Question

IMPORTANT: I know the answer is "B". Could you please help explain to me the reasoning behind why that is? Thank you

One implication of the fact that profit functions are convex in prices is that firms will always prefer

a. stable input and output prices.

b. input and output prices that fluctuate about a given level.

c. stable input prices and fluctuating output prices.

d. fluctuating input prices and stable output prices.

Answer 1

The profit function is convex in product prices while the cost function is convex in input prices. This means that when output price increases by one unit then profit increase by one or more than one. Similarly when input price increases by one unit then cost increases by one or more than one unit. Therefore, if the input and output prices are related, as it is always, then when input price rises the output price rises as well. Therefore but profit tends to rise given the input prices remaining unchanged and the cost rises due to rise in input prices. Therefore, when both input and output prices rise then profit can falls or rise. However for some range of prices of input and output then profit rises as price rises for input and output. Hence the firm like the input and output price to fluctuate about a given level.