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Practice Problem Answers.
y
A.
y
B.
y
C.
2
1
1
1
2
2
x
D.
x
x
E. y
y
2
2
1
1
x
x
1. Consider the graphs above where “1” represents the first budget line and “2” represents how the
budget line would change as a result of a change in price or income.
a.)
b.)
c.)
d.)
e.)
Which graph represents what would happen if the price of X were to increase? B
Which graph represents what would happen if income were to decrease? D
Which graph represents what would happen if the price of X were to decrease? A
Which graph represents what would happen if the price of Y were to decrease? E
Which graph represents what would happen if income were to increase? C
2. Assume at the current level of consumption Joe’s Marginal Utility of X is 50 utils and his marginal
utility of Y is 20 utils. The price of X is $10 and the price of Y is $5. In order to maximize utility,
what will Joe purchase next?
The Marginal Utility/dollar of X is 5 (50/$10) and the Marginal Utility/dollar of Y is 4 (20/$5) so he will purchase
X.
Quantity
0
1
2
3
4
Total Utility
0
30
44
49
48
3. Refer to the table above. Marginal utility begins to decline when this individual consumes the
2nd quantity.
4. A utility maximizing consumer purchases 8 units of good A and 2 units of good B each week. What
do we know must be true of the 8th unit of good A compared to the 3rd unit of good B?
We know that the marginal utility per dollar received from the 8th unit of good A must be greater than the
marginal utility per dollar that s/he would receive from the 3rd unit of good B.
5. Total utility is maximized generally when a consumer’s marginal utility per dollar (MU/Price) is
equalized for the last unit of each good he or she buys.
6. Harry spends all his income ice cream and snicker bars. The price of ice cream is $5/quart and the price
of a snickers bar is $1. Harry has $20 to spend on the two goods. Note, we’re starting at the 9th snickers
bar, which means he has already purchased the first 8 snickers bars.
Harry's preferences for ice cream and snickers bars are as stated in the table below.
Q ice
cream
Utility ice MU ice
cream
cream
MU/$
Q
snickers
bars
9
10
11
12
13
MU
snickers
bars
14
10
8
6
4
MU/$
1
60
60
12
14
2
110
50
10
10
3
150
40
8
8
4
180
30
6
6
5
200
20
4
4
6a. Fill in the blanks in the table above
6b. In order to maximize utility given the prices and income above, Harry will buy 2 quarts of ice cream
and 10 snicker bars.
7. How is productivity measured and what does it mean to become more productive?
It is measured as output per unit of input (so labor productivity is given by Q / L). To become more
productive means to produce more per unit of input (so for labor productivity Q increases or L decreases,
other things constant).
8. What is the distinction between short-run and long-run production decisions?
In the short run at least one input is fixed. In the long run all inputs are variable.
9. Use the following production table to answer questions.
Labor
Output(Q)
0
0
1
10
2
22
3
30
4
38
5
40
6
41
9a. What is the marginal productivity of the second worker? 12
9b. Marginal productivity begins to decline when the firm hires the 3rd worker.
9c. Marginal costs begin to rise with the firm hires the 3rd worker.
10. Explain the law of diminishing marginal returns and how it relates to marginal costs.
Additional output received from additional inputs will eventually decline in the short run as more of an input is
employed. As marginal productivity declines, marginal costs rise (and vice versa).
11. Suppose at the current level of production average total costs=$300 and average variable costs=$250.
If marginal costs associated with the next units are $275, what will happen to average total costs and
average variable costs if they expand production?
Average total costs will fall (because marginal costs are below average total costs), and average variable
costs will rise (because marginal costs are above average variable costs).
12. Use the following production/cost table to answer the following questions.
Labor
Output(Q)
Fixed Costs Variable Costs Total Costs Marginal Costs
0
0
400
0
400
1
10
400
50
450
50/10=$5
2
22
400
100
500
50/12=$4.17
3
30
400
150
550
50/8=$6.25
4
38
400
200
600
50/8=$6.25
5
40
400
250
650
50/2=$25
6
41
400
300
700
50/1=$50
15a. Fill in the blanks in the table above.
15b. If this firm sells all its output at a constant price of $25, what is the profit maximizing Q? P=MC at
Q=40.
15c. What do their profits equal?
TR=P*Q – TC = $25*40 - $650 = $1,000 - $650 = $350
13a. It costs a firm $50 to produce an additional unit of their product. If they can sell the product for $50,
what would happen to their profits if they produce it?
If their MR=$50 and MC=$50, their profit would not change if they produce an additional unit.
13b. What will happen to their profit if they can sell it for $40 and their costs equal $50?
If their MR=$40 and their MC=$50 their profit would decrease by $10 if they produce an additional unit (so
they will not produce the additional unit).
13b. What will happen to their profit if they can sell it for $50 and their costs equal $30?
If their MR=$50 and their MC=$30 their profit would increase by $20 if they produce an additional unit (so
they will produce the additional unit).
14. Suppose a firm announces that they are investing $10 million in their facility in order to expand production.
What do we know must be true in order for this firm to be willing to make this investment?
We know the firm will only do it they expect it to be profitable. It will only be profitable if they receive at least
an additional $10 million in revenue as a result.
15. A firm knows it can make an additional $800 in revenue if it produces one more unit. Their current average
total costs equal $700. What happens to their profits if they produce the additional unit.
We don’t know (it’s indeterminate). You need information on marginal costs, not average costs to figure
out what will happen to profit.
16. Suppose a Firm A has half of the fixed costs as firm B, but the same total revenue and variable costs
for all quantities. What does this mean as far as the profit maximizing quantity of the 2 firms (will Firm
A’s be greater than, less than, or equal to Firm B’s?). What does this mean as far as the profit of the two
firms?
Fixed costs don’t matter in how much a firm produces, so Firm A and Firm B will produce the same
quantity. However, fixed costs do matter in how profitable a company is (because they are part of total
costs), so Firm A, which has a lower total cost, will have a higher profit than Firm B.
17. What are the three characteristics of perfectly competitive markets?
There are very many firms (so many no single firm can influence the market price).
All firms produce the same thing (a standardized product).
There are low barriers to entry and exit.
18. The demand curve in a perfectly competitive market is downward sloping. The demand curve of a
perfectly competitive firm is horizontal (equal to the market price).
19. Use the following diagram representing to answer the following questions
P
MC
ATC
AVC
20
d=MR
15
14
6
400
450
600
800
Q
a. What is the profit maximizing quantity? 600
b. What does profit equal at the profit maximizing Q? ($20 - $15)*600=3,000
c. What is the shutdown price? $6 (minimum of AVC)
d. At what price would profits equal zero? $14 (minimum of ATC)
e. If price changes from $20 to $14, what happens to this firm’s output? Output would decrease from 600 to
450.
Cost
marginal
cost
$70.00
E
$60.00
D
$50.00
C
$40.00
B
$30.00
A
$20.00
$10.00
$0.00
0
45
55
65
75
85
Quantity
20. Refer to the graph above. If the market price increases from $50 per unit to $60 per unit, how will a
profit-maximizing perfectly competitive firm change their output?
They will increase production from 65 to 75.
21. Refer to the graph above. If the market price equals $60, what will this firm’s revenue equal? What
will their profits equal?
Their revenue will equal $60*75=$4500. We can’t calculate their profits however because we’re not told
or shown their average total cost.
22. Suppose a firm is earning negative profit, but is continuing to operate. What do we know must be
true of TC compared to TR, and VC compared to TR? What do we know must be true of ATC compared
to P, and AVC compared to P?
Because profit is negative, we know that TR<TC. Because they are still operating we know that TR>VC.
Similarly, we know that AVC<P<ATC.
23. Suppose a barber shop has fixed cost equal to $1,000/month and total costs equal to $5000/month.
This shop will continue to operate in the short run as long its total revenue is greater than $4,000 (their
variable costs)?
24. What was Adam Smith talking about when he used the analogy of an “invisible hand” leading us and
allocating resources in society?
He was talking about prices and profits provide a signal and incentive to producers. When prices
increase (ie. if demand increases), more profit can be made, so more of it will it be produced. When
prices decrease (ie. if demand decreases), less profit can be made, so less of it will be produced.
25. Give the formulas for economic and accounting profit. Why can economic profits never be below
accounting profit?
Accounting profit = Total revenue – explicit costs
Economic profit = Total revenue – explicit costs – implicit costs
Economic profit must always be below (there was a typo on the original question) accounting profit because it is
equal to accounting profit – implicit costs, and implicit costs can never be negative.
26. If total revenue=$3,000, explicit costs=$2,000, and implicit costs=$1,200, what is this firms economic and
accounting profit?
Acct. profit=$1,000; Economic profit= -$200
27. What does it mean when economic profits are negative for a firm (mathematically and intuitively)?
Mathematically it means that (explicit + implicit costs) > total revenue.
Intuitively it indicates that the firm would be able toearn more if they devoted their resources toward their next
best alternative.
28. A firm’s accounting profit is $20,000, economic profit is $5,000, and total revenue equals $100,000.
What do their explicit costs and what implicit costs equal?
It means their total revenue is $20,000 greater than their explicit costs, so their explicit costs equal
$80,000. Because economic profit equals accounting profit minus implicit costs, their implicit costs must
equal $15,000.
29. Draw the MR, MC, ATC curves for a perfectly competitive firm that is earning zero profit.
P
ATC
MC
d=MR
Q
30. Explain the sequence of events that will occur when firms are earning economic profits in a perfectly
competitive industry by filling in the blanks below:
1. Firms enter the industry; 2. Market supply shifts right;
3. Equilibrium price decreases. ; 4. Firms’ marginal revenue decreases;
5. Firms’ profits decrease to zero.
31. Suppose farmers suddenly can earn considerably more per acre from growing wheat than from
growing potatoes. What can we expect will happen in the long run as far as number of farmers in each
industry and the prices of each good?
Some farmers will switch from growing potatoes to growing wheat causing the price of wheat to fall and
the price of potatoes to rise.
32. List three limitations of markets (or roles for the government in market systems).
We will go over several in class but I’m not exactly sure which ones. Three important ones include:
-Markets can restrict competition (government role: prevent monopolies)
-Not everything is for sale (government role: prevent harmful or dangerous goods from being exchanged
on markets).
-Markets can price some goods and services “wrong” in that they do not accurately reflect benefits and
costs (government role: tax or subsidize goods and services to more include full benefits and costs.
33. List four barriers to entry.
-Control over and essential input.
-High fixed costs (Economies of scale)
-Government granted barriers (patents and copyrights)
-Network economies