Economics 160
Study Questions
PRODUCTION AND COSTS
1. What is meant by the “short run”? What is a fixed input?
2. a. Fill in the table below.
Labor (L) Total Product (Q) Marginal Product (MP)
0 0 .
1 20 .
2 45 .
3 75 .
4 100 .
5 120 .
6 135 .
7 145 .
b. What is the law of diminishing marginal returns? According to the above table, does diminishing returns set in right away? Why might the marginal product initially rise?
c. Draw a graph of the total product curve (production function) and the marginal product curve.
3. a. Fill in the table below. Assume that P = $0.50.
Labor (L) Q MP P*MP
0 0 ------.
1 100 .
2 190 .
3 270 .
4 340 .
5 400 .
6 450 .
7 490 .
If the price for a unit of labor (wage rate) is $25 per labor unit, then how many workers would a profit-maximizing firm hire? Suppose the government passes a minimum wage law (price floor) that requires that firms pay a wage rate of at least $35 per unit of labor.
How workers would a profit-maximizing firm hire now?
4. Define: long run, fixed costs, variable costs.
5a. What is marginal cost? ..average total cost?...average fixed cost?... average variable cost?
5b. Fill in the table below.
Q TFC TVC TC AFC AVC ATC MC .
0 0 ------.
1 $10 .
2 $30 $45 .
3 $40 .
4 $140 .
5 $50 .
6. On a graph, draw in the AVC, ATC, and MC curves. What are the relationships between these three curves?
7. Which of the following regions violates the relationship between marginals and averages?
Marginal variable,
Average variable marginal variable
1 2 3 4 5
Average variable
8. True or False. Explain.
a. “If marginal cost is below average total cost then average total cost must be falling”.
b. “If the marginal product of labor is falling, then total product must be falling.”
c. “In the long run, all costs are variable costs.”
9. Country A has marginal product of labor of 10 and wage rate of $20/L. Country B has
a marginal product of labor of 2 and a wage rate of $5/L. Which country has the lower marginal cost?
10. What is meant by “economies of scale”? …by “diseconomies of scale”?
11. The following table shows long-run total cost for different quantities.
Does this firm experience economics of scale, diseconomies of scale , or constant returns to scale?
Q LRTC .
0 0 .
1 $20 .
2 $36 .
3 $48 .
4 $56 .
ANSWERS
1. Short run: a period of time over which at least one input is fixed. A fixed input is an input whose quantity cannot be varied (over some non-trivial period of time).
2. a.
Labor (L) Total Product (Q) Marginal Product (MP)
0 0 ---- .
1 20 20 .
2 45 25 .
3 75 30 .
4 100 25 .
5 120 20 .
6 135 15 .
7 145 10 .
2b. Diminishing marginal returns: As a firm adds equal amounts of one input, holding other inputs and technology constant, then beyond some point output may rise but at slower and slower rate.
No, it does not set in right away—initially MP rises, but past 3 units of labor is starts to fall.
MP might initially rise due to gains from division of labor or specialization.
3. Assume that P = $0.50.
Labor (L) Q MP P*MP
0 0 ------.
1 100 100 $50 .
2 190 90 $45 .
3 270 80 $40 .
4 340 70 $35 .
5 400 60 $30 .
6 450 50 $25 .
7 490 40 $20 .
P*MP = price of labor = $25 at a quantity of labor of 6. So the firm hires 6 workers.
At a wage rate of $35, the firm hires 4 workers.
4. Long run: All inputs are variable. Fixed costs: costs which do not vary as output varies. Variable costs: costs which do vary as output varies.
5. a. Marginal cost (MC) = (change in TC)/(change in Q).
Average total cost = TC/Q Average Fixed cost = FC/Q
Average variable cost = VC/Q.
5b.
Q TFC TVC TC AFC AVC ATC MC .
0 $60 0 $60 ------.
1 $60 $10 $70 $60 $10 $70 $10 .
2 $60 $30 $90 $30 $15 $45 $20 .
3 $60 $70 $130 $20 $23.33 $43.33 $40 .
4 $60 $140 $200 $15 $35 $50 $70 .
5 $60 $250 $310 $12 $50 $62 $110 .
6.
$/unit MC ATC
AVC
QAVCmin QATCmin Q
a. ATC and AVC converge as Q increases. To see this, notice that ATC=AVC+AFC, or rearranged AFC = ATC-AVC. In other words, AFC represents the vertical gap between
the ATC curve and AVC curve. Since AFC always falls as Q rises, then the gap between
ATC and AVC always gets smaller as Q increases—that is, these curves converge.
b. The minimum point of the ATC curve occurs at a larger quantity than the minimum point of the AVC (see above graph). To understand this, notice that in between
the quantities QAVCmin and QATCmin MC is above AVC (and so AVC must be rising). If AVC is rising then we are already past its minimum point. Yet MC is below ATC (and so ATC must be falling) and if ATC is still falling it has not yet reached its minimum point. c. If MC > ATC, then ATC must be rising.
If MC> AVC, then AVC must be rising.
If MC<ATC, then ATC must be falling.
If MC<AVC, then AVC must be falling.
If MC=ATC, then ATC must be at its minimum point.
If MC=AVC, then AVC must be at its minimum point.
7. Region 4. Notice that m<a in this region yet there is section of avg. that is rising. This cannot happen.
8. a. True.
b. False. MP may be falling but if it is still ABOVE AP, then AP has to be rising.
c. True. By definition, all input are variable in the long run and therefore all costs are variable.
9. Country A : MC = Wage/MP = $20/10 = $2. Country B: MC= $5/2= $2.50. So Country has the lower MC.
10. Economies of Scale: If a firm doubles ALL inputs, then output more than doubles.
This implies a declining long-run AC curve.
Diseconomies of scale: If a firm doubles ALL inputs, then output less than doubles.
This implies a rising long-run AC curve.
11. Economies of scale since LRAC falls as Q rises.
Q LRTC LRAC .
0 0 ---- .
1 $20 $20 .
2 $36 $18 .
3 $48 $16 .
4 $56 $14 .
Economics 160
Study Questions
PRICE TAKERS, COMPETITIVE INDUSTRIES
1. What is a price taker? What does this imply about the demand curve faced by a price-taking firm? What is marginal revenue? What is the relationship between P and MR for a price taker? What does the MR curve look like for a price taker?
2. Find profit-maximizing output from the table below. Assume that P= $50. Fill in table.
Q TR TC MR MC Profit .
0 $100 ------.
1 $110 .
2 $130 .
3 $160 .
4 $200 .
5 $250 .
6 $310 .
7 $380 .
8 $460 .
9 $550 .
10 $650 .
3. If MR>MC at Q1, then a firm can increase its profit by increasing production beyond
Q1. Explain in words why this is true. Show these two curves on a graph.
If MR<MC at Q1, then a firm can increase its profit by decreasing production below
Q1. Explain and show on a graph.
4. On a graph draw in the following curves: MR, MC, ATC, and AVC. On this graph, show profit-maximizing output and total profit.
5. True or false: If P>ATC, then a firm can increase its profit by increasing production. Use a graph and a written explanation to justify your answer.
6. See the graph below. What is profit-maximizing quantity? What is profit? If profit is negative, should the firm shut down in the short run? Justify your answer by comparing profit when the firm shuts down versus profit when the firm continues to operate.
P= $10.
It is up to you to label the curves.
$/unit
$16.3
$13
$12
$10
$8
$6
30 40 50 60 65 Q
7. What is the short-run equilibrium condition? ..long-run equilibrium condition for a competitive industry?
8. Assume the following for firm Z:
a. Labor costs (for hired labor) = $200,000/year.
b. Raw material costs = $100,000/year.
c. Total revenue= $400,000/year.
The owner of firm Z could be earning an annual salary of $50,000 elsewhere. The factory building used by this firm has a sale value of $2 million. The going rate interest is 10%.
Calculate economic profit and accounting profit. Your answer should make clear the difference between explicit costs and implicit costs.
9. Using graphs of the firm and the market, show and explain the effects of a decrease in market demand. Discuss both the short-run and long-run effects.
ANSWERS
1. Price taker: a firm (or individual) that is so small relative to the market that it cannot significantly influence the price of the good it sells. For example, a single orange producer will not be able to significantly influence the price of oranges.
It implies that the price taker faces a perfectly elastic demand curve.
MR = ΔTR/ΔQ. In words, MR is the additional revenue a firm receives from selling one more unit of output. P=MR for a price taker (see numerical example given in class).
The MR revenue curve is horizontal at P (again, see example given in class).
2. Assume that P= $80. Profit –maximizing output occurs at the quantity where MR=MC. In this case, that is at Q = 8 units.
Q TR TC MR MC Profit .
0 0 $100 ------100 .
1 80 $110 80 10 -30 .
2 160 $130 80 20 30 .
3 240 $160 80 30 80 .
4 320 $200 80 40 120 .
5 400 $250 80 50 150 .
6 480 $310 80 60 170 .
7 560 $380 80 70 180 .
8 640 $460 80 80 180 .
9 720 $550 80 90 170 .
10 800 $650 80 100 150 .
3. If MR>MC then a firm can add more to its revenue than to its costs by producing another unit. Since revenue would rise by more than costs, profit must increase.
If MR<MC then a firm can reduce its costs by more than its revenue by producing one less unit. Since costs would fall more than revenue, profit must increase.
MC MC
MC2
P MR P MR
MC1
Q1 Q Q2 Q
In the first graph, MR>MC at Q1. In the second graph, MR<MC at Q2.
4.
$/unit MC ATC
P MR=D
AVC
Q* Q
5. True or false: If P>ATC, then a firm can increase its profit by increasing production. This statement in false. This can be seen from the graph in question (4). Notice at the quantity where MR=MC that P>ATC. Yet, this is best the firm can do. Profits are maximized at MR=MC, if the firm was to produce more or less than this quantity profit would fall.
6. Profit-maximizing Q = 50 units (where MR=MC).
Profit at this quantity = (P-ATC)(Q) = (10-13)(50) = -150.
If the firm shuts down its profits (losses) equal FC.
To find FC notice that, AFC= ATC-AVC. At Q=50, AFC= 13-8= $5.
FC = AFC*Q= (5)(50) = $250. Therefore, losses if shut down equal $250.
It is better to continue to operate since losses are smaller (150 vs. 250).
7. SR equilibrium condition: P=MC for each firm.
LR equilibrium condition: P=MC=ATC. (That P=ATC indicates that economic profits are zero).
8. Economic Profit= TR – total explicit costs-total implicit costs.
TR = $400,000/year. Total explicit costs = $200,000+$100,000= $300,000.
Total implicit costs = $50,000 (the forgone salary) + $200,000 (forgone interest income).
Economic profit = 400,000-300,000-250,000= -$150,000.
Accounting profit=400,000-300,000= +$100,000.
9.
$/unit FIRM P MARKET
SRSM(n-m firms)
SRSM(n firms)
MC=SRSf
ATC
ATCSR LRS
P1 MR1 P1
PSR MRSR PSR
D1
D2
qsr q1 q QLR QSR Q1 Q
Assume market demand declines.
SR effects: The decrease in demand causes price to fall to PSR. This leads profit-maximizing firms to reduce output to qsr. At this new quantity, PSR < ATCSR and so firms are incurring losses in the short run.
LR effects: The existence of losses causes some firms to exit the industry. As this happens, the supply curve shifts to left. This causes price to be bid up. This process continues until P again equals ATC (which occurs at the original price). At this point, profit is again zero, so exit stops and as exit stops the supply curve stops shifting back.