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# Producer Theory

1. Suppose that a perfectly competitive firm is currently producing 10 units of output. You also have the following additional information:
P = \$6; MC; = \$6; AVC = \$3; ATC = \$8.
Given this:
a) This firm should continue to produce 10 units in the short run, but should exit the industry in the long run, unless price rises.
b) This firm should shut down in the short run, and exit the industry in the long run, unless price rises.
c) This firm should increase its price in order to maximize profits.
d) This firm should increase its output in order to maximize profits.
1. Suppose that a perfectly competitive industry is initially in long run equilibrium.
The government then introduces a \$1,000 annual fee that each firm in the industry must pay, no matter how much output it produces. Which of the following statements is TRUE?
a) Price will increase in the short run, but return to its initial level in the long run.
b) Price will not change in the short run, but will increase in the long run.
c) Price will increase in both the short and the long run, but the increase will be greater in the short run than in the long run.
d) Price will increase in both the short and the long run, but the increase will be greater in the long run than in the short run.
1. Suppose you are given the following information about a competitive firm: P = \$10; ATC = \$4; MC = \$10; q = 20.
Given this:
a) The firm should continue to produce 20 units of output; this is profit maximizing.
b) In order to maximize profits, the firm should produce more than 20 units of output.
c) In order to maximize profits, the firm should produce fewer than 20 units of output.
d) The firm should shut down in the short run and exit in the long run.
2. Which of the following statements about competitive firms is FALSE?
a) A competitive firm maximizes profit by producing the level of output at which price equal marginal cost.
b) A competitive firm maximizes profit by producing the level of output at which marginal revenue equals marginal cost.
c) For a competitive firm, marginal revenue is less than price.
d) For a competitive firm, economic profits equal zero in the long run.
3. Suppose you are given the following information about a competitive firm: P = \$10
ATC = \$4
MC = \$6 q = 20.
Which of the following statements is true?
a) The firm should continue to produce 20 units of output; this is profit maximizing.
b) In order to maximize profits, the firm should produce more than 20 units of output.
c) In order to maximize profits, the firm should produce fewer than 20 units of output.
d) The firm should shut down in the short run and exit in the long run.
4. Suppose that a perfectly competitive firm is currently producing 25 units of output. You also have the following additional information:
P = \$12.
The firms is operating at the minimum point of AVC AVC = \$4.
ATC = \$10.
The minimum point of ATC is where ATC = \$8.
If the firm wishes to maximize profits, which of the following statements is TRUE?
a) This firm should continue to produce 25 units in the short run, but exit in the long run.
b) The firm should increase output in the short run, but exit in the long run.
c) The firm should increase output in the short run, and will remain in the industry in the long run.
d) None of the above.
1. Which of the following statements about a competitive firm producing positive output is TRUE?
I. Price equals marginal cost in both the short run and the long run.
II. Price can be less than average total cost in the short run, but not in the long run.
III. If price is less than average total cost (so that the firm makes negative economic profits) it will shut down in the short run and exit in the long run.
a) I only.
b) I and II only.
c) I and III.
d) I, II, and III.
The following THREE questions refer to the diagram below, which illustrates a competitive firm’s cost curves and the supply and demand diagram for the industry. Assume that all firms in the industry have identical cost curves.
2. If demand is given by D1, then each firm in the industry will produce units of output.
a) 0.
b) 10.
c) 13.
d) 15.
3. If demand is given by D1, then how many firms operate in this industry?
a) There is insufficient information to determine the number of firms in the industry.
b) 10.
c) 20.
d) 30.
4. If demand shifts from D1 to D2, then, in the short run:
a) Firms will make positive economic profits.
b) New firms will enter the market.
c) The price will remain unchanged at \$25.
d) Some firms will stop producing, since price is below average variable cost.
5. Suppose that the wages competitive firms must pay to their workers increase. Which of the following statements is TRUE?
a) The firms’ marginal costs will rise.
b) The market supply curve will shift left and price will rise.
c) In the long run firms will be making zero economic profits.
d) All of the above are true.

The following TWO question refers to the diagram below, which illustrates a competitive firm’s cost curves, and the supply and demand diagram for the industry. Assume that all firms in the industry have identical cost curves.

1. If demand increases from D1 to D2, then, in the long run, how many firms will be in this industry?
a) 20.
b) 25.
c) 35.
d) 40.
2. If demand increases from D1 to D2, then, in the short run price will , and in the long run price will .
a) Rise to \$40; remain at \$40.
b) Rise to \$40; fall to \$25.
c) Rise to \$40; fall to \$15.
d) Rise to \$40; either rise or fall, depending on whether firms enter or exit.
3. Refer to the diagram below.

Which of the following labeled points is a long run equilibrium?
I. Point a.
II. Point b.
III. Point c.

a) I only.
b) I and II only.
c) I and III only.
d) I, II, and III.

### Summary Revision

Production Cost
The sum costs of all resources consumed in the process of making a product

The cost incurred by a manufacturer when producing a good or service. Production costs include a variety of expenses including, but not limited to, labor, raw materials, rent of equipment, insurance etc.

• Types of Costs
Total cost: sum of fixed and variable costs
• Fixed: the cost a producer must pay in order to start the production
• Variable: the cost of inputs that vary with the quantity of the firm output
• Sunk: a cost that, once paid, the firm cannot recover
• Marginal: the additional cost of producing an additional unit of output
• Average: a firm’s total cost per unit of output

Average & Marginal Cost
The marginal cost curve intersects average-total-cost and average-variable-cost at their minimums

Profit Maximization
The short or long run process by which a firm decides the price and output level that returns the greatest profit

Short Run
Conceptual time setting where some factors are fixed and others are variable

• Increase production if MC < Rm (added revenue per additional unit of output)
• Decrease production if MC > MR
• Continue production if MVC < P, even if ATC > P
• Shut down if AVC > P at each level of outputs

Long Run
Conceptual time setting where there are no fixed factors of production

Firm Behavior:

• Enter an industry in response to (expected) profits
• Leave an industry in response to losses
• Increase its plants in response to profits
• Decrease its plants in response to losses

General Profit Function
π = PQ – CQ

π: Profit
P: Price
Q: Quantity
C: Cost

Profit Function with One Factor
π = P*Q(L) – C(L)

Q(L): Quantity produced which depends on the level of Labor used

C(L): Cost to use L units of Labor

Profit Function with One Factor + Wage
π = PQ(L) – wL

Q(L): Quantity produced as a function of the number of hours worked (L)

C: the wage * number of hours worked

Profit Maximization on Short Run
The firm choses the hours such as to maximize the profit

(Remember the formula!)

Revenue
The money the firm receives from consumers

Revenue = Price * Quantity

Marginal Revenue
The increase in revenue due to an additional unit sold (the price of this unit)

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