1) A monopolist firm faces a demand with constant elasticity of –2.0.–2.0. It ha

Question

1) A monopolist firm faces a demand with constant elasticity of –2.0.–2.0. It has a constant marginal cost of $20 per unit and sets a price to maximize profit. If marginal cost should increase by 25 percent, would the price charged also rise by 25 percent?

2) Suppose a profit-maximizing monopolist is producing 800 units of output and is charging a price of $40 per unit.

a) If the elasticity of demand for the product is 2,2, find the marginal cost of the last unit produced.

b) What is the firm’s percentage markup of price over marginal cost?

c) Suppose that the average cost of the last unit produced is $15 and the firm’s fixed cost is $2000. Find the firm’s profit.

Explanation / Answer

1.

E=-2

MC = $20

Then, as per the Lerner Index formula,

(P-MC)/P = 1/|E|

P-20 = P/2

2P-P = 40

P = 40

If MC increases by 25%

Then, New MC = 20*1.25 = $25

P-25 = P/2

2P-P = 50

New Price = $50

Here, new price of $50 is 25% more than the old price of $40. Hence, there will be 25% increase in price also.

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