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CAT 1 AND 2
1.) You are a leading consultant with a firm producing milk within Laikipia County. One of your
main roles is to advice the firm on price strategies that would lead to maximize profits. The firm
is a monopolist which sells in two distinct markets, one of which is completely sealed off from
the other.
In line of your assignment, you establish that the total demand for the firms output is given by
the following equation:
Q = 50 – 0.5P
The demand for the firms output in the two markets is:
Q1 = 32 – 0.4P1
Q2 = 18 – 0.1 P2
P= Price
The total cost of production is given by C= 50 + 40Q, where C= total cost of producing a unit of
milk.
Required:
a) The total output that the firm must produce in order to maximize profits ( 3 marks)
0.5P = 50 – Q
P = 100 – 2Q
TR = P.Q = (100 – 2Q) Q
TR = 100Q – 2Q2
MR = dTR/ dQ = 100 – 4Q
BUT MR = MC
Thus 100 – 4Q = 40
Q = 15 (this is the total output that the firm must produce in order to maximize profits)
b) What price must be charged in each market in order to maximize profits ( 2 marks)
IN THE MARKET 1
MR1 = dTR/ dQ
TR1 = P1.Q1
Q1 = 32– 0.4P1
0.4P1 = 32 – Q1
P1 = 80 – 2.5Q1
TR1 = P.Q1 = (80 – 2.5Q1) Q1
TR1 = 80Q1 – 2.5Q12
MR1 = dTR1/ dQ1 = 80 – 5Q1
Thus 80 – 5Q1= 40
Q 1= 8
P1 = 80 – 2.5*8
P1 = 60 (price in market one)
IN THE MARKET 2
MR2 = dTR2/ dQ2
TR2 = P2.Q2
Q2 = 18– 0.1P2
0.1P2 = 18 – Q2
P2 = 180 – 10Q2
TR2 = P2.Q2= (180 – 10Q2) Q2
TR2= 180Q2 – 10Q22
MR2 = dTR2/ dQ2= 180 – 20Q2
Q 2= 7
P2 = 180 – 10*7
P2 = 110 (price in market two)
c) How much profit would the firm earn if it sold the output as a single price, and if the firm
discriminates
Profit = TR – TC
In the entire market Profit the firm would if it sold the output as a single price
TR = 100Q – 2Q2
Where Q = 15
Thus TR = 100*15 – 2*152 = 1050
TC = 50 + 40Q = 50 + 40*15 = 650
BUT Profit = TR – TC = 1050 – 650 = 400 profit the firm would earn if it sold the output
as a single price
Profit the firm would if the firm price discriminates
Profit = (TR1+ TR2 )– TC
(4 marks)
d) i.) The price elasticity of demand for the two markets at the equilibrium price and
quantity. (4 marks)
Assumption: Starting price is the individual market price while the equilibrium price is
the entire market price which is the final price.
Market 1 PED = ((15 – 8)/ (70 - 60))* 60/8 = 5.25 Thus Elastic as PED greater than 1
Market 2 PED = ((15 – 7)/ (70 - 110))* 110/7 = 3.14 Thus Elastic as PED greater than 1
ii.) Give a comment on how the price elasticity of demand may be used in making economic
decisions (3 marks)
Determination of price
The primary objective of any firm is to earn profit or increase revenue. Therefore, increasing
price of its products to maximize profit is one of the primary concerns of producers.
However, during the course of increasing price, the producers must not forget that demand and
price share inverse relationship. They must be aware that demand falls with rise in price. And
thus, they must increase price of their commodity to that level where their desired or optimal
If the product is inelastic (less or no effect on demand with change in price), the producer can
earn profit by setting high price. However, if the product is elastic (highly affected by even
slightest change in price), the producer must set low or at least reasonable price so that the
The situation where single group or company charges different prices for the same commodity at
different market is known as discriminating monopoly.
Joint products are various products generated by a single production procedure at a single time.
Sheep and wool, cotton and cotton seeds, wheat and hay, etc. are some examples of joint
products. We cannot separate the cost of producing wheat and hay, as producing wheat will
However, since they are two different products, we cannot sell them at the same price in the
market. Price elasticity of demand plays important role in determining the prices of these joint
products.
In the first place it is said that price discrimination is possible when the nature of the commodity
or service is such that there is no possibility of transference from one market to the other.
That is, the goods sold in the cheaper market cannot be resold in the dearer market; otherwise the
Price discrimination is possible when the two markets or markets are separated by large
distance or tariff barriers, so that it is not possible to transfer goods from a cheaper market to
dearer markets.
Price discrimination is possible when the consumers are ignorant about price discrimination, they
are not aware that in one part of the market prices are lower than in the other part.
4. Government Regulation:
Price discrimination occurs when the government rules and regulations permit. For instance,
according to rules, electricity rates are fixed at higher level for industrial purposes and lower for
domestic uses
5. Geographical Discrimination:
Price discrimination may be possible on account of geographical situations. The monopolist may
discriminate between home and foreign buyers by selling at lower price in the foreign market
A commodity may have different elasticity of demand in different markets. Thus, the market
A monopolist may create artificial differences by presenting the same commodity under different
names and labels, one for the rich and snobbish buyers and the other for the ordinary customers.
Factors of production is an economic term that describes the inputs that are used in the
production of goods or services in order to make an economic profit. The factors of production
out of one production process into another. Factor mobility may involve the movement of
factors between firms within an industry, as when one steel plant closes but sells its
production equipment to another steel firm. Mobility may involve the movement of
when a farm worker migrates to another country or when a factory is moved abroad.
The mobility of labour depends on the extent to which Labour is educated and trained. Higher or
more a person is educated and skilled. The greater are his chances of moving from one
occupations or place to another. Geographical and vertical mobility is very much dependent on
The inner urge of the workers to rise in life determines the mobility. If workers are optimist and
broad minded, they will move to other jobs and places. Differences in language, habits, religion
caste etc. will not be hindrances in their mobility.
The mobility of labour also depends upon the social set-up. A society dominated by caste system
and joint family system lacks in mobility of labour. But where the joint family and caste systems
do not exist or have disintegrated family, the mobility of labour increases.
In a developed agricultural area or where there is agricultural development labour moves from
high population to low population areas during busy seasons.
c.) What is the significance of the laws of diminishing marginal returns and
the laws of returns to scale in the management and economic policy
decision-making process?
( 6 marks)
3) Several theories relating to wages, interest and profits are propounded on the basis of the Law
of Diminishing Returns. The theory of distribution of national income is also based on this law.
4) The Law of Diminishing Returns is highly useful for understanding the problems of
developing countries. Because agriculture is the main occupation and primary sector in these
5) The theory of pricing of factors of production is also based on the Law of Diminishing
Returns.
7) The Law of Diminishing Returns is also the basis for explaining the behaviors of cost of
production.
1. Microeconomics: Principles, Problems, & Policies by Campbell C, Stanley Brue, and
Sean Flynn
4. Principles of Microeconomics 12th Edition by: Karl E. Case, Ray C. Fair and Sharon
E. Oster