Department of Economics University of Pacific

Spring Semester 2010

ECONOMICS 53 Problem Set 4

Due before lecture on March 4 Part 1: Multiple Choice (30 Questions, 1.5 Points Each)
1. Total cost is calculated as A) the sum of total fixed cost and total variable cost. B) the product of average total cost and price. C) the sum of all the firms explicit costs. D) the sum of average fixed cost and average variable cost. 2. The Farley Farm, a dairy company, has total costs of $15,000 and total variable costs of $2,000. The Farley Farms total fixed costs are A) $0. B) $13,000. C) $17,000. D) indeterminate because the firms output level is not known. 3. Both Kate and John own saltwater taffy factories. Kates factory has low fixed costs and high variable costs. Johns factory has high fixed costs and low variable costs. Currently, each factory is producing 1,000 boxes of taffy at the same total cost. Complete the following statement with the correct answer. If each produces A) less, their costs will be equal. B) more, their costs will be equal. C) more, the costs of Kates factory will exceed those of Johns factory. D) less, the costs of Kates factory will exceed those of Johns factory. 4. Which statement is NOT true regarding the total variable cost curve? A) increases as output increases. B) shows the variable cost of production given current factor prices. C) starts at the origin. D) is a horizontal line. 5. Marginal cost is ________ average variable cost when ________. A) equal to; average total cost is minimized B) less than; total cost is maximized C) greater than; average fixed cost is minimized D) equal to; average variable cost is minimized

6. Marginal cost is ________ average variable cost when ________. A) equal to; average total cost is minimized B) less than; total cost is maximized C) greater than; average fixed cost is minimized D) equal to; average variable cost is minimized (Disregard this questionIts repeated) 7. In the short run, as output increases, A) the difference between average total cost and average variable cost decreases. B) the difference between total cost and average variable cost decreases. C) marginal cost eventually decreases. D) All of the above are correct. 8. The main decision for a profit maximizing perfectly competitive firm is not what ________ but what ________. A) level of output to produce; price to charge B) price to charge; level of output to produce C) level of output to produce; total revenue to achieve D) price to charge; total cost to achieve 9. If the market price is $25 in a perfectly competitive market, the marginal revenue from selling the fifth unit is A) $25. B) $5. C) $125. D) Unable to determine. More information needed. 10. The marginal revenue curve for a perfectly competitive firm is A) downward sloping. B) upward sloping. C) horizontal. D) vertical. 11. Joes Butcher Shop is producing where MR = MC, Joes Butcher Shop must be A) earning a zero economic profit. B) incurring a loss. C) maximizing profits. D) maximizing revenue but not maximizing profits. 12. Wheat is produced in a perfectly competitive market. Market demand for wheat increases. This will cause the individual wheat farmers marginal revenue to ________ and their profit maximizing level of output to ________. A) increase; increase B) increase; decrease C) decrease; increase D) decrease; decrease

In this industry the market equilibrium price is P = $15. 13. Refer to Figure 9.1. For this farmer to maximize profits he should produce ________ bushels of wheat. A) 6 B)9 C) 12 D) 16 14. Refer to Figure 9.1. If this farmer is maximizing profits, his total costs will be D) $132. A) $11 B) $66. C) $90. 15. Refer to Figure 9.1. If this farmer is maximizing his profits, his TVC is

A) $24.

B) $42.

C) $108.

D) $255.

16. Refer to Figure 9.1. This farmers fixed costs are A) $0. B) $24. C) $45. D) indeterminate unless we know the level of output the firm is producing. 17. Refer to Figure 9.1. If this farmer is maximizing profits, his total revenue will be A) $90. B) $135. C) $180. D) $240. 18. Refer to Figure 9.1. If this farmer is maximizing profits, his profit will be C) $48. D) $72. A) -$24. B) $45. 19. Refer to Figure 9.1. This farmer would earn a zero economic profit if price was A) $7. B) $9. C) $10. D) $11. 20. Refer to Figure 9.1. This farmers shutdown point is at a price of C) $7. D) $10. A) $0. B) $4.

21. If TR > TC, a firm would ________ in the short run and ________ in the long run. A) operate; expand B) operate; contract C) shut down; expand D) shut down; contract 22. A market is competitive if I. firms have the flexibility to price their own product. II. each firm sells slightly different products III. each firm is small compared to the entire industry. A) I and II only B) I and III only C) III only D) All of the above are correct. 23. Firms that are breaking even are A) earning zero economic profits. B) earning less than a normal rate of return. C) shutting down in the short run. D) All of the above are correct. 24. The owner of Tie-Dyed T-shirts, a perfectly competitive firm, has hired you to give him some economic advice. He has told you that the market price for his shirts is $20 and that he is currently producing 200 shirts at an AVC of $15 and an ATC of $25. You tell him he should continue to operate in the short run because A) he is earning positive economic profits of $4,000. B) his loss from operating is only $2,000 which is less than his loss if he shuts down. C) he has to pay his fixed costs of $2,000 if he shuts down which is greater than his loss when he operates. D) In fact you do not tell him to operate -- he should shut down since he has a loss.

25. Refer to Figure 9.3. In the short run this firm should ________ and in the long run this firm should ________, if economic conditions do not change. A) shut down; exit the industry B) exit the industry; shut down C) continue to produce where MC = MR; expand D) continue to produce where MC = MR; shut down 26. Engineers for the Off Road Skateboard Company have determined that a 10% increase in all inputs will cause output to increase by 5%. Assuming that input prices remain constant, you correctly deduce that such a change will cause ________ as output increases. A) total cost to decrease B) average total costs to increase C) average total costs to decrease D) average fixed costs to increase 27. For economies of scale, a(n) ________ in a firms scale of production leads to ________ average total cost. A) increase; lower B) increase; higher C) decrease; lower D) decrease; no change in 28. On the upward sloping portion of a firms long run average cost curve, it is experiencing A) economies of scale B) constant returns to scale C) diseconomies of scale D) diminishing marginal returns 29. In the long run firms will expand as long as there are more ________ and new firms will enter the industry as long as they earn ________. A) economies of scale; zero profits B) economies of scale; positive economic profits C) diseconomies of scale; zero profits D) diseconomies of scale; positive economic profits 30. Assume the market for beef is perfectly competitive. Beef producers are currently earning a zero economic profit. If consumers switch to beef from chicken, which of the following is most likely to occur? A) Beef producers will now incur economic profits in both the short run and the long run. B) Beef producers will incur economic profits in the short run. Some producers will enter the industry until all firms in the industry are earning a zero economic profit. C) Beef producers will incur economic profits in the short run. Some producers will enter the industry as long as all firms in the industry are earning an economic profit. D) Beef producers will now earn economic losses in the short run and there will be no additional adjustments in the long run.

Part II: Short Answers Question 1: Total Costs and Profit Maximization
You run a firm that produces T-shirts that are sold in a perfectly competitive market. Your firm faces the following cost and revenue schedule: Quantity of TShirts 0 1 2 3 4 5 6 Total Costs (TC) 5 12 22 33 45 60 78 Total Fixed Costs (TFC) 5 5 5 5 5 5 5 Total Variable Costs (TVC) 0 7 17 28 40 55 73 Average Fixed Costs (AFC) N/A 5 2.50 1.67 1.25 1 0.83 Average Variable Costs (AVC) N/A 7 8.5 9.33 10 11 12.17 Average Total Costs (ATC) N/A 12 11 11 11.25 12 13 Marginal Cost (MC) N/A 7 10 11 12 15 18 Total Revenue (TR) 0 12 24 36 48 60 72 Profit

-5 0 2 3 3 0 -5

(a) Assume that the price of t-shirts is $12. Complete the table above.

(b) Sketch the following curves: AFC, ATC, MC. (You may use EXCEL or another software program to draw the graphs or you can do it by hand.)

AFC
6 5 4 AFC 3 2 1 0 0 1 2 3 4 5 6 7 AFC

Quantity

ATC
13.5 13 12.5 12 11.5 11 10.5 0 1 2 3 4 5 6 7 ATC

Quantity

MC
20 18 16 14 12 10 8 6 4 2 0 0 1 2 3 4 5 6 7

MC

(c) What is the optimal level of production for your t-shit firm? Optimal production is where MR=MC Since P = $12 therefore MR = $12 Looking at the table we see that MR = MC = 12 at Q = 4. Thus the optimal production is 4 t-shirts.

Question2: Total Costs using Algebra

Noah runs a garden bench production plant. The total production costs are captured by the following production cost functions: TC = Q2 + 100Q + 500 (total cost function) MC = 2Q + 100 (marginal cost function) Where Q = number of benches produced If Noah produces 100 benches. Calculate the following (a) Total Variable Costs (TVC) The variable cost is the component of the cost function that depends on output TVC = Q2 100Q thus TVC = 1002 + 100(100) = 20,000 (b) Total Fixed Costs (TFC) Total fixed costs are costs that doesnt depend on the level of output. We can see that if Q = 0, total costs are 500, thus total fixed costs are 500. (c) Total Costs (TC) Total costs are TVC + TFC = 20,000 + 500 = 20,500 (d) Average Variable Costs (AVC) AVC = TVC/Q = 20,000/100 = 200 (e) Average Fixed Costs (AFC) AFC = TFC/Q = 500/100 = 5 (f) Average Total Costs (ATC) ATC = TC/Q =20,500 /100 = 205 (g) Marginal Cost (MC) MC = 2(100) + 100 = 300 Suppose the industry for garden benches is perfectly competitive and the market equilibrium price is $200 (i) If Noah produces 100 benches, is he producing the optimal profit maximizing level of benches? Explain your answer. Calculate the profit for Noah at Q = 100. No. We see that at 100 benches MR =$200 while MC = $300. In this case since MR is not equal to MC Noah is not producing at the optimal profit maximizing level. At Q = 100, TR = $200 x 100 = $20,000. As we saw in Part (c) TC = $20,500 therefore profit is equal to -$500 (j) Calculate the profit maximizing level of output for Noahs bench factory. What is the profit at this level of production? MR=MC is where the firm will produce. MC = 2Q + 100=MR=200 2Q+100 = 200 Q =50 At Q = 50 TR = P x Q = 200 x 50 = 10,000 TC = 502 + 100(50) = 7500 Profit = 10000-7500 = 2,500

(j) Noah would shut down his business if benches fall below what price? Shut down rule is P = AVC The equation for AVC is Q + 100. We get this from dividing the TVC function by Q. But we know that at shutdown Q = 0. Therefore P = 100. If the price of benches fall below 100, Noah would shut down his business. Question 3 Investors put up $520,000 to construct a building and purchase all equipment for a new Thai restaurant called Thai Me Up. The investors expect to earn a minimum return of 10% on their investment. The restaurant is open 52 weeks per year and serves 900 meals per week. The fixed costs are spread over the 52 weeks. Included in the fixed costs is the 10% return to the investors (the interest paid to the investors are paid out in equal weekly installments) and $1000 per week in other fixed costs. Variable costs include $1000 in weekly wages and $600 per week for materials, electricity, etc. The restaurant charges $5 on average per meal. (a) Calculate total fixed costs per week for the restaurant Fixed costs include the return to the investors: 10% x $520,000 = $52,000 per year. Paid in weekly installments = $1000 per week paid to investors. Additional fixed costs amounts to $1000 per week. Total fixed costs = $2000. (b) Calculate total variable costs per week for the restaurant Variable costs include the $1000 in weekly wages and the $600 per week for materials, electricity, etc. Thus total variable costs = $1600 (c) Calculate total costs per week for the restaurant Total costs = Total Fixed costs per week + Total Variable costs per week = $3600 (d) Calculate total revenue per week for the restaurant P = $5 average, Q = 900 meals per week. TR = P x Q = $5 x 900 = $4500 (e) Calculate the economic profit per week for the restaurant Profit = TR TC = $4500 - $3600 = $900 (f) If Thai Me Up were to shut down, what would the economic profit be? Profit = -TFC = -$2000

Question #4: Perfect Compettition: Graphcial Analysis Figure 1: Wheat Market

For the following questions refer to the figure above. Assume that the wheat industry is perfectly competitive. (a) What are the three conditions needed for the wheat industry to be perfectly competitive? 1. Many, small firms which cannot influence the market price 2. Firms sell homogeneous (similar) products 3. Easy entry and exit from industry (b) If the demand for wheat is at D2 what is the profit-maximizing level of output for a representative firm? At that level of output what is the total revenue, total cost and economic profit? At D2, the market equilbrium price would be at $7 which would also be the MR. Recall for the representative firm the MR curve is also the demand curve it faces. A perfectly competitive firm will produce where MR = MC. In the right hand panel that would be where Q = 13. Total revenue will be TR= P x Q = $7 x 13 = $91 Total cost will be TC = ATC x Q. But notice that at Q = 13, ATC equals $7. Thus TC will also equal $91. Economic Profit = $91 - $91 = $0 (c) If the demand for wheat increases to D3 what is the profit-maximizing level of output for a representative firm? Calculate the amount of economic loss or profit. (In your answer assume that the ATC is the same as the ATC you found in Part b) Would you expect entry or exit of firms from the industry in the long-run? Explain. At D3, the market equilbrium price would be at $9 which would also be the MR. A perfectly competitive firm will produce where MR = MC. In the right hand panel that would be where Q = 15. At that price the firm is clearly earning an economic profit. TR = $9 x 15 = $135 while TC = ATC x Q = $7 x 15 = $105. Thus the firm is earning an economic profit of $30. The presence of economic profits will encourage firms to enter the industry in the long-run.

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(d) If the demand for wheat increases to D1 what is the profit-maximizing level of output for a representative firm? If the demand curve shifts to the left to D1 the equilibrium price will be at P = $5. It is clear from the diagram that at that point where MR=MC, P < AVC. Thus the shut down rule says the firm will stop production immediately. The profit-maximizing level of output is 0.

Question #5 From Short-Run to Long-Run Draw a supply and demand diagram showing equilibrium at a price of $10. Next to it draw a graph of a perfectly competitive firm that is incurring a short-run loss at this price, but is still producing. Use the diagram to show the long-term adjustment of the industry and the firm if demand remains constant. Explain the adjustment mechanism. The adjustment will be that firms will leave the industry, which will cause the market supply curve will shift to the left. The price will gradually rise until MR=MC=P=ATC

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