Question

Suppose a perfectly competitive firm has marginal and total costs given by M C = 3 + 2q and T C = 2 + 3q + q2, respectively, where q is the quantity of output produced by the firm. In a monetary union the firm faces a constant price p1 = 9 for its product. Outside of the monetary union with a flexible exchange rate it faces a 50-50 chance of p2 = 11 or p3 = 7. The firm decides on the profit maximizing quantity q by setting p = MC which maximizes its profit π = (p ∗ q) − TC.

(a) What are the firm’s profit maximizing quantity, price and profit in a monetary union? (b) What is the average profit with a flexible exchange rate?

(c) Does more exchange rate certainty in a monetary union lead to higher profits for the firm?

Answer 1