Micro Test 2

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What's the user cost of capital?

User Cost of Capital = Economic Depreciation + (Interest Rate)*(Value of Capital)

diseconomies of scale

when a doubling of output requires more than twice the cost.

economies of scale

when a firm can double its output at less than twice the cost

marginal rate of technical substitution of labor for capital

is the amount by which the input of capital can be reduced when one extra unit of labor is used so that output remains constant.

Cost functions

relate the cost of production to the firm's level of output

A certain brand of vacuum cleaners can be purchased from several local stores as well as from several catalogues or websites. a. If all sellers charge the same price for the vacuum cleaner, will they all earn zero economic profit in the long run? If so, why do the sellers stay in the market? b. If all sellers charge the same price and one local seller owns the building in which he does business, paying no rent, is this seller earning a positive economic profit? c. Does the seller who pays no rent have an incentive to lower the price that he charges for the vacuum cleaner?

7. A certain brand of vacuum cleaners can be purchased from several local stores as well as from several catalogues or websites. a. If all sellers charge the same price for the vacuum cleaner, will they all earn zero economic profit in the long run? If so, why do the sellers stay in the market? Yes, all earn zero economic profit in the long run. If economic profit were greater than zero for, say, online sellers, then firms would enter the online industry and eventually drive economic profit for online sellers to zero. If economic profit were negative for catalogue sellers, some catalogue firms would exit the industry until economic profit returned to zero. So all must earn zero economic profit in the long run. Anything else will generate entry or exit until economic profit returns to zero. They stay in the market because the economic profit considers the opportunity cost of running the store. b. If all sellers charge the same price and one local seller owns the building in which he does business, paying no rent, is this seller earning a positive economic profit? No this seller would still earn zero economic profit. If he pays no rent then the accounting cost of using the building is zero, but there is still an opportunity cost, which represents the value of the building in its best alternative use. c. Does the seller who pays no rent have an incentive to lower the price that he charges for the vacuum cleaner? No he has no incentive to charge a lower price because he can sell as many units as he wants at the current market price. Lowering his price will only reduce his economic profit. Since all firms sell the identical good, they will all charge the same price for that good.

8. In DC, bars and restaurants who want to serve booze must first obtain a liquor license from the Alcohol Beverage Regulation Administration (ABRA). Suppose there are only a handful of restaurants have liquor licenses that allow them to sell alcohol. The number of liquor licenses is fixed. Among these restaurants, the average accounting profit is $60,000/year. a. What's the definition of economic rent? What's the economic rent for holding one liquor license? b. Do restaurants with liquor licenses make positive profit? If not, why?

8. a. Economic rent is what firms are willing to pay for an input less the minimum amount necessary to buy it. In this case, economic rent is $60,000. b. No, the restaurants with liquor licenses makes zero economic profit when considering the opportunity cost of holding the liquor license. Instead of selling alcohol, the restaurant could've rent out the license for $60,000/year.

A firm has a fixed production cost of $5000 and a constant marginal cost of production of $500 per unit produced. a. What is the firm's total cost function? Average cost? b. If the firm wanted to minimize the average total cost, would it choose to be very large or very small? Explain.

A firm has a fixed production cost of $5000 and a constant marginal cost of production of $500 per unit produced. a. What is the firm's total cost function? Average cost? The variable cost of producing an additional unit, marginal cost, is constant at $500, so , and . Fixed cost is $5000 and therefore average fixed cost is . The total cost function is fixed cost plus variable cost or TC 5000 500q. Average total cost is the sum of average variable cost and average fixed cost: . b. If the firm wanted to minimize the average total cost, would it choose to be very large or very small? Explain. The firm would choose to be very large because average total cost decreases as q is increased.As q becomes extremely large, ATC will equal approximately 500 because the average fixed cost becomes close to zero.

Consider a city that has a number of hot dog stands operating throughout the downtown area. Suppose that each vendor has a marginal cost of $1.50 per hot dog sold and no fixed cost. Suppose the maximum number of hot dogs that any one vendor can sell is 100 per day. a. If the price of a hot dog is $2, how may hot dogs does each vendor want to sell? Since marginal cost is equal to $1.50 and the price is $2, each hot dog vendor will want to sell as many hot dogs as possible, which is 100 per day. b. If the industry is perfectly competitive, will the price remain at $2 for a hot dog? If not, what will the price be? Each hot dog vendor is making a profit of $0.50 per hot dog at the current $2 price: a total profit of $50. Therefore, the price will not remain at $2, because these positive economic profits will encourage new vendors to enter the market. As new firms start selling hot dogs, market supply will increase and price will drop until economic profits are driven to zero. That will happen when price falls to $1.50, where price equals average cost. (Note that AC = MC = $1.50 for firms in this industry because fixed cost is zero and MC is constant at $1.50). c. If each vendor sells exactly 100 hot dogs a day and the demand for hot dogs from vendors in the city is Q = 4400 − 1200P, how many vendors are there? At the current price of $2, the total number of hot dogs demanded is Q = 4400 − 1200(2) = 2000, so there are 2000/100 = 20 vendors. In the long run, price will fall to $1.50, and the number of hot dogs demanded will increase to Q = 2600. If each vendor sells 100 hot dogs, there will be 26 vendors in the long run.

What is the difference between economic profit and producer surplus?

Economic profit is the difference between total revenue and total cost. Producer surplus is the difference between total revenue and total variable cost. So fixed cost is subtracted to find profit but not producer surplus, and thus profit equals producer surplus minus fixed cost (or producer surplus equals profit plus fixed cost).

What is the difference between economies of scale and return to scale? In real life, give an personal example of diseconomies of scale.

Economies of scale depend on the relationship between cost and output—that is, how does cost change when output is doubled? Returns to scale depend on what happens to output when all inputs are doubled. The difference is that economies of scale reflect input proportions that change optimally as output is increased, while returns to scale are based on fixed input proportions (such as two units of labor for every unit of capital) as output increases.

True or false: A firm should always produce at an output at which long-run average cost is minimized. Explain.

False. In the long run, under perfect competition, firms will produce where long-run average cost is minimized. In the short run, however, it may be optimal to produce at a different level. For example, if price is above the long-run equilibrium price, the firm will maximize short-run profit by producing a greater amount of output than the level at which LAC is minimized as illustrated in the diagram. PL is the long-run equilibrium price, and qL is the output level that minimizes LAC. If price increases to P in the short run, the firm maximizes profit by producing q′, which is greater than qL, because that is the output level at which SMC (short-run marginal cost) equals price.

For the graph below: question 8 homework 4 a. Find out at least two best combination of labor and capital. Ex: (L3, K1) b. What is the slope of isocost? What is the slope of isoquant? Do they equal to each other for the combinations you provided in part a? c. At point P, is the isoquant slope larger or smaller compared to the one for isocost? (Please take absolute value of the slopes.) d. Compare MPLw and MPKr. Which one is larger? What is the economic intuition behind it? e. If you can freely adjust capital and labor at point P, will you rent more or less capital?

For the graph below: a. Find out at least two best combination of labor and capital. Ex: (L3, K1) (L1, K1) and (L2, K2) b. What is the slope of isocost? What is the slope of isoquant? Do they equal to each other for the combinations you provided in part a? Slope of isocost = - w/r. The slope of isoquant = - MPL/MPK. They are equal to each other since they are tangent for those points. c. At point P, is the isoquant slope larger or smaller compared to the one for isocost? (Please take absolute value of the slopes.) The slope of isoquant is smaller. d. Compare MPLw and MPKr. Which one is larger? What is the economic intuition behind it? MPKr is larger. It means the last dollar spent on capital brings in more product than the labor. e. If you can freely adjust capital and labor at point P, will you rent more or less capital?

Give three examples of perfectly competitive market.

Rice. Apple Bananas

Suppose that a competitive firm's marginal cost of producing output q is given by MC(q) = 3 + 2q. Assume that the market price of the firm's product is $9. a. What level of output will the firm produce? b. What is the firm's producer surplus? c. Suppose that the average variable cost of the firm is given by AVC(q) = 3 + q. Suppose that the firm's fixed costs are known to be $3. Will the firm be earning a positive, negative, or zero profit in the short run?

Suppose that a competitive firm's marginal cost of producing output q is given by MC(q) = 3 + 2q. Assume that the market price of the firm's product is $9. a. What level of output will the firm produce? The firm should set the market price equal to marginal cost to maximize its profits: 9 = 3 + 2q, or q = 3. b. What is the firm's producer surplus? Producer surplus is equal to the area below the market price, that is, $9.00, and above the marginal cost curve, that is, 3 + 2q. Because MC is linear, producer surplus is a triangle with a base equal to 3 (since q = 3) and a height of $6 (9 − 3 = 6). The area of a triangle is (1/2) × (base) × (height). Therefore, producer surplus is (0.5)(3)(6) = $9. c. Suppose that the average variable cost of the firm is given by AVC(q) = 3 + q. Suppose that the firm's fixed costs are known to be $3. Will the firm be earning a positive, negative, or zero profit in the short run? Profit is equal to total revenue minus total cost. Total cost is equal to total variable cost plus fixed cost. Total variable cost is equal to AVC(q) × q. At q = 3, AVC(q) = 3 + 3 = 6, and therefore TVC = (6)(3) = $18. Fixed cost is equal to $3. Therefore, total cost equals TVC plus TFC, or C = $18 + 3 = $21. Total revenue is price times quantity: R = ($9)(3) = $27. Profit is total revenue minus total cost: π = $27 − 21 = $6. Therefore, the firm is earning positive economic profits. More easily, you might recall that profit equals producer surplus minus fixed cost. Since we found that producer surplus was $9 in part b, profit equals 9 − 3 or $6.

Suppose you are given the following information about a particular industry: Qd=6500-100P Market Demand Qs=1200P Market Supply C(q)=722+ (q^2/200) Firm total cost fuction MC(q)=2q/200 Assume that all firms are identical, and that the market is characterized by perfect competition. a. Find the equilibrium price, the equilibrium quantity, the output supplied by the firm, and the profit of each firm. b. Would you expect to see entry into or exit from the industry in the long run? Explain. What effect will entry or exit have on market equilibrium? c.What is the lowest price at which each firm would sell its output in the long run? Is profit positive, negative, or zero at this price? Explain. d. What is the lowest price at which each firm would sell its output in the short run? Is profit positive, negative, or zero at this price? Explain.

Suppose you are given the following information about a particular industry: Assume that all firms are identical, and that the market is characterized by perfect competition. a. Find the equilibrium price, the equilibrium quantity, the output supplied by the firm, and the profit of each firm. Equilibrium price and quantity are found by setting market demand equal to market supply: 6500 − 100P = 1200P. Solve to find P = $5 and substitute into either equation to find Q = 6000. To find the output for the firm set price equal to marginal cost: so q = 500. Profit is total revenue minus total cost or . Notice that since the total output in the market is 6000, and each firm's output is 500, there must be 6000/500 = 12 firms in the industry. b. Would you expect to see entry into or exit from the industry in the long run? Explain. What effect will entry or exit have on market equilibrium? We would expect entry because firms in the industry are making positive economic profits. As new firms enter, market supply will increase (that is, the market supply curve will shift down and to the right), which will cause the market equilibrium price to fall, all else the same. This, in turn, will reduce each firm's optimal output and profit. When profit falls to zero, no further entry will occur. c. What is the lowest price at which each firm would sell its output in the long run? Is profit positive, negative, or zero at this price? Explain. In the long run profit falls to zero, which means price falls to the minimum value of AC. To find the minimum average cost, set marginal cost equal to average cost and solve for q: Therefore, the firm will not sell for any price less than $3.80 in the long run. The long-run equilibrium price is therefore $3.80, and at a price of $3.80, each firm sells 380 units and earns an economic profit of zero because P = AC. d. What is the lowest price at which each firm would sell its output in the short run? Is profit positive, negative, or zero at this price? Explain. The firm will sell its output at any price above zero in the short run, because marginal cost is above average variable cost (MC = q/100 > AVC = q/200) for all positive prices. Profit is negative if price is just above zero.

Suppose you are the manager of a watchmaking firm operating in a competitive market. Your cost of production is given by C = 200 + 2q2, where q is the level of output and C is total cost. (The marginal cost of production is 4q; the fixed cost is $200.) a. If the price of watches is $100, how many watches should you produce to maximize profit? Profits are maximized where price equals marginal cost. Therefore, 100 = 4q, or q = 25. b. What will the profit level be? Profit is equal to total revenue minus total cost: π = Pq − (200 + 2q2). Thus, π = (100)(25) − (200 + 2(25)2) = $1050. c. At what minimum price will the firm produce a positive output? The firm will produce in the short run if its revenues are greater than its total variable costs. The firm's short-run supply curve is its MC curve above minimum AVC. Here, AVC = Also, MC = 4q. So, MC is greater than AVC for any quantity greater than 0. This means that the firm produces in the short run as long as price is positive.

Joe quits his computer programming job, where he was earning a salary of $50,000 per year, to start his own computer software business in a building that he owns and was previously renting out for $24,000 per year. In his first year of business he has the following expenses: salary paid to himself, $40,000; rent, $0; other expenses, $25,000. Find the accounting cost and the economic cost associated with Joe's computer software business.

The accounting cost includes only the explicit expenses, which are Joe's salary and his other expenses: $40,000 + 25,000 = $65,000. Economic cost includes these explicit expenses plus opportunity costs. Therefore, economic cost includes the $24,000 Joe gave up by not renting the building and an extra $10,000 because he paid himself a salary $10,000 below market ($50,000 − 40,000). Economic cost is then $40,000 + 25,000 + 24,000 + 10,000 = $99,000.

An increase in the demand for movies also increases the salaries of actors and actresses. Is the long-run supply curve for films likely to be horizontal or upward sloping? Explain.

The long-run supply curve depends on the cost structure of the industry. Assuming there is a relatively fixed supply of actors and actresses, as more films are produced, higher salaries must be offered. Therefore the industry experiences increasing costs. In an increasing-cost industry, the long-run supply curve is upward sloping. Thus the supply curve for films would be upward sloping.

What assumptions are necessary for a market to be perfectly competitive? In light of what you have learned in this chapter, why is each of these assumptions important?

The three primary assumptions of perfect competition are (1) all firms in the industry are price takers, (2) all firms produce identical products, and (3) there is free entry and exit of firms to and from the market. The first two assumptions are important because they imply that no firm has any market power and that each faces a horizontal demand curve. As a result, firms produce where price equals marginal cost, which defines their supply curves. With free entry and exit, positive (negative) economic profits encourage firms to enter (exit) the industry. Entry and exit affect industry supply and price. In the long run, entry or exit continues until price equals long-run average cost and firms earn zero economic profit

2. When it comes to making business decisions, there are many types of costs including accounting cost, economic cost, opportunity cost, variable cost, fixed cost, and sunk cost. a. In the short run, what costs do you care? b. In the long run, what costs do you care?

When it comes to making business decisions, there are many types of costs including accounting cost, economic cost, opportunity cost, variable cost, fixed cost, and sunk cost. a. In the short run, what costs do you care? Everything except fixed cost and sunk cost. b. In the long run, what costs do you care? Everything except sunk cost.

isoquant

a curve that shows all combinations of inputs that yield a given level of output.

Isoquants always slope

downward because the marginal product of all inputs is positive.

Suppose the market for widgets can be described by the following equations: Demand: P = 10 - Q Supply: P = Q - 4 where P is the price in dollars per unit and Q is the quantity in thousands of units. Then: a. What is the equilibrium price and quantity? b. Suppose the government imposes a tax of $1 per unit to reduce widget consumption and raise government revenues. What will the new equilibrium quantity be? What price will the buyer pay? What amount per unit will the seller receive? c.Suppose the government has a change of heart about the importance of widgets to the happiness of the American public. The tax is removed and a subsidy of $1 per unit granted to widget producers. What will the equilibrium quantity be? What price will the buyer pay? What amount per unit (including the subsidy) will the seller receive? What will be the total cost to the government?

see answer key http://www.kimoon.co.kr/mi/pindyck-8/im/Ch09.pdf

expansion path

shows how its cost-minimizing input choices vary as the scale or output of its operation increases. As a result, the expansion path provides useful information relevant for long-run planning decisions.

Micro Test 2

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