Demand and Supply Analysis: The Firm (Reading 15)

Learning Outcome Statements (LOS)

a

Calculate, interpret, and compare accounting profit, economic profit, normal profit, and economic rent;

b

Calculate and interpret and compare total, average, and marginal revenue;

c     

Describe the firm’s factors of production;

d    

Calculate and interpret total, average, marginal, fixed, and variable cost;   

e  

Determine and describe breakeven and shutdown points of production;

f 

Explain how economies of scale and diseconomies of scale affect costs;

g

Describe approaches to determining the profit-maximizing level of output;

h

Distinguish between short-run and long-run profit maximization;

i

Distinguish among decreasing-cost, constant-cost, and increasing-cost industries and describe the long-run supply of each;

j

Calculate and interpret total, marginal, and average product of labor;

k

Describe the phenomenon of diminishing marginal returns and calculate and interpret the profit-maximizing utilization level of an input;

l

Determine the optimal combination of resources that minimizes cost;

Formulas:

Exercise Problems:

1.      Which of the following measures of profits is most likely necessary for a firm to stay in business in the long run?

A.    normal

B.     economic

C.     accounting

 Ans: A; normal profit is the level of accounting profit needed to just cover the implicit opportunity cost ignored in accounting cost. In highly competitive market situations, firms tend to earn the normal profit level over time because ease of market entry allows for other competing firms to compete away any economic profit over the long run.

B is incorrect; economic profit may be defined broadly as accounting profit less the implicit opportunity costs not included in total accounting cost.

C is incorrect; accounting profit is generally defined as net income reported on the income statement according to standards established by private and public financial oversight bodies that determine the rules for calculating accounting profit.

2.      The supply curve for a particular factor of production with total income consisting solely of economic rent is most likely:   

A.    vertical

B.     horizontal

C.     perfectly elastic

Ans: A; the surplus value known as economic rent results when a particular resource or good is fixed in supply and market price is higher than what is required to bring the resource or good onto the market and sustain its use.

When supply is relatively inelastic, a higher degree of market demand can result in pricing that creates economic rent. As extreme situation, when demand is perfect inelastic, which means supply curve is vertical, total income consist solely of economic rent.

3.      When the supply curve of a factor is perfectly elastic the factor income is most likely:

A.    Entirely economic rent

B.     Entirely opportunity cost

C.     Part economic rent and part opportunity cost

Ans: B; when the supply curve is perfectly elastic, no economic rent is included in income, so the income is entirely opportunity cost.

4.      A company compiles the following information:

The company’s economic profit is closest to:

A.  $90,000 

B.  $110,000

C.  $130,000

Ans: A ; here, accounting profit is

Economic profit equals to accounting profit minus normal profit, which is $130,000-$40,000=$90,000

5.      The return to entrepreneurial ability in a firm that makes a positive economic profit is most likely:

A.    normal

B.     less than normal

C.     greater than normal

Ans: C; the firm makes a positive economic means the return is greater than normal.

6.      In competitive markets, when the efficient quantity is produced the least likely result is to:

A.    Maximize total surplus

B.     Generate underproduction

C.     Minimize deadweight loss

Ans: B; in competitive markets, when the efficient quantity is produced, total supply equals to total demand, so there is no underproduction.

7.      A local laundry and dry cleaner collects the following data on its workforce productivity. Workers always work in teams of two, and the laundry earns $3.00 of revenue for each shirt laundered

The marginal revenue product ($ per worker) for hiring the fifth and sixth workers is closest to:

A.    14

B.     21

C.     42

Ans: B; the marginal revenue is when increasing hiring from 4 to 6, the average increase of revenue for the two workers. Here, 14 total product increased for hiring of fifth and sixth worker, so marginal revenue product is:

8.      In regard to the relation between output and costs in the short-run, a decline in the marginal cost most likely occurs at what level of production?

A.    Low output

B.     High output

C.     Profit-maximizing output

Ans: A; with the increase of output, the marginal cost curve first decreases to its lowest point, and then increase. So a decline in the marginal cost occurs at low output.

9.      In the short run, an increase in output at low levels of production will most likely cause:

A.    an increase in the marginal cost due to the rising total fixed cost

B.     an increase in the marginal cost due to the law of diminishing returns

C.     a decrease in the marginal cost due to economies from greater specialization

Ans: C; at low levels of production, expansion will lead to greater specialization, which will decrease the marginal cost.

A is incorrect; total fixed cost will not change in short run.

B is incorrect; return is irrelative to the marginal cost.

10.  The best characterization of a firm that is operating on its long-run average cost curve is when it:

A.    Experiences constant returns to scale

B.     Produces a given output at the least possible cost

C.     Chooses a plant size the minimizes the average fixed cost

 Ans: B; operating on long-run average cost curve means the firm has lowest cost possible at every output level, so it produces a given output at the least possible cost.

A is incorrect; economies of scale and diseconomies of scale could occur at the same time. Usually, economies of scale dominate at low level of output, and diseconomies of scale dominate at high level of output.

C is incorrect; a firm will choose a plant size that maximize the total profit.