Review Theory of the Firm Answers:

 

1.   Define Marginal Cost.

Ø      MC = DTC / DQ

Ø      Marginal cost is the cost of producing one more unit of output.

2.   Define Fixed Cost.

Ø      FC = TC – VC

Ø      Fixed cost is the cost of fixed input resources.

3.   Define Economic Profit.

Ø      Economic Profit = TR – TC (explicit costs + implicit costs)

 

                    Price             Quantity        Total Cost

                                               0                     12

                      28                     1                     22

                      24                     2                     32

                      20                     3                     42

                      16                     4                     52

                      12                     5                     62

                       8                      6                     72

 

Base your answers to the following questions on the previous table.

 

4.   What is the marginal cost of the 5th unit?

Ø      MC = 10

5.   What is the average fixed cost at 4 units?

Ø      AFC = $12 / 4 = $3

6.   What is total variable cost at 3 units?          

Ø      TVC = $42 - $12 = $30

7.   What is the marginal revenue of the 6th unit? What does that indicate about elasticity of demand?

Ø      MR = -$12

Ø      MR < 0 :  Inelastic Demand

8.   What output will the firm produce? Explain why.                                                              

Ø      MR = MC :  3 Units.

9.   What is the profit/loss situation at the best operating output?

Ø      Economic Profit = $18

10. What is the law of diminishing marginal returns?

Ø      As you add additional variable inputs to a fixed input, at some point you’ll reap smaller returns on that input.

11. Why does it occur?

Ø      Because there aren’t enough things for the variable inputs to do and therefore they become less productive.

 

                   # of Workers             Total Product

                             0                                  0

                             1                                  6

                             2                                 14

                             3                                 24

                             4                                 30

                             5                                 34

                             6                                 32

 

Use the information in the previous table to answer the next three questions (12-14).

 

12. After which worker does diminishing marginal returns set in? ____________________

Ø      3rd worker

13. What is the marginal product of the 2nd worker _______ of the 6th worker _______?

Ø      MP of the 2nd worker = 8

Ø      MP of the 6th worker = -2

14. What condition exists when the 6th worker is employed?

Ø      Negative Returns

15. What is the relationship between marginal cost and marginal product?

Ø      They are inverse images of each other.

16. Describe one force that can cause economies of scale.

Ø      Specialization of labor, management, or capital.

17. How are economies of scale different than increasing marginal returns?

Ø      Economies of scale are a long-run phenomenon.

 


 


18. What kind of firm does the previous graph represent? How do you know?

Ø      A perfectly competitive firm.  We know this because MR = D, and it is perfectly elastic (“price-takers”)

19. Given the information in the previous graph:

a)      Highlight the firm's best operating output and price.

Ø      P1, Q1 (Where MR =MC)

b)      Is the firm earning a profit, breaking even or losing money? (How can you tell?)

Ø      The firm is losing money since AR < ATC.

c)      What should the firm do in the short run?

Ø      The firm should keep operating since AR > AVC.

20. If firms in a perfectly competitive market face short run economic profits, what will happen to market output and market price in the long run? Explain why.

Ø      Firms will enter the industry causing the industry supply curve to shift to the right.  This, in turn, causes the market price to decrease and output to increase. 

21. Which of the following conditions will not be found in a perfectly competitive market?

      a.   Individual firms are price takers.

      b.   Everyone involved in the market is fully informed about prices, quantity and other market conditions.

      c.   There are many firms in the market.

      d.   Any firm may enter or exit the market in the long run.

      e.   While the products sold by firms are similar, there is some degree of product differentiation.

Ø      The answer is “e” since all products are homogeneous in a perfectly competitive market.

22. Is this firm producing the productively efficient level of output?

Ø      No, because P is NOT equal to minimum ATC.

23. Which of the following would cause the price of peanut butter to fall while the quantity purchased increased?

a.       The price of peanuts (used to make peanut butter) decreases 

b.      The price of peanuts (used to make peanut butter) increases

c.       The price of jelly (a complementary good) increases

d.      The price of jelly (a complementary good) decreases

e.       Consumer incomes increase

Ø      The answer is “a” since the supply curve would shift to the right.

24.  A pure monopolist’s demand curve…

      a.   is perfectly inelastic

      b.   is highly elastic

      c.   coincides with its marginal revenue curve

      d.   lies below its marginal revenue curve

      e.   lies above its marginal revenue curve

Ø      A monopolist is a price maker and therefore his or her demand curve will be downward sloping.  It will be greater than its marginal revenue curve if we assume that the monopolist is not price discriminating.

25. What would happen to the price and quantity of pens sold in the KO Bookstore if a Staples Office Supply Store opened at the corner of Kingswood Road and Outlook Avenue?

Ø      Price and quantity of K-O pens sold at the K-O Bookstore would fall because demand would decrease (shift to the left).
 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


Refer to the diagram above as you answer the following questions.

 

26. Highlight the firm's profit maximizing price and output.

Ø      Price = $A

Ø      Output = E

27. What rectangle represents the firm's total revenue? _______________

Ø      OAJE

28. What rectangle represents the firm's total cost? _______________

Ø      OBHE

29. What rectangle represents the firm's profit/loss? ________________

Ø      ABHJ

30. Is this firm operating at the socially optimum output? Why or why not.

Ø      No, because P > MC.

31. How would an increase in variable costs affect this firm's price and output?

Ø      It would cause price to increase and output to decrease because the marginal cost curve would shift up.

32. Which of the following is not a precondition for price discrimination?

      a.   The product involved must be a durable good.

      b.   The good or service cannot be resold by original buyers.

      c.   The seller must be able to segment the market, that is, to distinguish buyers with different elasticities of demand.

      d.   The seller must possess some degree of monopoly power.

 

33. If an industry has many sellers that offer differentiated products, and entry into the

      industry is easy, then it is best classified as ___________________

Ø      Monopolistic Competition.

34. Describe two barriers to entry.

Ø      Economies of scale.

Ø      Legal Barriers … patents, licenses, etc.

35. Which of the following statements is not true of oligopoly markets?

      a.   Firms seek to avoid price competition.

      b.   Significant economies of scale often exist in such industries.

      c.   Firms act independently and are not worried about the actions of their competitors.

      d.   Firms often compete through the use of advertising campaigns.

      e.   Some oligopoly markets use the price leader/ price follower model to determine price.


36. What kind of firm does the previous diagram depict? How can you tell?

Ø      Monopolistic competition since the demand curve is highly elastic.

37. How would the firm determine its best operating output?

MR = MC.

38. How is the firm doing in terms of profitability?

Ø      The firm is making an economic profit since P > ATC.

39. What time period does the diagram depict?

Ø      The diagram depicts the short-run since economic profits are being made.

40. Is the firm economically efficient? Why or why not?

Ø      No, because P > MC and P > minimum ATC.

41. Highlight the consumers' surplus.          

Ø      Consumer surplus is the area under the demand curve above the market price.

42. What is a natural monopoly?

Ø      An industry in which economies of scale are so great that a single firm can produce the product at a lower ATC than would be possible if more than one firm produced the product.

43. Draw a diagram of an unregulated natural monopoly that shows its profit maximizing price and output.

 

44. What is an example of a natural monopoly?

Ø      Natural Gas, Electricity, Wireless Communications, Long-Distance Phone Service, etc.

45. With reference to your graph, state where the government would set price and quantity in order to achieve a fair return.

Ø      P = ATC

46. With reference to your graph, state where the government would set price and quantity in order to achieve the socially optimum output.

Ø      P = MC