LONG QUESTIONS

Q1. Suppose that there are 100 consumers in a perfectly competitive market and individual demand
curves of these consumers are identical. Also, assume that there are 10 firms in the industry and
these firms are identical as well. The following information is provided about this competitive
market:

Individual Demand Curve: P = 100 – 10QD

Total Cost of a Representative (individual) Firm: TC = 20Q + (1/6) Q2 + 100

a) Find total variable cost (TVC), total fixed cost (TFC) and marginal cost (MC) functions of the
representative firm.

Total Variable Cost = TVC = 20Q + (1/6) Q2

Total Fixed Cost = TFC = 100

Marginal Cost = MC = 20 + (1/3) Q

b) Find average total cost (ATC), average variable cost (AVC), average fixed cost (AFC) functions of the
representative firm.

ATC = TC/Q = 20 + (1/6) Q + 100/Q

AVC = TVC/Q = 20 + (1/6) Q

AFC = TFC/Q = 100/Q

c) What is the market demand function?

To find the market demand we need to horizontally sum the individual demand curves for each of
these firms;

P = 100 – (1/10) Q

d) What is the market supply function?

To find the market supply curve we need to horizontally sum the MC curves for each of these firms.
Thus, with each firm’s MC = 20 + (1/3) Q;

P = 20 + (1/30) Q

e) What is the equilibrium price and quantity in this market?

QD = Qs

100 – (1/10) Q = 20 + (1/30) Q

Q = 600 units

P = 100 – (1/10) Q = 100 – (1/10) (600) = 40 TL

f) What is the quantity produced by the representative firm?

The representative firm is a price taker and will see the market price of $40 as its marginal revenue
curve. It will profit maximize by producing that level of output where MR equals MC.

Thus, 40 = 20 + (1/3) Q -> Q = 60 units

g) Calculate the level of profits that the representative firm is earning.

Profit = TR – TC = 2400-1900 = 500 TL

TR = 40*60 = 2400 TL

TC = 20(60) + (1/6) (60) ^2 + 100 = 1200 + 600 + 100 = 1900 TL

h) Holding everything else constant, what do you predict will happen in this industry in the long run?
Explain your answer fully with a verbal description rather than a numeric calculation.

Since the representative firm is earning positive economic profit we can conclude that this is a
short-run equilibrium. We know that when the industry is in a long-run equilibrium that the
representative firm in the industry will earn zero economic profit. Thus, we can predict that in the
long run there will be entry of new firms into this industry. This entry will cause the market supply
curve to shift to the right and this shift will result in the market equilibrium quantity increasing
while the market equilibrium price will decrease relative to its current levels. There will be more
firms in the industry, and each firm will produce an output that is smaller than 60 units.

Q2. You are given the following information about industry of X-netbook:

• Long-run average costs:

Labor cost: 3 TL per unit of output; Capital cost: 4 TL per unit of output

• The industry is in long-run equilibrium

• Industry is perfectly competitive: with each of 50 firms producing the same amount of output

• Total industry output = 8000 units

a) Show the current conditions by drawing two diagrams: one showing the industry (demand and
supply) and one showing a representative firm (short-run and long-run costs). Mark clearly the
prevailing price in the market in both of the diagrams.
b) Indicate the profit /loss level of the representative firm on the diagram.

Profits = 0 since MR = MC = P.

The demand of X-netbook is expected to grow rapidly over the next few years to a level of twice as
high it is now. But due to short-run diminishing returns the existing firms in the industry could only
increase the quantity supplied by % 50.

c) Show and explain the effect of the above developments on the industry in the short run by using
the diagram you have drawn in part (a) as your initial point.

As demand doubled, we move to D1. But on the same supply curve, equilibrium quantity supplied
increases to 12000; (8000 + 50%). So, as demand increases, price also increases.

d) Show the effect of the above developments on a typical firm in the short-run by using the short-
run and long-run cost curves. Use the diagram you have drawn in part (a) as your initial point. Also
show the level of profits/losses in your diagram.

Profits = (P1 – SRATC1) *240

e) Explain how the typical firm and the industry as a whole will move to the new long run
equilibrium.

Since profit is positive, the number of firms that entered to the market will increase. So, as
quantity supplied increases, price will go down and profits will be zero.

f) Show the final long-run equilibrium of the industry after all the adjustments have taken place
assuming that long-run equilibrium price is the same as initial long-run equilibrium

Demand shock: D0 → D1

Entries: S0 → S1

3. Suppose a chair manufacturer is producing in the short run (with its existing plant and
equipment). The manufacturer has observed the following levels of production
corresponding to different numbers of workers:

a. Calculate the marginal and average product of labor for this production function.
b. Does this production function exhibit diminishing returns to labor? Explain.
c. Explain intuitively what might cause the marginal product of labor to become
negative.
Solution:

a. Calculate the marginal and average product of labor for this production function.

b. Does this production function exhibit diminishing returns to labor? Explain.

Yes, this production function exhibits diminishing returns to labor. The marginal product of
labor, the extra output produced by each additional worker, diminishes as workers are added,
and this starts to occur with the second unit of labor.

c. Explain intuitively what might cause the marginal product of labor to become negative.
Labor’s negative marginal product for L > 5 may arise from congestion in the chair
manufacturer’s factory. Since more laborers are using the same fixed amount of capital, it is
possible that they could get in each other’s way, decreasing efficiency and the amount of
output. Firms also have to control the quality of their output, and the high congestion of labor
may produce products that are not of a high enough quality to be offered for sale, which can
contribute to a negative marginal product.
4. Do the following functions exhibit increasing, constant, or decreasing returns to scale?
What happens to the marginal product of each individual factor as that factor is
increased and the other factor held constant?
a.

b.
c.
MULTIPLE CHOICES

1. Which of the following is not a characteristic of a perfectly competitive market structure?

A) There are a very large number of firms that are small compared to the market.
B) All firms sell identical products.
C) There are no restrictions to entry by new firms.
D) There are restrictions on exit of firms.

2. If a perfectly competitive firm's price is above its average total cost, the firm
A) is earning a profit.
B) should shut down.
C) is incurring a loss.
D) is breaking even.

3. In comparing the changes in TVC and TC associated with an additional unit of output, we find that:
A) No generalization about the changes in TC and TVC can be made.
B) The changes in TC and TVC are equal.
C) The change in TC is greater than the change in TVC.
D) The change in TVC is greater than the change in TC

FIGURE 1

4. Refer to Figure 1. Suppose the prevailing price is P1 and the firm is currently producing its loss-
minimizing quantity. Identify the area that represents the loss.
A) P2 deP1
B) P3cbP1
C) P3caP0
D) 0P1 bQ1

5. Both individual buyers and sellers in perfect competition

A) can influence the market price by their own individual actions.
B) can influence the market price by joining with a few of their competitors.
C) have to take the market price as a given.
D) have the market price dictated to them by government.

6. Suppose the equilibrium price in a perfectly competitive industry is $15 and a firm in the industry
charges $21. Which of the following will happen?
A) The firm's profits will increase.
B) The firm's revenue will increase.
C) The firm will not sell any output.
D) The firm will sell more output than its competitors.

7. If a typical firm in a perfectly competitive industry is incurring losses, then

A) all firms will continue to lose money.
B) some firms will exit in the long run, causing market supply to decrease and market price to rise
increasing profits for the remaining firms.
C) some firms will exit in the long run, causing market supply to decrease and market price to fall
increasing losses for the remaining firms.
D) some firms will enter in the long run, causing market supply to increase and market price to rise
increasing profit for all firms.

8. Which of the following describes the difference between the market demand curve for a perfectly
competitive industry and the demand curve for a firm in this industry?
A) The market demand curve is a horizontal line; the firm's demand curve is downward-sloping.
B) The market demand curve is downward-sloping; the firm's demand curve is a vertical line.
C) The market demand curve cannot have a constant slope; the firm's demand curve has a slope
equal to zero.
D) The market demand curve is downward-sloping; the firm's demand curve is a horizontal line.

9. If, for a perfectly competitive firm, price exceeds the marginal cost of production, the firm should
A) increase its output.
B) reduce its output.
C) keep output constant and enjoy the above normal profit.
D) lower the price.

10. What is always true at the quantity where a firm's average total cost equals average revenue?
A) The firm's revenue is maximized.
B) The firm's profit is maximized.
C) The firm breaks even.
D) Marginal cost equals marginal revenue.

11. When a perfectly competitive firm finds that its market price is below its minimum average
variable cost, it will sell
A) the output where marginal revenue equals marginal cost.
B) any positive output the entrepreneur decides upon because all of it can be sold.
C) nothing at all; the firm shuts down.
D) the output where average total cost equals price.

12. The supply curve of a perfectly competitive firm in the short run is
A) the firm's average variable cost curve.
B) the portion of the firm's marginal cost curve below the minimum point of the average variable
cost curve.
C) the portion of the firm's marginal cost curve above the minimum point of the average variable
cost curve.
D) the portion of the firm's marginal cost curve above the minimum point of the average total cost
curve.

13. In a graph that illustrates a perfectly competitive firm, marginal revenue is

A) a diagonal line that lies below the firm's demand curve.
B) a line that intersects the firm's demand curve from below at its lowest point.
C) a line that intersects the firm's average total cost curve from below at its lowest point.
D) the same as the firm's demand curve.

14. In the long run, a perfectly competitive firm earning zero economic profits
a. will exit the market in search of more profitable use of its resources.
b. is earning a normal rate of return on its investments.
c. signifies that the firm is performing poorly and so should exit the market.
d. Both a and c

15. When firms in a perfectly competitive industry are experiencing economic profits
a. new firms enter the industry in pursuit of above normal profits, which causes the price to
fall to the point where firms are earning a zero economic profit.
b. there is no incentive for new firms to enter the market since they can easily earn a
comparable rate of return in other markets.
c. firms earn above normal profits until demand falls, which causes price and marginal revenue
to fall until economic profits are equal to zero.
d. new firms attempt to enter the market in pursuit of above normal profits but are unable to
due to barriers to entry.

16. In the long run, a constant cost industry

a. has an upward sloping supply curve as the quantity supplied increases with increases in
demand.
b. expands in response to an increase in demand despite rising input costs, and so the long run
supply curve is horizontal.
c. does not expand in response to an increase in demand and so the long run supply curve is
horizontal.
d. can expand in response to an increase in demand without input costs changing, and so the
long run supply curve is horizontal.

17. A firm faces the following cost function: TC = 50 + 2Q + Q². The market price is $8. Should the firm
shut down in the short run?

A) Yes, because it cannot cover its variable costs.

B) No, because it covers its variable costs but incurs a loss.
C) No, because it is making a profit.
D) Yes, because total costs exceed total revenue.

Explanation: The firm produces if price is above AVC. At Q = 4, AVC = 2 + 4 = $6, which is less than the
price of $8. The firm incurs a loss but continues producing.

18. Which of the following markets closely resembles a perfectly competitive market?
A) Smartphone manufacturing
B) Agricultural produce like wheat
C) Airline industry
D) Software development

Explanation: Agricultural markets like wheat production meet many criteria of perfect competition,
such as homogeneous products and numerous small sellers.

19. If the government imposes a per-unit tax on a perfectly competitive market, what happens in the
short run?

A) Firms exit immediately as they cannot make a profit.

B) The market price increases by the full amount of the tax.
C) Firms continue producing if the price covers average variable costs.
D) The supply curve shifts left, and firms increase output."*

Answer: C

Explanation: In the short run, firms will produce as long as the price covers AVC, even with the tax.
The supply curve shifts left due to increased costs.

20. A farmer is deciding how to allocate resources between two crops, Wheat and Corn. The Marginal
Product (MP) per dollar spent on each crop is as follows:

Wheat: MP = 20 units per dollar

Corn: MP = 15 units per dollar

To maximize output, which crop should the farmer allocate more resources to?

a) Allocate equally to both crops

b) Allocate more to Wheat

c) Allocate more to Corn

d) Stop production for both crops

TRUE FALSE QUESTIONS

1. In the long run, firms in a perfectly competitive market can increase their economic profit by
improving production efficiency.

Answer: False

Explanation: In the long run, economic profits in a perfectly competitive market are zero due to free
entry and exit of firms. While improving efficiency might reduce costs, it will not lead to sustained
economic profits because prices adjust to the point where only normal profits are earned.

2. The total variable cost curve always begins at the origin because variable costs depend on the level
of output.

Answer: True

Explanation: Total variable cost (TVC) is zero when output is zero, as variable costs are incurred only
when production takes place. The TVC curve starts at the origin and increases as output increases.

3. If a firm’s marginal cost is increasing, its average variable cost must also be increasing.

Answer: False

Explanation: Even if marginal cost (MC) is increasing, average variable cost (AVC) may still be
decreasing if MC is less than AVC. AVC starts to increase only when MC exceeds it.

4. In a perfectly competitive market, a firm will always produce at the minimum point of its average
total cost curve in the long run.

Answer: True

Explanation: In the long run, firms adjust their output and scale of production to minimize their
average total costs, as this is the only way to stay competitive and earn zero economic profit.

5. When marginal cost equals average total cost, the average total cost is at its maximum.

Answer: False

Explanation: When marginal cost (MC) equals average total cost (ATC), the ATC is at its minimum. This
is because MC intersects ATC at its lowest point.

6. In the short run, all inputs are variable, whereas in the long run, at least one input is fixed."

Answer: False

Explanation: In the short run, at least one input (e.g., capital) is fixed, while in the long run, all inputs
are variable.

7. In an increasing-cost industry, input prices rise as industry output expands, leading to an upward-
sloping long-run supply curve.

Answer: True

Explanation: Increasing-cost industries experience higher input costs with output expansion,
resulting in a positively sloped LR supply curve.