REVIEW QUESTIONS

1. What is the difference between accounting profit and economic profit? How could a firm earn
positive accounting profit but negative economic profit?
2. Why is the marginal revenue of a perfectly competitive firm equal to the market price?
3. Would a perfectly competitive firm produce if price were less than the minimum level of average
variable cost? Would it produce if price were less than the minimum level of short-run average cost?
4. What is the shutdown price when all fixed costs are sunk? What is the shutdown price when all
fixed costs are nonsunk?
5. How does the price elasticity of supply affect changes in the short-run equilibrium price that results
from an exogenous shift in the market demand curve?
6. Consider two perfectly competitive industries— Industry 1 and Industry 2. Each faces identical
demand and cost conditions except that the minimum efficient scale output in Industry 1 is twice that
of Industry 2. In a long-run perfectly competitive equilibrium, which industry will have more firms?
7. What is economic rent? How does it differ from economic profit?
8. What is the producer surplus for an individual firm? What is the producer surplus for a market when
the number of firms in the industry is fixed and input prices do not vary as industry output changes?
When is producer surplus equal to economic profit (for either a firm or an industry)? When producer
surplus and economic profit are not equal, which is bigger?
9. In the long-run equilibrium in an increasing-cost industry, each firm earns zero economic profits.
Yet there is a positive area between the long-run industry supply curve and the long-run equilibrium
price. What does this area represent?
10. Explain the difference between the following concepts: producer surplus, economic profit, and
economic rent.
PROBLEMS
Exercises.1:
The annual accounting statement of revenues and costs for a local flower shop shows the following:
Revenues $250,000
Supplies $ 25,000
Employee salaries $170,000
If the owners of the firm closed its operations, they could rent out the land for $100,000. They would
then avoid incurring any of the expenses for employees and supplies. Calculate the shop’s accounting
profit and its economic profit. Would the owners be better off operating the shop or shutting it down?
Explain.
9.2. Last year, the accounting ledger for an owner of a small drug store showed the following
information about her annual receipts and expenditures (she lives in a taxfree country, so don’t worry
about taxes):
Revenues $1,000,000
Wages paid to hired labor $ 300,000 (other than herself)
Utilities (fuel, telephone, water) $ 20,000
Purchases of drugs and other supplies $ 500,000 for the store
Wages paid to herself $ 100,000
She pays a competitive wage rate to her workers, and the utilities and drugs and other supplies are all
obtained at market prices. She already owns the building, so she pays no money for its use. If she were
to close the business, she could avoid all of her expenses and, of course, would have no revenue.
However, she could rent out her building for $200,000. She could also work elsewhere herself. Her
two employment alternatives include working as a lawyer, earning wages of $100,000, or working at a
local restaurant, earning $20,000. Determine her accounting profit and her economic profit if she stays
in the drug store business. If the two are different, explain the difference.
9.3. A firm sells a product in a perfectly competitive market, at a price of $50. The firm has a fixed
cost of $30. Fill in the following table and indicate the level of output that maximizes profit. How
would the profit-maximizing choice of output change if the fixed cost increased from $40 to $60?
More generally, explain how the level of fixed cost affects the choice of output.

Output (units) Total revenue Total cost Profit ($) Marginal Marginal cost
($/unit) ($/unit) revenue ($/unit)
($/unit)
0 0
1 50
2 20
3 30
4 42
5 54
6 70

9.4. A firm can sell its product at a price of $150 in a perfectly competitive market. Below is an
incomplete table of a firm’s various costs of producing up to 6 units of output. Fill in the remaining
cells of the table, and then calculate the profit the firm earns when it maximizes profit.

Q TC TVC AFC AC MC AVC

1 200
2 100
3 20
4 240
5 24
6 660 160

9.5. A competitive, profit-maximizing firm operates at a point where its short-run average cost curve is
upward sloping. What does this imply about the firm’s economic profits? Briefly explain.
9.6. A bicycle-repair shop charges the competitive market price of $10 per bike repaired. The firm’s
short run total cost is given by STC(Q) = Q2/2, and the associated marginal cost curve is SMC(Q)= Q.
a) What quantity should the firm produce if it wants to maximize its profit?
b) Draw the shop’s total revenue and total cost curves, and graph the total profit function on the same
diagram. Using your graph, state (approximately) the profit-maximizing quantity in each case.
9.7. A producer operating in a perfectly competitive market has chosen his output level to maximize
profit. At that output, his revenue and costs are as follows:
Revenue $200
Variable costs $120
Sunk fixed costs $60
Nonsunk fixed costs $40
Calculate his producer surplus and his profits. Which (if either) of these should he use to determine
whether he should exit the market in the short run? Briefly explain.
9.8. Dave’s Fresh Catfish is a northern Mississippi farm that operates in the perfectly competitive
catfish farming industry. Dave’s short-run total cost curve is STC(Q) = 400 + 2Q + 0.5Q2, where Q is
the number of catfish harvested per month. The corresponding short-run marginal cost curve is
SMC(Q)= 2 + Q. All of the fixed costs are sunk.
a) What is the equation for the average variable cost (AVC)?
b) What is the minimum level of average variable costs?
c) What is Dave’s short-run supply curve?
9.9. Ron’s Window Washing Service is a small business that operates in the perfectly competitive
residential window washing industry in Evanston, Illinois. The short-run total cost of production is
STC(Q) = 40 + 10Q + 0.1Q2, where Q is the number of windows washed per day. The corresponding
short-run marginal cost function is SMC(Q) = 10 + 0.2Q. The prevailing market price is $20 per
window.
a) How many windows should Ron wash to maximize profit?
b) What is Ron’s maximum daily profit?
c) Graph SMC, SAC, and the profit-maximizing quantity. On this graph, indicate the maximum daily
profit.
d) What is Ron’s short-run supply curve, assuming that all of the $40 per day fixed costs are sunk?
e) What is Ron’s short-run supply curve, assuming that if he produces zero output, he can rent or sell
his fixed assets and therefore avoid all his fixed costs?
9.10 The bolt-making industry currently consists of 20 producers, all of whom operate with the
identical short-run total cost curve STC (Q) = 16 + Q2, where Q is the annual output of a firm. The
corresponding short-run marginal cost curve is SMC (Q) = 2Q. The market demand curve for bolts is
D(P)=110- P, where P is the market price.
a) Assuming that all of each firm’s $16 fixed cost is sunk, what is a firm’s short-run supply curve?
b) What is the short-run market supply curve?
c) Determine the short-run equilibrium price and quantity in this industry
9.11. Newsprint (the paper used for newspapers) is produced in a perfectly competitive market. Each
identi- cal firm has a total variable cost TVC (Q) = 40Q + 0.5Q2, with an associated marginal cost
curve SMC(Q)= 40 + Q. A firm’s fixed cost is entirely nonsunk and equal to 50.
a) Calculate the price below which the firm will not produce any output in the short run.
b) Assume that there are 12 identical firms in this industry. Currently, the market demand for
newsprint is D (P) = 360-2P, where D (P) is the quantity consumed in the market when the price is P.
What is the short-run equilibrium price?
9.12. The oil drilling industry consists of 60 producers, all of whom have an identical short-run total
cost curve, STC (Q) = 64 + 2Q2, where Q is the monthly output of a firm and $64 is the monthly fixed
cost. The corresponding short-run marginal cost curve is SMC (Q) = 4Q. Assume that $32 of the
firm’s monthly $64 fixed cost can be avoided if the firm produces zero output in a month. The market
demand curve for oil drilling services is D(P ) = 400- 5P, where D(P ) is monthly demand at
price P. Find the market supply curve in this market, and determine the short-run equilibrium price.
9.13. There are currently 10 identical firms in the perfectly competitive gadget manufacturing
industry. Each firm operates in the short run with a total fixed cost of F and total variable cost of 2Q2,
where Q is the number of gadgets produced by each firm. The marginal cost for each firm is MC=
4Q. Each firm also has nonsunk fixed costs of 128. Each firm would just break even (earn zero
economic profit) if the market price were 40. (Note: The equilibrium price is not necessarily 40 when
there are 10 firms in the market.) The market demand for gadgets is QM = 180- 2.5P, where QM is the
amount purchased in the entire market.
a) How large are the total fixed costs for each firm? Explain.
b) What would be the shutdown price for each firm? Explain.
c) Draw a graph of the short-run supply schedule for this firm. Label it clearly.
d) What is the equilibrium price when there are 10 firms currently in the market?
e) With the cost structure assumed for each firm in this problem, how many firms would be in the
market at an equilibrium in which every firm’s economic profits are zero?
9.14. A perfectly competitive industry consists of two types of firms: 100 firms of type A and 30 firms
of type B. Each type A firm has a short-run supply curve SA(P)=2P. Each type B firm has a short-run
supply curve SB(P )=10P. The market demand curve is D(P) = 5000-500P. What is the short-run
equilibrium price in this market? At this price, how much does each type A firm produce, and how
much does each type B firm produce?
9.15. A market contains a group of identical price-taking firms. Each firm has a marginal cost curve
SMC (Q) = 2Q, where Q is the annual output of each firm. A study reveals that each firm will produce
if the price exceeds $20 per unit and will shut down if the price is less than $20 per unit. The market
demand curve for the industry is D(P)=240- P/2, where P is the market price. At the equilibrium
market price, each firm produces 20 units. What is the equilibrium market price, and how many firms
are in this industry?
9.16. The wood-pallet market contains many identical firms, each with the short-run total cost
function STC(Q)= 400+5Q+ Q2, where Q is the firm’s annual output (and all of the firm’s $400 fixed
cost is sunk). The corresponding marginal cost function is SMC (Q) = 5+2Q. The market demand
curve for this industry is D(P )=262.5-P/2, where P is the market price. Each firm in the industry is
currently earning zero economic profit. How many firms are in this industry, and what is the market
equilibrium price?
9.17. Suppose a competitive, profit-maximizing firm operates at a point where its short-run average
cost curve is upward sloping. What does this imply about the firm’s economic profits? If the profit-
maximizing firm operates at a point where its short-run average cost curve is down- ward sloping,
what does this imply about the firm’s economic profits?
9.18. A firm in a competitive industry produces its output in two plants. Its total cost of producing
Q1 units from the first plant is TC1 = (Q1)2, and the marginal cost at this plant is MC1 = 2Q1. The
firm’s total cost of producing Q2 units from the second plant is TC2 = 2(Q2)2; the marginal cost at this
plant is MC2 =4Q2. The price in the market is P. What fraction of the firm’s total supply will be
produced at plant 2?
9.19 A competitive industry consists of six type A firms and four type B firms. Each firm of type
A operates with the supply curve

Each firm of type B operates with the supply curve

a) Suppose the market demand is , at the market equilibrium, which firms are
producing, and what is the equilibrium price?

b) Suppose the market demand is , At the market equilibrium, which firms are
producing, and what is the equilibrium price?
9.20. A firm’s short-run supply curve is given by

What is the equation of the firm’s marginal cost curve SMC (Q)?

9.21. Consider a point on a supply curve where price and quantity are positive. Determine the
numerical value of the price elasticity of supply at that point when the supply curve is
a) Vertical at a positive quantity b) horizontal at a positive price
c) A straight line through the origin, with a positive slope
9.22. During the week of February 9–15, 2001, the U.S. rose market cleared at a price of $1.00 per
stem, and 4 mil- lion stems were sold that week. During the week of June 5–11, 2001, the U.S. rose
market cleared at a price of $0.20 per stem, and 3.8 million stems were sold that week. From this
information, what would you conclude about the price elasticity of supply in the U.S. rose market?
9.23. The global cobalt mining industry is perfectly competitive. Each existing firm and every
potential entrant faces an identical U-shaped average cost curve. The minimum level of average cost is
$5 per ton and occurs when a firm produces 2 million tons of cobalt per year. The market demand
curve for cobalt is D(P)= 205-P, where D (P ) is the demand for cobalt in millions of tons per year
when the market price is P dollars per ton. What is the long-run equilibrium price for cobalt? How
much cobalt does each producer make at this equilibrium price? How many active cobalt producers
will be in the market?
9.24. The global propylene industry is perfectly competitive, and each producer has the long-run
marginal cost function MC (Q) = 40- 12Q+ Q2. The corresponding long-run average cost function is
AC (Q) = 40-6Q+Q2/3. The market demand curve for propylene is D(P) =2200-100P. What is the
long-run equilibrium price in this industry, and at this price, how much would an individual firm
produce? How many active producers are in the propylene market in a long run competitive
equilibrium?
9.25. The raspberry growing industry in the United States is perfectly competitive, and each
producer has a long-run marginal cost curve given by MC(Q)= 20 + 2Q. The corresponding
long-run average cost function is given by AC (Q) = 20 +Q+ . The market demand curve is D (P)
= 2,488 -2P. What is the long-run equilibrium price in this industry, and at this price, how much
would an individual firm produce? How many active producers are in the raspberry growing industry
in a long-run competitive equilibrium?
9.26. Suppose that the world market for calcium is perfectly competitive and that, as a first
approximation, all existing producers and potential entrants are identical. Consider the following
information about the price of calcium:
• Between 1990 and 1995, the market price was stable at about $2 per pound.
• In the first three months of 1996, the market price doubled, reaching a high of $4 per pound, where
it remained for the rest of 1996.
• Throughout 1997 and 1998, the market price of calcium declined, eventually reaching $2 per
pound by the end of 1998.
• Between 1998 and 2002, the market price was stable at about $2 per pound.
Assuming that the technology for producing calcium did not change between 1990 and 2002 and that
input prices faced by calcium producers have remained constant, what explains the pattern of prices
that prevailed between 1990 and 2002? Is it likely that there are more producers of calcium in 2002
than there were in 1990? Fewer? The same number? Explain your answer.

9.27. It is 2017, and you work for a prestigious management consultant firm whose client is a large
agribusiness company that is considering acquiring an ownership stake in several U.S. Yellow perch
farming operations. (The yellow perch is a fresh fish found in the United States and raised
commercially for sale as food.) As a member of the consulting team working on this project, you
have been assigned the task of understanding why the U.S. farm-raised perch industry has evolved as
it has over the last six years.
Between 2010 and 2013, the farm-raised yellow perch market was stable. However, in
2013 an unexpected exogenous shock occurred that affected prices and quantities in the
market. You don’t know much about the details of the industry, and since the industry is not covered
extensively in the press, it is hard to find articles on the Web about what happened to the industry.
From talking to the client, you learn that the shock might have had something to do with either a
change in the market demand for yellow perch or a change in the price of corn (which affects the
price of perch feed). But you do not know for sure, nor do you know whether the shock was a
permanent change or merely a temporary one. However, you do have data (obtained from the
client), shown in the accompanying table, on yellow perch prices, market demand, quantity
supplied, and the number of producers. The data pertain to 2010–2013, 2014 (within one year of the
shock), and 2016 (three years after the shock). You also know (from the client) that yellow perch
farms are virtually identical, with U-shaped long-run average cost curves. You also learn from the
client that the minimum efficient scale of a typical yellow perch farm occurs at a rate of production of
about 1,000 pounds per month (and this is unaffected by changes in the prices of key inputs such as
feed or labour).
a) Based on the data in the table, what type of shock most likely explains the evolution of
the yellow perch farming industry from 2010–2013 to 2016?
2010–2013 2014: within 6 months 2016: 3 years after
of the shock shock
Market price of yellow $3.00 per pound $4.00 per pound $3.00 per pound
perch
Total quantity yellow 100,000 pounds per 120,000 pounds per 150,000 pounds
perch demanded in the month month
United States
Quantity of yellow perch 1,000 pounds per 1,200 pounds per 1,000 pounds per
supplied by a typical month month month
yellow perch farm
Number of active 100 100 150
yellow perch farms
b) How would your answer change if the number of active yellow perch farms in 2016 was 100?
c) How would your answer change if the data in the table looked like this?

2010–2013 2014: within 6 months 2016: 3 years after

of the shock shock
Market price of yellow $3.00 per pound $3.50 per pound $3.00 per pound
perch
Total quantity yellow 100,000 pounds per 90,000 pounds per 80,000 pounds
perch demanded in the month month
United States
Quantity of yellow perch 1,000 pounds per 900 pounds per 1,000 pounds per
supplied by a typical month month month
yellow perch farm
Number of active 100 100 150
yellow perch farms

9.28. The long-run total cost function for producers of mineral water is TC (Q) = cQ, where Q is the
output of an individual firm expressed as thousands of litters per year. The market demand curve is
D (P)= a-bP. Find the long-run equilibrium price and quantity in terms of a, b, and c. Can you
determine the equilibrium number of firms? If so, what is it? If not, why not?
9.29. Support or refute the following: ―In the long run the firm’s producer surplus and profits will be
equal.‖
9.30. Each firm in the perfectly competitive widget industry produces with the levels of marginal
cost (MC) and total variable cost (TVC) at various levels of output Q shown in the following table.
Each firm has a total fixed cost of 64 and a sunk fixed cost of 48.

Q 1 2 3 4 5 6 7 8 9 10 11 12

MC 4 6 8 10 12 14 16 18 20 22 24 26

TVC 3 8 15 24 35 48 63 80 99 120 143 168

a) Draw a clearly labelled graph of the short-run supply schedule for this firm. Be sure to indicate the
shutdown price for each firm and to explain your reasoning for the shape of the supply curve.
b) What is each firm’s producer surplus when the market price is 16?
c) What is the breakeven price for each firm?
9.31. In a constant-cost industry in which firms have U-shaped average cost curves, the long-run
market supply curve is a horizontal line. This market supply curve is not the horizontal sum of
individual firms’ long-run supply curves. In this respect, the long-run market supply curve differs from
the short-run market supply curve, which, in a constant-cost industry, will equal the horizontal sum of
individual firms’ short-run supply curves. Why does the derivation of the long-run market supply
curve differ from the derivation of the short-run market supply curve?

9.32. The long-run average cost for production of hard-disk drives is given by
where Q is the annual output of a firm, w is the wage rate for
skilled assembly labour, and r is the price of capital services. The corresponding long-run marginal
cost curve is the demand for labour for an individual firm is

The price of capital services is fixed at r=1.

a) In a long-run competitive equilibrium, how much outputs will each firm produce?
b) In a long-run competitive equilibrium, what will be the market price? Note that your answer will be
expressed as a function of w.
c) In a long-run competitive equilibrium, how much skilled labours will each firm demand? Again,
your answer will be in terms of w.
d) Suppose that the market demand curve is given by D (P) =10,000/P. What is the market
equilibrium quantity as a function of w?
e) What is the long-run equilibrium number of firms as a function of w?
f ) Using your answers to parts (c) and (e), determine the overall demand for skilled labour in this
industry as a function of w.
g) Suppose that the supply curve for the skilled labour used in this industry is f (w) =50w. At what
value of w does the supply of skilled labour equal the demand for skilled labour?
h) Using your answer from part (g), go back through parts (b), (d), and (e) to determine the long-run
equilibrium price, market demand, and number of firms in this industry.
i) Repeat the analysis in this problem, now assuming that the market demand curve is given by D(P)=
20,000/P.
9.33. A price-taking firm’s supply curve is s(P) =10P. What is the producer surplus for this firm if
the market price is $20? By how much does producer surplus change when the market price increases
from $20 to $21?
9.34. The semiconductor market consists of 100 identical firms, each with a short-run
marginal cost curve SMC(Q)= 4Q. The equilibrium price in the market is $200. Assuming that all
of the firm’s fixed costs are sunk, what is the producer surplus of an individual firm and what is the
overall producer surplus for the market?
9.35. Consider an industry in which chief executive officers (CEOs) run firms. There are two types
of CEOs: exceptional and average. There is a fixed supply of 100 exceptional CEOs and an unlimited
supply of average CEOs. Any individual capable of being a CEO in this industry is willing to work
for a salary of $144,000 per year. The long-run total cost of a firm that hires an exceptional CEO at
this salary is
Where Q is annual output in thousands of units and total cost is expressed in thousands of dollars per
year.

The corresponding long-run marginal cost curve is , where marginal cost is expressed
as dollars per unit. The long-run total cost for a firm that hires an average CEO for $144,000 per year
is . The corresponding marginal cost curve is . The market
demand curve in this market is D (P) = 7,200-100P, where P is the market price and D (P) is the
market quantity, expressed in thousands of units per year.
a) What is the minimum efficient scale for a firm run by an average CEO? What is the minimum level
of long- run average cost for such a firm?
b) What is the long-run equilibrium price in this industry, assuming that it consists of firms with both
exceptional and average CEOs?
c) At this price, how much output will a firm with an average CEO produce? How much outputs will
a firm with an exceptional CEO produce?
d) At this price, how much output will be demanded?
e) Using your answers to parts (c) and (d), determine how many firms with average CEOs will be in
this industry at a long-run equilibrium.
f ) What is the economic rent attributable to an exceptional CEO?
g) If firms with exceptional CEOs hire them at the reservation wage of $144,000 per year, how much
economic profit do these firms make?
h) Assuming that firms bid against each other for the ser- vices of exceptional CEOs, what would you
expect their salaries to be in a long-run competitive equilibrium?