Eco 411 Problem Set 1

July 30, 2019

Due in class on August 13, 2019 or before. Late problem sets will not be accepted, unless prior permission is
given.

Instructions
• Please submit the problem set in groups of 2-3 students.

• Please make sure to write the names of the members of the group on top of the problem set and staple the
pages in the problem set together.

• You can discuss with your classmates (but must mention the names of people outside of the group you
discussed it with), you are also free to use online resources but proper citation is required. Also remember
that plagiarism is not permitted. In case you do not cite properly, it will result in a score of zero for the
problem set portion of the final grade.

Question 1
A firm uses two inputs, called 1 and 2 to produce an output. Let xi denote the number of units of input i used in
the production process. The production function is given by

1/2
f (x1 , x2 ) = x1 [min{x2 , 9}]1/2

The unit prices of these inputs are given by w1 and w2 respectively. Derive the firm’s cost function.

Question 2
Bhavna’s inverse demand function for tea is given by

p = 288/(q + 1)2 .

Bhavna is currently consuming 11 units of tea at a price of 2 per unit.

1. How much money would Bhavna be willing to pay to have this amount rather than no tea at all?

2. Suppose that the price of tea rises from 2 to 18. What is Bhavna’s change in consumer surplus?

Question 3
A monopoly supplier of tea has constant production costs of 1 a unit. It is currently charging 2 a unit to its
customers. At this price the elasticity of demand is 0.5. Is the current selling price of 2 a unit profit maximizing?

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Question 4
HC, a monopoly supplier of tea, sells to a market 10 Km away from the tea plant. The demand as a function of
delivered price (p) in paise in that market is Demand = 100 − p. Variable manufacturing costs are 20 paise a unit
and transportation costs are 1 paise per unit per Km. HC is not obliged to serve all markets.

1. Suppose HC adopts a uniform delivery price (UDP). That is HC pays the transportation costs. What UDP
price will maximize HC’s profit?

2. Suppose HC adopts a Freight On Board Price (FOB). That is customers pay the transportation costs. What
FOB price (per unit) should HC quote to maximize its profit?

Question 5
SF has a patent on a product that is used as a key input in producing industrial and home cleaner. Currently, SF
produces the product and sells it to companies who manufacture the final products for the home and industrial
users. SF faces the following demand curves in each segment:

• (Industry) D = 80 − p

• (Home) D = 20 − p

where D is demand and p is price per unit. SF can produce the product at a constant 5 a unit.

1. Determine the profit maximizing price SF should charge in the industrial market.

2. Determine the profit maximizing price SF should charge in the home market.

3. If SF is forced to charge the same price in both markets, what price should it charge to maximize profit?

Question 6
Suppose TwoPlus creates a Premium version of smartphone, but could disable some of the features in order to
create a Normal version of smartphone. Both versions have zero marginal cost.
Suppose that TwoPlus has two groups of customers each interested in buying at most one version. 30 intense users
are willing to pay up to 20 for the Premium version and 0 for the Normal version. 70 casual users are willing to
pay up to 7 for the Premium version and 5 for the Normal version. Each consumer will choose the product that
gives her the highest (consumer) surplus.

1. If TwoPlus offers only the Premium version of the product, what price should it charge in order to maximize
revenue?

2. If TwoPlus offers both versions of the phone, what prices should it set to maximize revenue.

3. Now suppose that instead of valuing the Normal version at 0, the intense users value the Normal Version
at 12. Keep all the other willingness to pay same as before. What prices should TwoPlus set to maximize
revenue? What is the total change in TwoPlus’ revenue compared to part 2?

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Question 7
A monopolist has a high quality software program of quality qH = 1 which it can produce at 0 cost. They can also
produce any quality qL ≤ 1 at 0 cost, but it is not possible for them to create a quality higher than 1. There are
two types of consumers in the market, those with high valuations and those with low valuations. The fraction of
consumers with high valuations is α < 1/2. Those with high valuations receive utility 4q − q 2 less the price they
paid if they buy software of quality q. Those with low valuations receive utility 2q − q 2 less the price paid from
buying software of quality q. The monopolist offers a contract for the high valuation consumers, quality qH = 1 at
price pH , and a contract for the low valuation consumers, quality qL at price pL .

1. Suppose the firm can observe each consumer’s valuation and can first degree price discriminate. Determine
qL , pL , and pH the firm would set to maximize profits.

2. Suppose now that the firm cannot observe the valuation of each consumer. Write down the Lagrangian
associated with the firm’s problem when they can only second-degree price discriminate.

3. Solve for the optimal qL , pL , and pH the monopolist would set.

4. How do qL and pH vary with α? What is the intuition for this?

Question 8
Assume that demand for services per period is Pt = 1000 − Qt where Qt is the stock of the durable consumed. Let
the discount factor for consumers and the firm be given by δ < 1. Find the profit-maximizing prices and outputs
for a durable goods monopolist with zero marginal costs when there are two periods for the following:

1. A monopolist who leases.

2. A monopolist who sells its output, but is able to commit to prices.

3. A monopolist sells who its output, but is not able to commit to prices.

Question 9
Hydra is the sole provider of electricity in a remote island in the Bay of Bengal. The company is considering how
much to invest in electricity generation capacity (measured in Kilowatt/hour). There are no operating costs (c = 0).
However, the capacity cost is r = 4 per Kilowatt/hour generation capacity.
The day and night inverse demand functions for electricity are pD = 12 − 0.5qD and pN = 24 − 2qN , respec-
tively. Compute Hydra’s profit-maximizing investment level in capacity K, the daytime price of electricity pD , and
nighttime price, pN .

Question 10
MS produces two products, X and Y. Both products are produced at 0 marginal cost. MS faces four customers
whose reservation price (i.e. maximum willingness to pay) for the products are shown below:

• Customer A: RP for X=30, RP for Y=90

• Customer B: RP for X=40, RP for Y=60

• Customer C: RP for X=60, RP for Y=40

• Customer D: RP for X=90, RP for Y=30

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Consider the 3 alternative pricing strategies: (a) selling each product separately, (b) pure bundling and (c) mixed
bundling. For each strategy determine the profit maximizing price to be charged and resulting profit. Which
strategy yields highest profit?

Question 11
DMC is the monopoly supplier of tea into a market that consists of heavy and light users. Half the market are
heavy users and the other half are light users. The demand curves (as a function of unit price) for a member of
each segment are shown below:

• (Heavy) DH (p) = 100 − p

• (Light) DL (p) = 10 − p

DMC can produce each unit of tea for 5 a unit.

1. Determine the profit maximizing two-part tariff DMC should charge to the heavy users.

2. Determine the profit maximizing two-part tariff DMC should charge to the hight users.

3. If DMC is forced to use the same two-part tariff for both segments, what should it be set at to maximize
profit?