Chapter 11 - Problems
Note that I am not giving solutions, but hints.
FACTS AND TOOLS
1. Should a firm increase production in the short run? Decrease it? or continue producing the same amount?
A. If marginal cost is less than price, increase output. MC will rise -- but more importantly, so will profit.
B. If marginal cost is greater than price, decrease output. You are losing money if you cannot cover
marginal cost, and if reducing output to 1 unit still leaves MC greater than price, shut down.
C. If marginal cost is equal to price, you would lose by any change.
2. Think about what higher wages did to the supply curve. What it does to the supply curve, it will do to the
marginal cost curve, since the supply curve is just the result of all the MC curves.
If wages rise, the supply curve shifts _____ (left/right), and as a result the equilibrium quantity becomes ___
(greater, lesser) than before.
You must also think about what it will do for price, remembering that we are talking about market price and the
production decisions of just ONE competitive firm. What impact will one farmer growing one more or one less
bushel of wheat have on the market price of a bushel of wheat?
If more is produced will more or fewer workers be hired? What if less is produced?
3. Short-run and long-run impacts of a shift in demand can differ, depending on whether the long-run supply is
that of a constant-cost (or constant returns to scale) industry, as in this problem, or an increasing-cost
(diminishing returns to scale) industry, or a decreasing-cost (increasing returns to scale) industry.
Consider the similar problem with an increasing demand for the output of a constant-cost industry.
The equations for initial demand and short-run supply were (illustration on next page)
Demand :
P = 500 - 2 Q
Short-run Supply : P = 3 Q
Confirm that P* = 300 and Q* = 100
New demand: P = 600 - 2 Q
Equilibrium with new demand and short run supply: P = 360, Q = 120
Long-run supply: P = 300 (constant-cost industry: AC, and therefore price, remains 300)
In the long run, firms enter or expand their operations (building new factories) and new
equilibrium will be found by substituting the long-run price of 300 into the new demand:
300 = 600 - 2 Q*
Q* = 150
Note that:
a. Marginal cost of production will be highest in the short run, after demand increases, before
firms have had time to enter the industry or build new factories.
Marginal cost of production will be the lowest in both the new and old equilibrium
b. Firms will not be offering sales at all in the short run.
c. Price will be greater than average cost in the short run, after demand increases.
This is the reason for expanding output or entering the industry.
d. Profits will be positive in the short run, after demand increases. In both the initial and long run
equilibrium, there will be zero economic profit (or “normal” accounting profit”)
e. Since we are assuming perfect competition, all firms are and remain relatively small. This
means that it is more likely that firms enter and exit rather than simply expand or contract.
-- Point 1 represents:
A. Initial equilibrium in the short run
B. Initial equilibrium in the short and long run
C. Short-run equilbrium after demand increases
D. Long-run equilibrium after demand increases
E. Both long and short run equilibrium after demand increases.
-- Point 2 represents: [same options]
-- Point 3 represents: [same options]
-- The solid red line is:
A. Short-run demand B. Long run demand C. Short-run marginal cost
D. Long-run marginal cost
E. Long-run average cost
-- The dashed red line is: [same options as last question]
-- The dashed green line is: [same options as last question]
The short run equilibrium condition is of course Qs = Qd or Ps = Pd
The possible locations of long run equilibrium are determined by:(note that the actual location must be
determined by two curves; choose the best answer for all possible locations of the other curves)
A. The solid red line
B. The solid green line
C. The dashed green line
D. The dashed red line.
Explain how we know that this is a constant cost industry.
(No, the title of the graph is NOT a sufficient answer.)
-- Point 1 represents:
A. Initial equilibrium in the short run B. Initial equilibrium in the short and long run
C. Short-run equilbrium after demand increases D. Long-run equilibrium after demand increases
E. Both long and short run equilibrium after demand increases.
-- Point 2 represents: [same options]
-- Point 3 represents: [same options]
-- The solid red line is:
A. Short-run demand B. Long run demand C. Short-run marginal cost
D. Long-run marginal cost
E. Long-run average cost F. Short-run and long-run demand
-- The dashed red line is: [same options as last question]
-- The dashed green line is: [same options as last question]
The short run equilibrium condition is of course Qs = Qd or Ps = Pd
The possible locations of long run equilibrium are determined by:(note that the actual location must be
determined by two curves; choose the best answer for all possible locations of the other curves)
A. The solid red line
B. The solid green line
C. The dashed green line D. The dashed red line.
Explain how we know that this is an increasing cost industry.
The long run supply curve has the equation 200 + Q; the new demand curve is 800 - 2Q.
The initial demand and supply equations remain the same as in the last problem.
-- Point 1 represents:
A. Initial equilibrium in the short run B. Initial equilibrium in the short and long run
C. Short-run equilbrium after demand increases D. Long-run equilibrium after demand increases
E. Both long and short run equilibrium after demand increases.
-- Point 2 represents: [same options]
-- Point 3 represents: [same options]
-- The solid red line is:
A. Short-run demand B. Long run demand C. Short-run marginal cost
D. Long-run marginal cost
E. Long-run average cost F. Short-run average cost
-- The dashed red line is: [same options as last question]
-- The dashed green line is: [same options as last question]
The short run equilibrium condition is of course Qs = Qd or Ps = Pd
The possible locations of long run equilibrium are determined by:(note that the actual location must be
determined by two curves; choose the best answer for all possible locations of the other curves)
A. The solid red line
B. The solid green line
C. The dashed green line
D. The dashed red line.
Explain how we know that this is a decreasing cost industry.
Note that the equations have changed from the previous problem:
SR Demand = 1200 - 5 Q
SR Supply =
5Q
LR Demand = 1400 - 5 Q
LR Supply = 720 - Q
For each of the industries on the last three pages, be sure you can say:
-- when the marginal cost of production will be lowest
A. In the long run after demand increases
B. In the short run before demand increases
C. In the short run after demand increases
-- when profits will be highest.
Same options as before
-- when economic profits will be zero.
-- when losses will be made.
-- will the long run involve firms entering or leaving the industry?
Note that under perfect competition, we assume all the firms are “small”,
so there is not much room for individual firms to expand a great deal.
Question 4. Since carpet manufacturing is a decreasing cost industry, look back at the appropriate graph to
conclude what a fall in demand would do to long run price.
Question 5. Since made to order items such as classic car parts are more expensive than parts for models
currently produced in large quantities, the appropriate graph to look at would be that for
A. increasing cost industries.
B. decreasing cost industries
C. constant cost industries.
The long run price of classic car parts would be likely to ---- if the demand for those parts increased.
A. Increase
B. Decrease
C. Stay the same.
Question 6. Which graph captures the situation descibed in this problem?
Use the graph to conclude whether your friend is:
A. right in the short run, but wrong in the long run.
B. wrong in the short run, but right in the long run.
C. right in the short run, and right in the long run.
D. wrong in both the short and long run.
Question 7. Both HDTV and flash memory have been decreasing cost industries.
Use the graphs to answer the specific questions here.
The most interesting question is if a massive increase in demand would have any effect on
price in the long run.
Question 8. My standard example of a competitive industry has been the small farm. Does the average
stockholder face the same situtation of being unable to raise or lower the price of his stock?
THINKING AND PROBLEM SOLVING
Question 1. A parallel question would deal with Sam's Shirts, with production costs rising with output:
Assume that price is $ 40, and marginal cost = 10 * thousands of shirts produced.
Fill in the following table:
Shirts
1000
2000
3000
4000
5000
Marg. cost
10
20
Marg. Revenue
Variable Cost
10,000
Change in profit per shirt
40
How many shirts should Sam produce?
Question 1A.
How would Sam's decision change if he had a fixed cost of $ 4000 for interest on the loan he took out to
buy sewing machines? What is the fixed cost were 40,000 ? or 400,000 ?
Question 2.
How long is the “long run”? Answer: long enough to permit the expansion or contraction of productive
capacity. This will be different for food carts and restaurants and steel mills and electrical engineers. How will it
differ?
Question 4. Pajamas are a constant cost industry, so go back to the appropriate cost. Note that the big change
will be that, after the excise tax, both short-run marginal costs, and long run average costs, will go up by $ 2
Question 7. Your answer involves distinguishing between marginal and average cost, and identifying what each
of the consultants must mean when he says “costs”. Both may be right about the facts, but only one has taken the
correct decision. Who is it?
Question 8. Wine production.
This is easy to answer once you compute operating profit = price - variable costs.
Why can we ignore fixed costs in our answer?
Question 9. Carrie's Photocopies.
Be sure to do this one. It will be reviewed in class.
Question 10. Instead of computing marginal and average grades, compute marginal and average tax rates.
Forbes.com has a link to announced tax rates for 2014 earnings (google “IRS announces 2014 tax brackets”
What are the marginal and average taxes for a married couple with taxable income of $ 85,000?
(note that you have already subtracted the standard deductions and exemptions when you say “taxable income”)
CHALLENGES
1. Why is the trend in the relative price of metals downward? Is it an increasing or decreasing cost industry?
If increasing, would the result be due to a change in supply or demand? If decreasing?
2. Books versus movies. Think about fixed cost and risk of loss.
5. This challenge is very challenging. There will be a question on the exam like it (only a bit kinder)