, I end up
losing 50, but abandoning the project now would be worse—I would lose the entire 250
R&D expense.
Exercise 5.5. For the demand curve in Exercise 5.4, the total valuation curve for the consumers is
v(Q) = 50Q − Q2 .
a. If the R&D expense is 250, what is your profit? What is the consumer surplus? What are the total gains from
trade?
Solution: Since I do not develop the product, I have zero revenue, zero cost, and zero
profit. Similarly, the consumers get no surplus from the good.
b. If the R&D expense is 100, what is your profit? What is the consumer surplus? What are the total gains from
trade?
Solution: My profit is the variable profit (200) minus the R&D expense (100), which
equals 100.
I produce 10 units and so the consumers’ total valuation is
v(10) = (50 × 10) − 102 = 500 − 100 = 400.
Their total expenditure is 30 × 10 = 100. Hence, their surplus is 100.

Total surplus is therefore 200.
Exercise 5.6. You are the CEO of Benevolent Dictators Ltd. There is a good that could be developed with an
R&D investment of 250, after which the good could be produced at a constant marginal cost of 10. The potential
market for this good has the following demand curve:
d(P) = 25 − (1/2)P .
This implies the following total valuation curve for the consumers:
v(Q) = 50Q − Q2 .
The purpose of this exercise is to formulate a plan before making the investment, given your objective to maximize
total surplus (whether or not you can break even doing so).
a. If you were to develop the product, how much would you produce?
Solution: I choose Q to equate MV = MC. I can find the marginal valuation curve either
by differentiating the total valuation curve or by calculating the inverse of the demand curve
(solving Q = 25 − (1/2)P for P as a function of Q). Either way, I obtain
mv(Q) = 50 − 2Q .
Then I solve mv(Q) = mc(Q), or 50 − 2Q = 10. This yields Q = 20.

Shortcut: Given that the marginal cost is constant, I can also produce the amount that
would be demanded if I charged the marginal cost. This yields d(10) = 25 − (1/2)10 = 20.
(Of course, same answer, different method.)
b. Calculate the “variable surplus”—that is, the surplus not taking into account the fixed cost.
Solution: The variable surplus is the total valuation of the 20 units minus the variable
cost of the 20 units. The total valuation is
v(20) = (50 × 20) − 202 = 1000 − 400 = 600 .
The variable cost is

MC × Q = 10 × 20 = 200 .
Therefore, variable surplus is 600 − 200 = 400.
c. Should you make the investment?
Solution: I check whether variable surplus (400) exceeds the fixed cost (250). It does—
hence, I make the investment.
d. Suppose instead the R&D cost is only 100. How would your answers change?
Solution: No changes.
Since the fixed cost does not affect the marginal conditions, its amount does not affect
how much I produce if I choose to develop the product. Since the fixed cost is lower, I still
want to develop the product.
Exercise 5.7. This problem refers back to Exercise 5.6.

a. What are the total gains from trade if the R&D expense is 250?
Solution: Total gains from trade equal total valuation minus total cost or, equivalently,
the variable surplus minus the fixed cost. Either way, the answer is 150.
b. What are the total gains from trade if the R&D expense is 100?
Solution: 400 − 100 = 300.
Exercise 5.8. Combine the results from Exercises 5.4–5.7 to fill in the following table for the demand curve
and marginal cost in those exercises.
FC Possible surplus Actual surplus Deadweight loss
250
100
What is the difference between the sources of the deadweight loss in the two cases?
Solution:
FC Possible surplus Actual surplus Deadweight loss
250 150 0 150

100 300 200 100
In the first case (FC = 250), the deadweight loss occurs because the patent system does not
provide full incentives for innovation, and hence the investment does not take place even
though it should.
In the second case, the deadweight loss occurs because the patent monopoly allows the
firm to keep the price above the marginal cost. Thus, the amount of production is less than
socially optimal.
© August 2006
Chapter 6
How Pricing Depends on the Demand Curve
Exercise 6.1. The following is a nice application of these simple conclusions. It is difficult because it requires
several steps of reasoning.
Suppose the author of a book has a contract with a book publisher, which pays him $100,000 plus 7% of the
wholesale value of all sales of his book. The publisher has a fixed production cost of $200,000 (including the
$100,000 royalty) for the book, plus an additional cost of $5 per copy for printing and distribution. Both parties
(the author and the publisher) care only about maximizing their own profit. Compare the price that the publisher
will set (the one that maximizes the publisher’s profit) with the price the author would like the publisher to set (the
one that maximizes the author’s profit). Although you do not have enough information to determine these prices,
you can say which one is higher. Explain your reasoning carefully.
Solution: Let Pr be the price that maximizes sales revenue. The authors preferred price
is Pr and the publisher’s preferred price is above Pr , as follows.
The author’s cost is fixed (and sunk). Hence, the author wants to maximize his own
revenue: $100,000 plus 7% of the sales revenue. This revenue is maximized if and only if
sales revenue is maximized, i.e., by a price of Pr .
The book publisher, on the other hand, has a strictly positive constant marginal cost.
Hence, it will set a price that is higher than the one that maximizes its own revenue. Since
its own revenue is 93% of sales revenue, the price that maximizes its own revenue is Pr .
Exercise 6.2. Evaluate: “After an advertising campaign, the cost of the advertising is sunk; hence, the adver-
tising campaign should have no effect on the firm’s pricing strategy.”
Solution: The premise is correct but the conclusion is wrong. The advertising cost is
sunk and does not affect the firm’s pricing decision, but the advertising campaign has shifted
the demand curve and this shift affects the pricing decision.
For example, you are considering a 2b advertising campaign. Once the advertising
campaign is over, its cost is a sunk cost and hence the cost should not affect your pricing
strategy. That does not mean that the campaign should not affect your pricing—the adver-
tising has shifted your demand curve. However, only due to this shift should the advertising
affect your pricing. For example, if the advertising campaign is a flop and has no effect on
demand, then your pricing should not change even though 2b are down the drain. If, af-
ter the advertising campaign, you discover cost overruns so that the total cost was actually
4b, then this discovery should not influence your pricing either.
To decide whether or not to invest the 2b in the advertising, you should look to the
future and see whether the expected shift in the demand curve will increase profit by more
than 2b. However, that does not mean that when pricing you look to the past and let your
decisions be influenced by the amount of money spent.
Firms, Prices & Markets • Solutions for Chapter 6 (How Pricing Depends on the Demand Curve) 2
Exercise 6.3. Suppose that two monopolists, F and S, sell the same product but in different markets. Firm
F sells in France and and firm S sells in Switzerland. The demand in these two countries has the following
characteristics:
1. at any given price, the quantity demanded in France is greater than the quantity demanded in Switzerland;
2. at any given price, the elasticity of demand is identical in both countries; and
3. demand becomes less elastic as one moves down the demand curve (toward lower price and higher quantity).
The two monopolists have identical cost functions with no fixed cost and increasing marginal cost.
Use this information to compare the firms’ profit-maximizing prices. At play here is the volume effect. State
the implication of the volume effect for this example. Then use marginal analysis to give a careful but succinct
explanation of why this is true.
Solution: The two demand curves are equally elastic, one has greater demand than the
other, and the common cost curve has increasing marginal cost. Therefore, the volume
effect is that the profit-maximizing price is higher for the higher-volume curve. I.e., firm F
charges a higher price.
Explanation: If the firms charge the same price, then each has the same elasticity of
demand and hence the same marginal revenue. However, since demand is higher in France
and marginal cost is increasing, firm F has higher marginal cost. Hence, the monopolists
cannot both be satisfying MC = MR. The monopolist in France will charge a higher price
than the monopolist in Switzerland, as this reduces France’s marginal cost and increases
elasticity and hence marginal revenue.
Exercise 6.4. Though elasticity is not the same as slope, slope does determine the relative elasticities of two
demand curves at a point where they intersect. In the equation
dQ P
E=− ,
dP Q
P and Q are the same for the two demand curves at their intersection point. Hence, the curve whose slope dQ/dP
is greater in magnitude has higher elasticity. Since we graph demand curves with price on the vertical axis, the
curve with higher dQ/dP in magnitude is less steep. The curve with higher slope in magnitude—less steep, given
the way we usually graph demand curves—is thus the more elastic one (at that point).
Use this information to answer the following question. You are told that one of the two demand curves in
Figure E6.1 is less elastic than the other. Which one is less elastic? How did you determine this?
Figure E6.1
€
d1
d2
Q
Firms, Prices & Markets • Solutions for Chapter 6 (How Pricing Depends on the Demand Curve) 3
Solution: d1 is more elastic than d2 , as follows.

At a point in which two demand curves intersect, the less steep one is more elastic.
In this case, d1 is more elastic than d2 at the price at which the two curves intersection.
Therefore, d2 cannot be a more elastic demand curve than d2 . (This would imply that, at
every price, d2 is more elastic than d1 , but we’ve found a counterexample.) Therefore, d1
must be more elastic than d2 .

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Firms, Prices & Markets Timothy Van Zandt

Solution: Total valuation is 57 + 54 + 51 + 48 + 45 = 255. See Figure E2.1.

Solution: Demand is 5. Total values are as follows:

See Figure E2.2.

Solution: See Figure E2.3.

Solution: See Figure E2.4.

Exercise 2.3. Suppose there are 8 buyers with valuations 2, 3, 3, 4, 5, 5, 7, and 8.

Solution: The total valuation of the “top” four buyers is 8 + 7 + 5 + 5 = 25.

Solution: Total expenditure is 4.5 × 4 = 18. Total consumer surplus is 25 − 18 = 7.

a. Compute the equilibrium price and quantity.

Solution: We find the equilibrium price by solving

Solution: See Figure E2.6.

d Τ (Ps ) = d(Ps + 15) = 50 − (1/2)(Ps + 15) = 42.5 − (1/2)Ps .

Solution: We find the price Ps received by sellers by solving

Solution: See Figure E2.7.

Q = 12 − 0.6P + 0.2Ps − 3Pg + 0.2I. (E3.1)

a. Are minivans normal goods?

b. Are minivans and station wagons substitutes or complements?

c. Are minivans and gasoline substitutes or complements?

Solution: Q = 12 − 0.6P + (0.2 × 16) − (3 × 3) + (0.2 × 25) = 11.2 − 0.6P.

b. Are exercise videos and exercise equipment complements or substitutes?

a. A decrease in the price of French wine.

Solution: Demand increases. This is a movement along the demand curve.

b. A new study linking longevity with moderate amounts of red wine.

c. An increase in the price of California wine.

d. A severe drought in the wine-growing regions of France.

Solution: The formula for arc elasticity is

Solution: Unhappy (assuming that happiness is measured by profits). Revenues have

($690/pound) × (8 tons) × (2000 pounds/ton) = $11.04 M

1908 850 5,986

Solution: (i) From 1910 to 1911, arc elasticity is

(ii) From 1915 to 1916, arc elasticity is

1. workers and machines who print the newspaper;

1. Initial development of software: $10 million.

Exercise 4.4. Consider the following cost function:

c(Q) = 100 + 10Q + Q2 .

b. At what output level Qu is average cost lowest?

c. What is the minimum average cost ACu ?

Solution: ACu = ac(Qu ) = 100/10 + 10 + 10 = 30.

Solution: I use on values after the increase in marginal cost.

Solution: I use on values after the increase in the fixed cost.

Exercise 4.8. Consider the following cost function:

b. At what output level Qu is average cost lowest?

c. What is the minimum average cost ACu ?

Solution: ACu = ac(Qu ) = 144/12 + 3 + 12 = 27.

Solution: There are two reasons:

b. What is your total profit as a function of B and L?

b. The binding parts of the participation and self-selection constraints are:

Identify these constraints by name.

c. Calculate your optimal prices.

d. Calculate the profit (given the optimal prices) as a function of B and L.

Solution: (B × 600) + (L × 200).

A. sell only unrestricted tickets at a high price to business travelers only;

Solution: Option C is best:

Solution: Option A is best:

Solution: Option B is best:

Solution: For each price P (equal to one of the valuations), we calculate:

1. demand Q = the number of customers whose reservation values are at least P;

Price of 22 yields highest profit of $48, with sales equal to 6.