Answers to Questions for Review
1. Economic profit includes all costs, while accounting profit looks only at cash flow. The firm should consider economic profit only.
2. Unless firms act as though their pricing decisions affect other firms, we should assume that firms act as price takers.
3. The dry cleaning markets would be nearly perfect except that many people do not want to drive far for their clothing pickups and dropoffs. In small towns there may only be one or two cleaners so less competition will be present.
4. Price = TR/Q, so this firm's demand curve is given by P=a - 2Q. Since its price is a declining function of output, it cannot be a perfectly competitive firm.
5. No, because managers often relate to their competition by trial and error actions moving in the direction of what succeeds for them. This moves the firm to the quantity of output that is consistent with perfect competition outcomes.
6. The firm should shut down if and only if its price is below AVC. MC can lie below AFC at the same time price lies above AVC (see diagram). So false.
7. The value
of the last unit to consumers (the price) equals the opportunity cost of
resources necessary to produce that unit.
8. The effect of such a tax is to produce a parallel upward movement in each firm's long-run average cost curve. The output level for which the minimum value of LAC occurs will thus be the same as before, which means that firms in long-run equilibrium will each have the same amount of output as before. So true.
9. A firm will have a long-run marginal cost function that is above average cost for all points past the minimum point on the long-run average cost curve. If demand causes price to be above the minimum average cost in the short-run, then firms could be operating where price equals long-run marginal cost and they could be making economic profits. When entry occurs in the long-run the price will fall and price will equal long-run marginal cost at the long-run equilibrium output level. Thus the statement is false. See the diagram on the next page.
10. Consumer surplus in a competitive industry is the area between the price line and the market demand curve, not the individual firm's demand curve. Since the market demand curve is downward sloping, there will in general be positive consumer surplus. Indeed, compared to other market structures, perfect competition creates the maximum consumer surplus. So false.
11. Pecuniary economes and diseconomies are industry wide concepts that are operative when all firms act similarly to put pressure on input prices. Since many inputs effect all industries it is less likely that any one industry will impact input prices substantially cause pecuniary effects.
12. Yes, in the short run, firms that innovate first will reap economic profit until other firms catch up and compete away the economic profit. Thus intensive innovation efforts are consistent with the perfect competition model.
Answers to Chapter 11 Problems
1.
Price
64 ATC MC
48 profit (6x4)
AVC
32 Price
26
16
0 2 4 6 8 10
Quantity
2. Setting price P = 10 equal to marginal cost of SMC = 2 + 4Q, solve for quantity 10 = 2 + 4Q or 8 = 4Q or Q = 2. The fixed cost that leads to zero economic profit is calculated by solving p = (P – AVC)Q – FC = 0 or (10 – 6)2 – FC = 0 for FC = 8.
3.
SR supply =
MCi = 4 + Qi
Qi = MCi - 4
= Q = 
- 4000
Q = 1000 MC - 4000
MC = P, so Q = 1000 P - 4000, which means that industry supply is given by
P = 4 + Q/1000.
SR equilibrium Q: 4 + Q/1000 = 10 - 2Q/1000
3Q/1000 = 6, Q = 2000, P = 6.
Consumer surplus = area of upper triangle = 4000.
Producer surplus = area of lower triangle = 2000.
Total loss in surplus = 6000.
4. In the long run, both the demand and supply curves will be more elastic than in the short run, making the loss in both consumer and producer surpluses smaller.
5. Since P = SMC > AVC, the firm should continue at its current level of output in the short run. In the long run, it should select the plant size for which P = LMC = SMC. As indicated in the diagram below, this means it should switch to a smaller plant size in the long run.
6. Long-run equilibrium price for this industry will occur at the minimum value of LAC.
LAC= LTC/Q= Q2 - 10Q + 36
dLAC/dQ =2Q-10=0, which solves for Q=5.
At Q=5, LAC=25-50+36=11.
7. The LAC curve for firms in this industry is given by LTC/Q=Q+4. The minimum value of LAC now occurs at an output level of 0, where LAC takes the value 4. As a practical matter, the notion of an infinitesimally small firm has no meaning. Because of indivisibilities, a firm's LAC curve will increase beyond some point as Q shrinks toward zero.
8. The taxi industry supply curve for Metropolis is a horizontal line at P=$0.20/mile. The demand schedule intersects it at Q=80,000 miles/yr, which means 8 taxis. The equilibrium fare will be $0.20/mile.
9. If the total number of taxis is reduced from 8 to 6, the equilibrium fare will rise to $0.40/mile. Ignoring the opportunity cost of the medallion, each medallion owner will earn a profit of $(0.40-0.20)10,000= $2000/yr. If the annual interest rate is 10%, a person would need $20,000 in order to earn as much interest as a medallion holder earns each year in profit. So medallions will sell in the market for $20,000 each. A person who buys a medallion at this price will earn zero economic profit.
10. The
short-run MC curve for firms in the industry is dSTC/dQ
= 10 + 2wQ. The equilibrium output is found by equating P and MC: 10 + 2wQ* = 28, which yields
Q*=9/w. For firms with normal managers, w = 2, so Q* = 9/2 = 4.5. Profit of
normal firms = 
= 28(4.5) - 2 (4.5)2 - 45 - M =40.5 - M. For the firm that hires
Merlin, w = 1, so Q* = 9. Profit of firm with Merlin as manager = 
= 28(9) - 92 - 90 - Mm = 81 - Mm,
where Mm is Merlin's salary. The premium paid to Merlin
in equilibrium will be exactly the amount required to equate his firm's profits
with those of other firms.
= 81 - Mm = = 40.5 - M, so
Mm - M = 81 - 40.5 = 40.5.
11. a) With the new process your costs, excluding your payment for use of the patent, will be TC' = 4 + Q + Q2. To find your profit maximizing output level, we equate your new marginal cost, MC' = 1 + 2Q, to the industry price, which, as before, will be the minimum value of the average cost curve associated with the prevailing technology: LAC = 8/Q + 2 + 2Q => dLAC/dQ = 2 - 8/Q2 = 0 => Q* = 2 => LAC = 10 = P*. If we use Q' to denote the patent holding firm's profit-maximizing output level, we have MC'=10 = 1 + 2Q' => Q' = 4.5. The patent holder's economic profit will thus be TR - TC = 45 – 4.5 – 20.25 = 16.25 So the most you would be willing to pay for the patent is 16.25.
11. b) Because the patented process can reduce the costs of each of the 1001 firms by half, it is worth considerably more than 16.25; thus the investor would not be willing to sell exclusive rights to its use to one firm at that price. For example, he could sell the patent to two firms for 16.24.
12. a)
MC=
Similarly, AVC=wL/Q=w/AP. So when
AP=MP, it follows that MC=AVC.
12. b) Since the firm is perfectly competitive, its output price is equal to marginal cost, which here is equal to AVC. So all of the firm's revenue is paid out to its workers, leaving none for its cost of capital. Thus, if the firm stays open in the short run, its loss will be equal to its fixed capital costs of $40/day, which is the same loss it would suffer if it were to shut down. So the firm is indifferent between shutting down and remaining open in the short run.
13. TC = 0.2 Q2 - 5Q + 30.
MC = dTC/dQ = 0.4 Q - 5.
In equilibrium MC = P, which implies 0.4Q - 5 = 6, which solves for Q = 27.5.
Profit = revenue – cost = 27.5x6 - [0.2(27.5)2 -5(27.5) + 30] = 121.25. Since the firm earns positive profit, it should stay open.
14. Demand is given by P = 5-0.002Q, and supply is given by P=0.2+0.004Q. In equilibrium, sale and purchase prices are equal. Thus, we get 5-0.002Q=0.2+0.004Q, which solves for Q=800 and P=3.4. With tax, assume the supply curve shifts upward by 1 unit, which makes it: P=1.2+0.004Q.
When we solve 5-0.002Q=1.2+0.004Q, we get Q=1900/3 and P=56/15.
This is the price paid by the consumer. The supplier gets P=41/15.
The incidence of tax on the supplier is 2/3, and on the consumer it is 1/3.
The consumer surplus before tax is [(5-3.4)x800]/2 = 640.
The producer surplus before tax is [(3.4-0.2)x800]/2 = 1280.
The consumer surplus after tax is [(5-56/15)x1900/3]/2 = 401.11.
The producer surplus after tax is [(41/15-0.2)x1900/3]/2 = 802.22.
Lost consumer surplus is 238.88.
Lost producer surplus is 477.77.
15. 1) Since the supply curve faced by the individual firm is elastic, the advertisement (which shifts the demand curve out) will increase quantity increase but leave price unchanged.
15. 2) The result will be a shift in the long-run supply curve. Price will increase and quantity will decrease.
16. a) LAC = TC/Q = 4Q + 100 +100/Q.
The minimum point on LAC is found either by graphing the LAC curve or by taking the first
derivative and setting it to zero. dLAC/dQ = 4 - 100/Q2 = 0, which yields Q = 5.
In the long run P = LAC = 140
16. b) If demand is Q=1000-P, then at P=140, we get Q=860. So in long run equilibrium, there will be 860/5 = 172 firms.
16. c) Now LAC = (TC-36)/Q = 4Q + 100 + 64/Q. Again, the minimum point on LAC is found either by graphing the LAC curve or by taking the first derivative and setting it to zero.
dLAC/dQ = 4 - 64/Q2 = 0, which yields Q = 4. In the long run P = LAC = 132.
17. At a world price of 30, domestic demand is 35 million bushels per year. Domestic producerssupply the 20 million bushels of this total, foreign producers the remaining 15 million (left panel.) With a tariff of $20/bu, the import price becomes $50/bu. Because the domestic market clears at $40/bu (center panel), this means that no beans will be imported. Since no beans are imported, the tariff raises no revenue. Consumer surplus and producer surplus with the tariff is the area of triangle ABC (center panel), which equals $1350/yr. Consumer surplus and producer surplus before the tariff-- the shaded area in the right panel-- was $1425/yr, which means that the tariff has reduced consumer and producer surplus by $75/yr.
18. (i) Costs will fall for all existing firms. At existing prices the firms will make positive economic profits and increase output.
18. (ii) New firms will enter the industry because of profits.
18. (iii) The industry supply curve will shift out until profits are again driven down to zero. The final result is that prices fall, quantity increases, and there are more firms than before. In other words, consumers reap all the surplus from this innovation.