Reading 14 - Topics in Demand and Supply Analysis

17. The marketing director for a Swiss specialty equipment manufacturer estimates the firm can sell 200 units and earn total revenue of CHF500,000. However, if 250 units are sold, revenue will total CHF600,000. The marginal revenue per unit associated with marketing 250 units instead of 200 units is closest to: A. CHF 2,000. B. CHF 2,400. C. CHF 2,500.

A is correct. Marginal revenue per unit is defined as the change in total revenue divided by the change in quantity sold. MR = ∆TR ÷ ∆Q. In this case, change in total revenue equals CHF100,000, and change in total units sold equals 50. CHF100,000 ÷ 50 = CHF2,000.

Exhibit 1: 21. Refer to the data in Exhibit 1. When quantity produced is equal to 4 units, the average fixed cost (AFC) is closest to: A. 50. B. 60. C. 110.

A is correct. Average fixed cost is equal to total fixed cost divided by quantity produced: AFC = TFC/Q = 200/4 = 50.

26. Under conditions of perfect competition, a company will break even when market price is equal to the minimum point of the: A. average total cost curve. B. average variable cost curve. C. short-run marginal cost curve.

A is correct. A company is said to break even if its total revenue is equal to its total cost. Under conditions of perfect competition, a company will break even when market price is equal to the minimum point of the average total cost curve.

35. Under conditions of perfect competition, in the long run firms will most likely earn: A. normal profits. B. positive economic profits. C. negative economic profits.

A is correct. Competition should drive prices down to long-run marginal cost, resulting in only normal profits being earned.

16. The production relationship between the number of machine hours and total product for a company is presented below. Diminishing marginal returns first occur beyond machine hour: A. 3. B. 4. C. 5.

A is correct. Diminishing marginal returns occur when the marginal product of a resource decreases as additional units of that input are employed. Marginal product, which is the additional output resulting from using one more unit of input, is presented below. The marginal product of the third machine hour is 6 and declines thereafter. Consequently, diminishing marginal returns are first evident beyond three machine hours.

18. An agricultural firm operating in a perfectly competitive market supplies wheat to manufacturers of consumer food products and animal feeds. If the firm were able to expand its production and unit sales by 10% the most likely result would be: A. a 10% increase in total revenue. B. a 10% increase in average revenue. C. an increase in total revenue of less than 10%.

A is correct. In a perfectly competitive market, an increase in supply by a single firm will not affect price. Therefore, an increase in units sold by the firm will be matched proportionately by an increase in revenue.

12. In the case of a normal good with a decrease in own price, which of the following statements is most likely true? A. Both the substitution and income effects lead to an increase in the quantity purchased. B. The substitution effect leads to an increase in the quantity purchased, while the income effect has no impact. C. The substitution effect leads to an increase in the quantity purchased, while the income effect leads to a decrease.

A is correct. In the case of normal goods, the income and substitution effects are reinforcing, leading to an increase in the amount purchased after a drop in price.

2. The demand for membership at a local health club is determined by the following equation: (Qdhm = 400 - 5Phm) where (Qdhm ) is the number of health club members and (Phm) is the price of membership. If the price of health club membership is $35, the price elasticity of demand is closest to: A. -0.778. B. -0.500. C. -0.438.

A is correct. Inserting the price of $35 into the demand function, quantity demanded is calculated as At a price of $35 per health club membership, the elasticity of demand is Price elasticity of demand = Price elasticity of demand = -5 × (35/225) = -0.778

14. Normal profit is best described as: A. zero economic profit. B. total revenue minus all explicit costs. C. the sum of accounting profit plus economic profit.

A is correct. Normal profit is the level of accounting profit such that implicit opportunity costs are just covered; thus, it is equal to a level of accounting profit such that economic profit is zero.

27. A company will shut down production in the short run if total revenue is less than total: A. fixed costs. B. variable costs. C. opportunity costs.

B is correct. A company will shut down production in the short run when total revenue is below total variable costs.

33. Diseconomies of scale most likely result from: A. specialization in the labor force. B. overlap of business functions and product lines. C. discounted prices on resources when buying in larger quantities.

B is correct. As the firm increases output, diseconomies of scale and higher average total costs can result when there is overlap and duplication of business functions and product lines.

32. A company is experiencing economies of scale when: A. cost per unit increases as output increases. B. it is operating at a point on the LRAC curve where the slope is negative. C. It is operating beyond the minimum point on the long-run average total cost curve.

B is correct. Economies of scale occur if, as the firm increases output, cost per unit of production falls. Graphically, this definition translates into a long-run average cost curve (LRAC) with a negative slope.

4. If the income elasticity of demand for a product is -0.6, a: A. 1% increase in income will result in a 0.6% increase in demand. B. 1% increase in income will result in a 0.6% decrease in demand. C. 0.6% increase in income will result in a 1% decrease in demand.

B is correct. Income elasticity is a measure of how sensitive quantity demanded is to a change in income. If the income elasticity of demand for the product is -0.6, whenever income increases by 1%, the quantity demanded of the product at each price decreases by 0.6%. Consequently, as income rises, consumers will purchase less of the product.

37. Refer to the data in Exhibit 2. The marginal product of labor demonstrates increasing returns for the firm if the number of workers is closest to but not more than: A. 2. B. 3. C. 4.

B is correct. Marginal product is equal to the change in total product divided by the change in labor. The increase in MP from 2 to 3 workers is 190: MP = ∆TP/∆L = (510 - 320)/(3 - 2) = 190/1 = 190.

3. Price elasticity of demand for a good will most likely be greater if: A. there are no substitutes for the good. B. consumers consider the good as discretionary. C. consumers spend a small portion of their budget on the good.

B is correct. Price elasticity of demand is likely to be greater for items that are seen as optional or discretionary.

5. An individual's demand for onions is given by the following equation: (Qdo = 3 − 0.05Po + 0.009I − 0.16Pt) where (Qdo) is the number of onions demanded, (Po) is the price per pound of onions, (I) is the household income, and (Pt) is the price per pound of tomatoes. If the price of onions is $1.25, household income is $2,500, and the price of tomatoes is $3.75, the cross-price elasticity of demand for onions with respect to the price of tomatoes is closest to: A. -1.0597. B. -0.0242. C. -0.0081.

B is correct. The cross-price elasticity of demand measures the responsiveness of the demand for onions in response to a change in the price of tomatoes. From the demand function equation: (Qdo) At a price of onions of $1.25 and a price of tomatoes of $3.75, the cross-price elasticity of demand is calculated as follows: Cross-price elasticity of demand =

6. Movement along the demand curve for good X occurs due to a change in: A. income. B. the price of good X. C. the price of a substitute for good X.

B is correct. The demand curve shows quantity demanded as a function of own price only.

29. When total revenue is greater than total variable costs but less than total costs, in the short term a firm will most likely: A. exit the market. B. stay in the market. C. shut down production.

B is correct. When total revenue is enough to cover variable costs but not total fixed costs in full, the firm can survive in the short run but would be unable to maintain financial solvency in the long run.

8. The market demand function for four-year private universities is given by the equation Qdpr = 84 - 3.1Ppr + 0.8I + 0.9Ppu where (Qdpr) is the number of applicants to private universities per year in thousands, Ppr is the average price of private universities (in thousands of USD), I is the household monthly income (in thousands of USD), and Ppu is the average price of public (government-supported) universities (in thousands of USD). Assume that Ppr is equal to 38, I is equal to 100, and Ppu is equal to 18. The price elasticity of demand for private universities is closest to: A. -3.1. B. -1.9. C. 0.6.

B is correct. From the demand function: Solve for (Qdpr)= At (Ppr) =

31. A firm that increases its quantity produced without any change in per-unit cost is experiencing: A. economies of scale. B. diseconomies of scale. C. constant returns to scale.

C is correct. Output increases in the same proportion as input increases occur at constant returns to scale.

28. A company has total variable costs of $4 million and fixed costs of $3 million. Based on this information, the company will stay in the market in the long term if total revenue is at least: A. $3.0 million. B. $4.5 million. C. $7.0 million.

C is correct. A company will stay in the market in the long term if total revenue is equal to or greater than total cost. Because total costs are $7 million ($4 million variable costs and $3 million fixed costs), the company will stay in the market in the long term if total revenue equals at least $7 million.

23. Refer to the data in Exhibit 1. The level of unit production resulting in the lowest average total cost (ATC) is closest to: A. 3. B. 4. C. 5.

C is correct. Average total cost is equal to total cost divided by quantity produced. At 5 units produced the average total cost is 104. ATC = TC/Q = 520/5 = 104.

22. Refer to the data in Exhibit 1. When the firm increases production from 4 to 5 units, the marginal cost (MC) is closest to: A. 40. B. 64. C. 80.

C is correct. Marginal cost is equal to the change in total cost divided by the change in quantity produced. MC = ∆TC/∆Q = 80/1 = 80.

34. A firm is operating beyond minimum efficient scale in a perfectly competitive industry. To maintain long-term viability the most likely course of action for the firm is to: A. operate at the current level of production. B. increase its level of production to gain economies of scale. C. decrease its level of production to the minimum point on the long-run average total cost curve.

C is correct. The firm operating at greater than long-run efficient scale is subject to diseconomies of scale. It should plan to decrease its level of production.

25. The short-term shutdown point of production for a firm operating under perfect competition will most likely occur when: A. price is equal to average total cost. B. marginal revenue is equal to marginal cost. C. marginal revenue is equal to average variable costs.

C is correct. The firm should shut down production when marginal revenue is less than average variable cost.

1. If the price elasticity coefficient of the demand curve for paper clips is equal to -1, demand is: A. elastic. B. inelastic. C. unit elastic.

C is correct. When the price elasticity of demand coefficient is -1, demand is said to be unit elastic, or unitary elastic.

11. If the cross-price elasticity between two goods is negative, the two goods are classified as: A. normal. B. substitutes. C. complements.

C is correct. With complements, consumption goes up or down together. With a negative cross-price elasticity, as the price of one good goes up, the demand for both falls.

9. The income elasticity of demand for private universities is closest to: A. 0.5. B. 0.8. C. 1.3.

C is correct. From the demand function: Solve for (Qdpr) = At I = 100, the income elasticity of demand =

Summary

This reading addressed several important concepts that extend the basic market model of demand and supply to assist the analyst in assessing a firm's breakeven and shutdown points of production. Demand concepts covered include own-price elasticity of demand, cross-price elasticity of demand, and income elasticity of demand. Supply concepts covered include total, average, and marginal product of labor; total, variable, and marginal cost of labor; and total and marginal revenue. These concepts are used to calculate the breakeven and shutdown points of production. Elasticity of demand is a measure of how sensitive quantity demanded is to changes in various variables. Own-price elasticity of demand is the ratio of percentage change in quantity demanded to percentage change in a good or service's own price. If own-price elasticity of demand is greater than one in absolute terms, demand is elastic and a decline in price will result in higher total expenditure on that good. If own-price elasticity of demand is less than one in absolute terms, demand is inelastic and a decline in price will result in a lower total expenditure on that good. If own-price elasticity of demand is equal to negative one, demand is unit, or unitary, elastic and total expenditure on that good is independent of price. Own-price elasticity of demand will almost always be negative. Income elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in consumer income. Demand is negatively sloped because of either the substitution effect or the income effect. The substitution effect is the phenomenon in which, as a good's price falls, more of this good is substituted for other, more expensive goods. The income effect is the phenomenon in which, as a good's price falls, real income rises and, if this good is normal, more of it will be purchased. If the good is inferior, the income effect will partially or fully offset the substitution effect. There are two exceptions to the law of demand: Giffen goods and Veblen goods. Giffen goods are highly inferior and make up a large portion of the consumer budget. As price falls, the substitution effect tends to cause more of the good to be consumed, but the highly negative income effect overwhelms the substitution effect. Demand curves for Giffen goods are positively sloped. Veblen goods are highly valued high-priced "status" goods; consumers may tend to buy more of a good if its price rises. If income elasticity of demand is positive, the good is a normal good. If income elasticity of demand is negative, the good is an inferior good. Cross-price elasticity of demand is the ratio of the percentage change in quantity demanded of one good to the percentage change in the price of a related good. If cross-price elasticity between two goods is positive, they are substitutes, and if cross-price elasticity between two goods is negative, they are complements. The law of demand states that a decrease in price will cause an increase in quantity demanded. Total product of labor is a short-run concept that is the total quantity that is able to be produced for each level of labor input, holding all other inputs constant. Average product of labor (APL) is the total product of labor divided by number of labor hours. Marginal product of labor (MPL) is the change in total product divided by the change in labor hours. MPL might rise as more labor is added to a fixed amount of capital. The law of diminishing returns dictates that additional output must fall as more and more labor is added to a fixed amount of capital. Production costs increase as input prices rise and fall as inputs become more productive. Short-run total cost (STC) is the total expenditure on fixed capital plus the total expenditure on labor. Short-run marginal cost (SMC) equals the ratio of wage to marginal product of labor (MPL). Average variable cost (AVC) is the ratio of wage to average product of labor (APL). Average total cost (ATC) is total cost (TC) divided by the number of units produced. Revenue is price times quantity sold. Marginal revenue (MR) is the ratio of change in revenue to change in output. Firms under conditions of perfect competition have no pricing power and, therefore, face a perfectly horizontal demand curve at the market price. For firms under conditions of perfect competition, price is identical to marginal revenue (MR). Firms under conditions of imperfect competition face a negatively sloped demand curve and have pricing power. For firms under conditions of imperfect competition, marginal revenue (MR) is less than price. Economic profit equals total revenue (TR) minus total economic cost, whereas accounting profit equals TR minus total accounting cost. Economic cost takes into account the total opportunity cost of all factors of production. Opportunity cost is the next best alternative forgone in making a decision. Maximum economic profit requires that (1) marginal revenue (MR) equals marginal cost (MC) and (2) MC not be falling with output. The breakeven point occurs when total revenue (TR) equals total cost (TC), otherwise stated as the output quantity at which average total cost (ATC) equals price. Shutdown occurs when a firm is better off not operating than continuing to operate. If all fixed costs are sunk costs, then shutdown occurs when the market price falls below minimum average variable cost. After shutdown, the firm incurs only fixed costs and loses less money than it would operating at a price that does not cover variable costs. In the short run, it may be rational for a firm to continue to operate while earning negative economic profit if some unavoidable fixed costs are covered. Economies of scale is defined as decreasing long-run cost per unit as output increases. Diseconomies of scale is defined as increasing long-run cost per unit as output increases. Long-run average total cost is the cost of production per unit of output under conditions in which all inputs are variable. Specialization efficiencies and bargaining power in input price can lead to economies of scale. Bureaucratic and communication breakdowns and bottlenecks that raise input prices can lead to diseconomies of scale. The minimum point on the long-run average total cost curve defines the minimum efficient scale for the firm.

19. An operator of a ski resort is considering offering price reductions on weekday ski passes. At the normal price of €50 per day, 300 customers are expected to buy passes each weekday. At a discounted price of €40 per day 450 customers are expected to buy passes each weekday. The marginal revenue per customer earned from offering the discounted price is closest to: A. €20. B. €40. C. €50.

A is correct. Marginal revenue per unit is defined as the change in total revenues divided by the change in quantity sold. MR = ∆TR ÷ ∆Q. In this case, change in total revenue per day equals €3,000 [(450 × €40) - (300 × €50)], and change in units sold equals 150 (450 - 300). €3,000 ÷ 150 = €20.

13. For a Giffen good, the: A. demand curve is positively sloped. B. substitution effect overwhelms the income effect. C. income and substitution effects are in the same direction.

A is correct. The income effect overwhelms the substitution effect such that an increase in the price of the good results in greater demand for the good, resulting in a positively sloped demand curve.

15. A company plans to hire additional factory employees. In the short run, marginal returns are most likely to decrease if: A. the factory is operating at full capacity. B. the factory is experiencing a labor shortage. C. workers are required to multitask and share duties.

A is correct. The law of diminishing returns occurs in the short run when additional output falls as more and more labor is added to a fixed amount of capital. When a factory is operating at full capacity, adding additional employees will not increase production because the physical plant is already 100% employed. More labor hours will add to costs without adding to output, thus resulting in diminishing marginal returns.

30. A profit maximum is least likely to occur when: A. average total cost is minimized. B. marginal revenue equals marginal cost. C. the difference between total revenue and total cost is maximized.

A is correct. The quantity at which average total cost is minimized does not necessarily correspond to a profit maximum.

7. A wireless phone manufacturer introduced a next-generation phone that received a high level of positive publicity. Despite running several high-speed production assembly lines, the manufacturer is still falling short in meeting demand for the phone nine months after introduction. Which of the following statements is the most plausible explanation for the demand/supply imbalance? A. The phone price is low relative to the equilibrium price. B. Competitors introduced next-generation phones at a similar price. C. Consumer incomes grew faster than the manufacturer anticipated.

A is correct. The situation described is one of excess demand because, in order for markets to clear at the given level of quantity supplied, the company would need to raise prices.

Exhibit 2: 36. Refer to the data in Exhibit 2. The number of workers resulting in the highest level of average product of labor is closest to: A. 3. B. 4. C. 5.

A is correct. Three workers produce the highest average product equal to 170. AP = 510/3 = 170.

20. The marginal revenue per unit sold for a firm doing business under conditions of perfect competition will most likely be: A. equal to average revenue. B. less than average revenue. C. greater than average revenue.

A is correct. Under perfect competition, a firm is a price taker at any quantity supplied to the market, and AR = MR = Price.

24. The short-term breakeven point of production for a firm operating under perfect competition will most likely occur when: A. price is equal to average total cost. B. marginal revenue is equal to marginal cost. C. marginal revenue is equal to average variable costs.

A is correct. Under perfect competition, price equals marginal revenue. A firm breaks even when marginal revenue equals average total cost.

10. The cross-price elasticity of demand for private universities with respect to the price of public universities is closest to: A. 0.3. B. 3.1. C. 3.9.

A is correct. From the demand function: Solve for (Qdpr) = At P = 38, and Ppu = 18, the cross-price elasticity of demand = = 0.3