METU Department of Economics Econ 101: Introduction to Economics I Sections 01-02-03 2011-2012 Fall Semester

Problem Set 7 with SOLUTIONS (Ch. 8 and Ch. 9 in Case et al.; and Relevant Parts of Ch. 8 in Lipsey et al.)

PART A - QUESTIONS 1. Explain in your own words why the marginal cost curve is shaped the way it is (at first it decreases then it increases). 2. When a firm produces 100 units of a good, its average total cost is 3 TL. When the firm produces 101 units, its average total cost is 3.25 TL. What can you say about the marginal cost of producing the 101st unit? Explain. (You dont have to give me the exact dollar amount of the marginal cost, but you can say something about the size of the marginal cost of producing the 101st unit.)

3. The table below shows the costs for a firm. Q Total fixed costs Total variable costs Total cost Marginal costs Average fixed costs Average variable costs Average total costs 0 500 0 1 2 3 280 600 80 108 225 160 1380 4 5 6 7

a) Fill in the remaining costs. b) Show the ATC, AVC, AFC and MC on the same graph. c) Explain what is happening to average fixed costs as Q increases, and explain how this is reflected in your graph.

4. The following table gives capital and labor combinations for 10 different levels of memory stick production of the Firm ABC.

Q 0 1 2 3 4 5 6 7 8 9 10 K 4 4 4 4 4 4 4 4 4 4 4 L 0 9 17 24 31 39 48 58 69 81 94
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a) Assume that the price of labor is $5 and the price of capital is $10 per unit. Compute total variable costs, the marginal costs, and the average variable costs for the firm at each output level, and graph their curves. Q TVC AVC MC 0 1 2 3 4 5 6 7 8 9 10

b) Do the curves have the shapes that you expect? Explain. c) Using the numbers and graphs that you constructed, explain the relationship between marginal cost and variable cost. d) Using the numbers and graphs that you constructed, explain the meaning of marginal cost in terms of additional inputs needed to produce a marginal unit of output. e) If the firm operates in a perfectly competitive market, and if output price was $ 55, how many units of output would the firm produce? Explain.

5. A perfectly competitive firm has fixed costs of $30 and total costs as indicated in the table below. Total Total Average Average Average fixed variable Total fixed variable total Marginal Output cost cost cost cost cost cost cost 0 30 1 39 2 47 3 54 4 60 5 67 6 75 7 84 8 95 9 108 10 123 a) Fill in the missing values in the table. b) Graph the curves for total fixed cost, total variable cost, and total cost . c) Graph the curves for AFC, AVC, ATC, and MC. Mark the two key points as discussed in class and also in the textbook. Explain why the MC curve intersects both the AVC and ATC curves at their minimums. d) What will happen to the AVC, ATC, and MC if the fixed cost increases by 40. e) How much will the firm produce if the market price that it faces is $13.5. Will the firm make
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profits or losses? How much? f) Answer the questions in part (e) is the price was $8.5. g) Answer the questions in part (e) is the price was $6. h) The following table represents the market demand schedule for the industry. Fill in the blanks (i.e. calculate corresponding values for individual supply schedule, profits, and industry supply). (Assume that there are 100 identical firms in the industry) Price 3 4 6 8.5 11 13.5 15 Supply by the firm Profit Industry supply Market demand 1000 800 700 600 300 200 50

i) What will the equilibrium price for the industry, what will be the quantity supplied by each firm?

6. Firm X, Firm Y, and Firm Z are all companies that sell ice cream cones in a perfectly competitive local ice cream market. We have observed that during the month of August, Firm X is closed, Firm Y is open and Firm Z is open. We have also heard that for the month of August, Firm X and Firm Z are both incurring losses, whereas Firm Y realizes positive profit in August. a) Match the three profit function graphs illustrated below with the each firm. Explain your answers briefly.

b) Using the standard graphs of marginal revenue, marginal cost, average total cost and average variable cost, illustrate and explain each firms cost position being careful to label things clearly and to have your graphs explain the observed behavior of these three firms in August. 7. Factory As short-run cost function is TCA = 124 + 18Q, while factory Bs is TCB = 18 + 124Q. Answer the following questions: a) You are told that both of the factories had the same total cost in this period. What was output
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in factory A? In factory B? b) What are fixed costs for factory A? For factory B? c) What are marginal costs for Factory A? For factory B? d) Suppose you want to produce only 0.5 units (Q=0.5). You want to pay as little as possible but must pay the cost of production. Which factory would you choose? e) Repeat part (d) assuming you want to produce 2 and 3 units, separately. f) What is a rule for production about choosing where to produce? (i.e. produce in factory A if output is _____, factory B if output is ______)

8. The following equations represent the TFC and the TVC of the firms, X-Power Inc. and YPower Inc. costs TFC TVC X-Power Inc. 30 20Q + 0.2Q2 Y-Power Inc. 50 2Q3+3Q2+8Q

a) What is the TFC for the firms when output equals 2 and when output equals 5, respectively? b) What is the TVC for the firms when output equals 2 and when output equals 5, respectively? c) Obtain the total cost (TC) functions of the firms and calculate TC values when Q = 10. d) Obtain the AVC functions of the firms. e) Obtain the AFC functions of the firms. f) Can you obtain the MC functions of the firms? If so, calculate the MC functions.

9. Suppose that a firm has four possible scales of production. The figure below shows the four short run average total cost curves for the respective firm sizes represented by ATC1, ATC2, ATC3, and ATC4 .

a) Which scale of production is best when output, Q = 25? In this scale, what is the per unit cos of producing 25 units?
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b) Which scale of production is best when output, Q = 40? In this scale, what is per unit cost of producing 40 units? c) Over what output range (approximately) on the long run average cost curve are increasing returns to scale illustrated? d) Over what output range (approximately) on the long run average cost curve are decreasing returns to scale illustrated? e) Over what output range (approximately) on the long run average cost curve are constant returns to scale illustrated?

10. 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.

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. d) Show the effect of the above developments on a typical firm in the short-run by using the shortrun 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. e) Explain how the typical firm and the industry as a whole will move to the new long-run equilibrium. 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

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11. As new regulation banned smoking in many areas, the demand for cigarettes has decreased. Now people spend their money on other products (denote as Y). Draw the graphs of the market and representative firm for cigarettes and for the market Y. a) Show the initial long-run equilibrium in both sectors and in a representative firm in each sector on the graph. b) Show what happens when demand changes in both sectors and representative firms. c) Show the long-run equilibrium in both sectors.

PART B - MULTIPLE CHOICE QUESTIONS The following table contains some figures for a firm's total fixed cost (TFC), total variable cost (TVC), total cost (TC), average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC), for various output levels (Q). Use this information to answer first 5 questions. Q units/day 10 20 30 40 50 TFC 500 TVC $/day 1500 2100 3050 500 3100 12.5 TC AFC 50 2250 86.7 AVC $/unit ATC

1. TC at Q = 30 units/day is a. $4700/day b. $2600/day c. $2100/day d. none of them

2. ATC at Q = 40 units/day is a. $127.50/unit b. $135.50/unit c. $76.25/unit d. none of them.

3. AVC at Q = 20 units/day is a. $140/unit b. $87.50/unit c. $225/unit d. none of them.

4. Over the output range from 30 to 40 units/day the firm's marginal cost is approximately a. $25/unit b. $175/unit c. $125/unit d. none of them.

5. Over the output range from 10 to 20 units/day the firm's marginal cost is approximately a. $25/unit b. $175/unit c. $125/unit d. none of them.

6. Which of the following definitions is not related to a long run analysis? a. total cost b. marginal cost c. average cost d. fixed cost

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7. If the total cost function is TC = 19Q + 28 , then: a) MC = 19 b) MC = 19Q c) AFC = 28 d) ATC = 28 / Q e. none of them.

8. If the total cost function is TC = 19Q + 28 , then: a) MC = 28 b) MC = 28Q c) AFC = 19 d) ATC = (19Q+28) / Q e. none of them.

9. If the total cost function is TC = 19Q + 28 , then: a) MC = 28 b) MC = 28Q c) AFC = 28/Q d) ATC = 19 / Q e. none of them.

10. If the total cost function is TC = 19Q + 28 , then: a) MC = 28 b) MC = 28Q c) TVC = 19Q d) ATC = 19 / Q e. none of them.

11. Economies of scale a) are represented by the declining portion of the average fixed cost curve b) account for the downward-sloping portion of the long-run average cost curve c) suggest that the firm's marginal cost curve lies above its average cost curve d) both (a) and (d) are correct

12. The vertical distance between average total cost and average variable cost curves decreases as output increases because a) it is traditional to draw the curves that way b) it works out that way with the geometry since both curves must reach their minimums on the marginal cost curve c) average fixed cost decreases as output increases d) marginal product first rises and then falls

13. When a firm exits an industry a) demand decreases and economic profits continue to decline b) market supply does not change c) market supply decreases, pushing market price higher d) market supply decreases, decreasing the firm's output price

14. The law of diminishing returns requires the assumption that a) technology remains fixed b) there be at least one fixed input c) beyond some point, there be decreasing returns to scale d) (a) and (b)

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15. A short-run average cost curve will touch the long-run average cost curve at a level of output only a) where the short-run cost curve is downward sloping b) where the short-run cost curve is upward sloping c) when the quantity of the fixed factor being employed is at the optimal level for that level of output d) none of the above

16. The XYZ Corporation increases all of its inputs by 25 percent and finds that its output increases by 15 percent. We can conclude that initially it was producing: a) in the range of diseconomies of scale b) in the range of economies of scale 17. As the firms output increases, in the short run a) average fixed cost increases continuously b) marginal cost reaches a maximum, then decreases c) average variable cost reaches a maximum, then decreases d) average variable cost approaches the average total cost c) where AP is less than MP d) at the point of minimum efficient scale

18. Other things being equal, if the fixed costs of a firm were to increase by $100,000 per year, which of the following will happen. a) Marginal costs and average variable costs would both rise. b) Average fixed costs and average variable costs would rise. c) Average fixed costs and average total costs would rise. d) Average fixed costs would rise, but marginal costs would fall.

19. Which of the following cost concepts is best described as "the increase in total cost that arises from an extra unit of production?" a) average variable cost b) marginal cost c) total fixed cost d) sunk cost

20. Refer to Fig.2, when will firm entry occur? a) when price is P1 or greater b) when demand is at D3 c) when demand is at D2 d) when price is P2 or less

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21. Let TFC, TVC, MC and TC denote total fixed cost, total variable cost, marginal cost and total cost respectively. Suppose lhan has a bakery. If the annual rent he pays increases, then: a) TFC increases; TVC increases; MC and TC remain the same b) TFC increases; TVC, MC and TC remain the same c) TFC increases; TC increases; MC and TVC remain the same d) TFC increases; TVC, MC and TC increase Price (dollars per pizza)

22. The vertical distance between ATC and AVC reflects: a) The law of diminishing returns b) The average fixed cost at each level of output. c) Marginal cost at each level of output. d) Implicit costs.

23. Which of the following must be true to describe the shape of the average cost curve? a) For levels of output where both marginal cost and average variable cost increase, average total cost must increase too. b) For levels of output where both average fixed cost and average variable cost decrease, average total cost must decrease too. c) For levels of output where both average fixed cost and average total cost decrease, average variable cost must decrease too. d) For levels of output where average variable cost increases, average total cost must increase too.

24. 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.

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