ECON1001

1. ECON1001 Tutorial 6

2. Q1) Which of the following is NOT true of a perfectly competitive firm? • It faces a perfectly elastic demand curve. • It is unable to influence the market price of the good it sells. • It seeks to maximize revenue. • Relative to the size of the market, the firm is small. • The firm’s only decision is how much output to produce. Ans: C

3. (A) is correct. Each firm in a perfectly competitive market is facing a horizontal demand for its products. • The demand is perfectly elastic because firms are selling homogeneous goods. It is very easy for the customers to find substitutes. • Note that the MARKET DEMAND is not horizontal. Only the demand for individual firms’ products is perfectly elastic.

4. (B) and (D) are the features of a perfectly competitive market. • In a perfectly competitive market, there is a huge number of firms and each firm is of a minuscule size (compared to the whole market) • Because each firm is so small, none of its action can influence the market. The firm will suffer if it deviates from the market price. There will not be any effect on the market price if the firm varies its output level. • Therefore, (B) and (D) are true.

5. (E) is also true. Indeed, when each firm is facing a given market price, what it can do is to determine how much output it is going to supply. • The decision on output is made based on the firm’s cost function. • A rational economic agent will always aim at maximising profits.

6. Is maximizing profit the same as minimizing cost? • What is the output level at which cost of production is minimized? • Zero output !! • Thus maximizing profit is not the same as minimizing cost!!

7. As mentioned just now, firms always aim at maximising PROFITS. • However, it does not mean that they aim at maximising REVENUE. (Profit is the difference between revenue and costs) • Therefore, (C) is the only option that is NOT true.

8. Q2) The Law of Diminishing Marginal Returns… • Is a Long Run concept. • Applies only to small and medium sized firms. • Is a Short and Long Run concept. • Applies only to large firms. • Is a short run concept. Ans: E

9. The Law of Diminishing Marginal Returns states that… • In a production where there are fixed and variable factors, • When more variable factors are added, additional output yielded by each marginal unit of input drops eventually.

10. Does the Law of Diminishing Marginal Returns have anything to do with firm size? • NO! • LDMR holds whenever a firm has both fixed and variable factors of production, regardless of size. • Firms of any size can be using (or not using) both fixed and variable factor input. • Hence, (B) and (D) can be eliminated because they are wrong.

11. (A), (C) and (E) are all about Long / Short Run. • What is Short Run? What is Long Run? Yes No Yes Yes

12. Recall that LDMR describes a situation at which both fixed and variable factors are in used. • So is it referring to Long Run or Short Run? • Short Run • Therefore, the answer is (E).

13. Q3) Suppose 40 employee-hours can produce 80 units of output. Assuming the Law of Diminishing Marginal Returns is present, to produce 160 units of output will require… • An additional 40 employee-hours. • A total of 80 or less employee-hours. • Less than 40 additional employee-hours. • A total of 81 or more employee-hours. • A total of 80 employee-hours. Ans: D

14. The LDMR states that with fixed and variable factors both being used in production, the marginal productivity of each additional unit of variable factor will eventually drop. • The firm is currently producing 80 units of output, by using 40 man hours. • If LDMR holds, then the marginal output of the 41st unit of input will be smaller than that of the 40th unit. • In other words, MB41<MB40.

15. The next additional employee-hours will be less productive than each of the previous 40. • MB80<MB79<….<MB41<MB40 • Therefore, to produce 80 more units of output (in addition to the initial 80), the firm will need more than 40 hours in addition.

16. Hence, (A) and (C) are both wrong. The firm will need an addition 40+ hours to work out the extra 80 units of output. • (E) is equivalent to (A) – saying that the firm needs an extra 40 hours. So (E) is also not the correct answer. • (B) implies that in terms of productivity, the next 40 hours will be the same or better than the previous 40 hours. Wrong! • (D) is the correct answer. It means more than 40 extra hours are needed to produce 80 more. This is the only option consistent with LDMR.

17. Q4) Suppose a firm is collecting $1999 in Total Revenue and the Total Cost of its fixed factors of production falls from $500 to $400. One can speculate that the firm will… • Expand output. • Lower Price. • Earn greater profits or smaller losses. • Contract output. • Earn smaller profits or great losses. Ans: C

18. First of all, how are production decisions made by firms in economics? • Firms make production decisions based on a universal rule: MC=MR • For a price taker, its marginal revenue is always equal to the price (MR=P) • Therefore, the firm only has to determine its output level. The optimal level of output is where MC = MR.

19. Now that the fixed cost of production has decreased. • Is the Marginal Cost (MC) schedule affected by any means? • NO! • So would the previous Q determined by MC=MR be affected? • NO!

20. Therefore, (A) and (D) can be eliminated as they are the wrong answers. • Output level is not affected by a change in fixed costs. • This is because a change in fixed costs has no effect on marginal benefits of output.

21. How about option (B)? • Since we are talking about Perfect Competition (Price Taker)… • Does the firm have any say on its price? • No! • Therefore, (B) is also not the answer.

22. That leaves us with options (C) and (D). • Recall that Profit = Revenue – Costs • Now that (Fixed) Costs have dropped… • What happens to Profit? • Increases! • Hence (C) is the correct answer.

23. Q5) If 3 workers are used per day and P = $10, the pizza shop makes a profit / loss (?) of ? each day.

24. When 3 workers are used, 150 pizzas are sold at $10. Fixed Cost = $500, and Variable Cost = $450. • Recall that… • Profit = Total Revenue – Total Costs • Total Revenue = $10 x 150 pizzas • TR = $1500

25. Total Cost = Fixed Cost + Var. Cost • TC = 500 + 450 = $950 • Profit = TR – TC = $1500 - $950 = $550 • Therefore, the shop is making a PROFIT of $550. (B)

26. Q6) If a firm is earning zero profits… A) Its revenue are sufficient to pay explicit costs, but not implicit costs. • The owner will not be able to pay himself or herself a salary. • It will shut down in the LR, but will continue to operate in the SR. • The owner is earning a return on his time and investment that is equal to the opportunity costs of that time and investment. • The firm is not making a profit-maximising output decision. Ans: D

27. In economics, total cost = explicit cost + implicit cost (including opportunity cost). • Profit = Total revenue – total cost. • This profit concept is true for both SR and LR. • Thus, (A) is false.

28. (E) is also not true. In economics, all agents are assumed to be rational. i.e. firms are all making profit-max decisions at all times. • (C) is not true as well. Since the firm is not making a loss, there is no reason for it to cease operating in the LR. • That leaves us with options (B) and (D).

29. Economic Profit is not the same as Accounting Profit. • In calculating Econ Profit, we look at costs of production, and these costs include opportunity costs. • The cost of hiring the owner to make entrepreneurial decisions has already entered our equation (either as fixed or variable costs depending on nature).

30. The opportunity cost of an entrepreneur is the amount s/he can make from elsewhere, using the same amount of time and effort. (OC = highest valued option foregone) • Hence, (B) is incorrect, and (D) is the right answer. • This implies that one's current salary is the highest amount h/she can earn elsewhere.

31. Q7) When the demand is P1=$7, what is the profit maximising output? Ans: B - 400 Q8) When the demand is P1=$7, what is the profit of the profit-maximising producer? Ans: C - $1,300

32. P MC MC ATC • How is π-max output determined? • MC = MR • What is MR in this case? • P = MR in Perfect Competition (hint: horizontal demand) • So find Q where MC = P • Q = 400 (7B) P1 P1 7 AVC 400 Q

33. P MC ATC • Π = TR – TC • TR = $7 x 400 = $ 2800 • TC = ATC x 400 = $3.75 x 400 = $1500 • Π = $1300 (8C) (Represented by the shaded area in the diagram) 7 P1 AVC 3.75 400 Q

34. Q9) If an industry experiences an increase in the number of firms, then… • The original firms will produce more. • The new firms will produce more than the original firms. • The industry supply curve will shift left. • The new firms will produce the same amount as the original firms. • The industry supply curve will shift right. Ans: E

35. Do we have any reason to say that (A) is true? • First, since the cost functions of the firms are not affected by the increase in no. of suppliers, and firms set output at MR=MC, we have no logical grounds to say the output level of original firms will change – unless there is a change in price. • Will price change? Price may decrease if there is an increase in market supply (holding the demand constant). A price decrease will only induce firms to produce less – not more. • Therefore, (A) is not the answer.

36. Do we know anything about the cost functions of the new and the original firms? • No! • Therefore, we cannot tell whether the firms are producing the same amount or not. • Options (B) and (D) are therefore eliminated.

37. Only (C) and (E) are left. • As there are more sellers in the market, the quantities of goods supplied at all prices increase. • Would that shift the industry supply curve to the left or to the right? • Right. • Hence, (E) is the correct answer.

38. Q10) If supply is perfectly elastic, • Producer surplus is equal to zero. • An increase in demand decreases producer surplus. • An upward shift of supply decreases producer surplus. • A downward shift of supply decreases producer surplus. • No output is produced. Ans: A

39. P S • In a general case, Producer surplus is the difference between Price and MC. • PS is represented as the shaded triangle in the diagram P* D Q

40. P • Now, however, supply is perfectly elastic (horizontal). • First of all, is any output produced? • Yes! • Q* is produced. • So (E) is incorrect. P* S D Q Q*

41. P • What is Producer Surplus in this case? • What is the difference between P and MC? • 0! • Hence, (A) is the correct answer. P* S D Q Q*

42. In this case, Producer Surplus cannot be further decreased. • Sellers are already selling at cost. • No one will be willing to reduce the price and make a loss. Hence, it is impossible for PS to drop. • As a result, (B), (C) and (D) are all rendered to be wrong.