0 $50 $0 $5 $-5 $50 $35 1 $50 $50 $40 $10 $50 $15 2 $50 $100 $55 $45 $50 $35 3 $50 $150 $90 $60 $50 $55 4 $50 $200 $145 $55 $65

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1 I. From Seminar Slides: 1. Output Price Total Marginal Total Marginal Profit Revenue Revenue Cost Cost 0 $50 $0 $5 $-5 1 $50 $50 $40 $10 $50 $15 2 $50 $100 $55 $45 3 $50 $150 $90 $60 $50 $55 4 $50 $200 $145 $55 $65 a) The short-run profit maximizing quantity is 3 and the corresponding profit is $60. b) Optimal quantity is 3 and the profit is $55. The lesson is that increasing fixed costs does not alter the optimal quantity but only reduces profits. Output Price Total Marginal Total Marginal Profit Revenue Revenue Cost Cost 0 $50 $0 $10 $-10 1 $50 $50 $45 $5 $50 $15 2 $50 $100 $60 $40 3 $50 $150 $95 $55 $50 $55 4 $50 $200 $150 $50 $65 c) Now the optimal quantity is 2 and profit is $5. Change in the variable cost affects the optimal output. Output Price Total Marginal Total Marginal Profit Revenue Revenue Cost Cost 0 $50 $0 $5 $-5 $50 $55 1 $50 $50 $60 $-10 2 $50 $100 $95 $5 $50 $55 3 $50 $150 $150 $0 $50 $75 4 $50 $200 $225 $-25 $85 1

2 1. Use a graph to demonstrate the circumstances that would prevail in a perfectly competitive market where firms are experiencing economic losses. Identify costs, revenue, and the economic losses on your graph. Using your graph, determine whether an individual firm will shut down in the short run, or choose to remain in the market. Explain your answer. The losses and revenues are identified on the individual firm's graph. Total cost is equal to the sum of the losses and revenue (because profit/loss=tr-tc, so TC=TR+profit/loss). The decision about whether this firm shuts down or remains in the market depends upon the position of average variable cost. If average variable cost is below P0 at output level Q0, the firm will remain in the market. If average variable cost is above P0 at output level Q0 the firm will shut down in the short run. 2. Suppose the book-printing industry is competitive and begins in a long-run equilibrium. a. Draw a diagram describing the typical firm in the industry. Answer: Figure below shows the curves of a typical firm in the industry, with average total cost ATC 1, marginal cost MC 1, and marginal revenue equal to price P1. The long-run-supply curve is the marginal cost curve above the minimum point of ATC 1. b. Hi-Tech Printing Company invents a new process that sharply reduces the cost of printing books. What happens to Hi-Tech s profits and the price of books in the short r un when Hi-Tech s patent prevents other firms from using the new technology? Answer: The new process reduces Hi-Tech s marginal cost to MC 2 and its average total cost to ATC 2, but the price remains at P 1 because other firms cannot use the new process. Thus Hi-Tech produces Q 2 units and earns positive profits. 2

3 c. What happens in the long run when the patent expires and other firms are free to use the technology? Answer: When the patent expires and other firms are free to use the technology, all firms average-total-cost curves decline to ATC 2, so the market price falls to P 3 and firms earn zero profit. 3. Explain why in the long run firms earn 0 profits. 4. Explain why P=MC for a firm in the competitive industry. 5. Explain why the long-run supply curve of a competitive industry is horizontal. Carefully describe all necessary assumption. 6. Give two reasons why the long-run industry supply curve may slope upward. Use an example to demonstrate your reasons. Answer: 1) Some resource used in production may be available only in limited quantities. Example: As more people become farmers, the price of land is bid up since its supply is limited. As the price of farm land is bid up, the costs to all farmers in the market rise. 2) Firms may have different cost structures. The example used to support the second reason is the market for painters. Anyone can enter the market for painting services, but not everyone has the same costs because some painters work faster than others. II. 1. If a firm's total cost rises as output rises, then a. marginal cost is positive b. profit cannot be maximized c. total cost is minimized d. marginal cost equals marginal revenue 3

4 e. the firm should shut down in the short run 2. The change in total profit when a firm increases its output by one unit equals a. total revenue minus total cost b. total revenue minus marginal revenue c. marginal revenue minus marginal cost d. total revenue minus marginal cost e. marginal revenue plus marginal cost Answer: c 3. If a firm is able to cover its variable costs by operating in the short run then, at its best output level, the a. marginal revenue is equal to marginal cost b. vertical distance between MR and MC is maximized c. vertical distance between TR and TC is minimized d. marginal cost curve lies above the marginal revenue curve e. marginal cost curve is minimized 4. In the short run, if a firm's total variable cost is higher than its total revenue at all possible output levels, the firm's minimum short-run loss a. equals its total fixed cost b. equals zero c. occurs at the maximum point of the total revenue curve d. occurs at the maximum point of its marginal revenue curve e. occurs at the minimum point of its marginal cost curve 5. Which of the following statements is correct? a. For all firms, marginal revenue equals the price of the good. b. Only for competitive firms does average revenue equal the price of the good. c. Marginal revenue can be calculated as total revenue divided by the quantity sold. d. Only for competitive firms does average revenue equal marginal revenue. 4

5 Answer: d 6. A profit-maximizing firm in a competitive market is currently producing 200 units of output. It has average revenue of $9 and average total cost of $7. It follows that the firm's a. average total cost curve intersects the marginal cost curve at an output level of less than 200 units. b. average variable cost curve intersects the marginal cost curve at an output level of less than 200 units. c. profit is $400. d. All of the above are correct. Answer: d. 7. A firm's total cost of production a. always increases as it produces more output b. can increase or decrease as it produces more output c. increases at a decreasing rate as long as it produces more output d. is fixed in the short run, because inputs are fixed in the short run e. can be minimized by producing where the firm's demand curve crosses the horizontal axis 8. What is true only at the output level where price equals average total cost? a. Marginal cost equals marginal revenue. b. Profit is maximized. c. Losses are minimized. d. Profit is zero. e. Cost is minimized. Answer: d 9. Marginal revenue is a. the change in total revenue divided by total output b. total revenue divided by total output c. total revenue minus total cost then divided by total output d. the change in total revenue divided by the change in price of output 5

6 e. the change in total revenue divided by the change in total output Answer: e 10. If a firm chooses to produce output at the point where MR equals MC, a. then TR - TC will be maximized if there is a profit b. economic profits will be zero c. there will be positive accounting profits d. there will be positive economic profits e. average cost must equal average revenue 11. Consider the marginal revenue and marginal cost curves shown in the figure above. Assume that the firm represented is able to cover its variable costs if it operates in the short run. What is the firm's optimal output level? a. 150 units b. 80 units c. 50 units d. less than 50 units e. between 50 and 80 units Answer: b 6

7 12. In the long run, if a firm's total cost exceeds its total revenue at all output levels, it should a. always exit the industry b. always continue operating c. increase the amount of its fixed inputs d. increase the proportion of its total cost that is fixed e. maximize the difference between its marginal revenue and its marginal cost 13. If a firm shuts down in the short run, then a. total revenue and total cost drop to zero b. total revenue drops to zero, but the firm must still pay its fixed cost c. total revenue drops to zero, but the firm must still pay some variable cost d. total cost drops to zero, but the firm still earns some residual revenues e. neither total revenue nor total cost drops to zero Answer: b 14. If a firm's short-run total cost curve lies above its total revenue curve at all output levels, the firm should a. always shut down in the short run b. always operate in the short run c. operate in the short run if the maximum operating loss is less than its total fixed cost d. operate in the short run if the minimum operating loss is less than its total fixed cost e. operate in the short run if the average operating loss is less than its total fixed cost Answer: d III. 1. At its best possible output level, a firm has total revenue of $3,500 per day and total cost of $7,000 per day. Should this firm shut down in the short run if: a. the firm has total fixed costs of $3,000 per day? Answer: If the firm s fixed costs are $3,000 per day, then its variable costs are $7,000 - $3,000 = $4,000 per day. Since its total revenue is less than this amount, this firm should shut down in the short run. 7

8 b. the firm has total variable costs of $3,000 per day? Answer: Since the firm is earning enough total revenue to cover these variable costs, it should continue to operate in the short run. 2. Quantity Produced COSTS Total Cost Marginal Cost Quantity Demanded REVENUES Total Price Revenue Marginal Revenue 0 $ $120 $ $150 $50 1 $120 $240 $120 2 $202 $52 2 $120 $360 $120 3 $257 $55 3 $120 $480 $120 4 $317 $60 4 $120 $600 $120 5 $385 $70 5 $120 $720 $120 6 $465 $80 6 $120 $840 $120 7 $562 $97 7 $120 $960 $120 8 $682 $120 8 $120 $1080 $120 a) Assuming that the firm operates in a perfectly competitive industry, fill out the table above. b) What level of output maximizes the profit? What is the corresponding profit? Answer: 8; $278. 8