Package: Test Bank

Title: Microeconomics: Theory and Application, 12e

Chapter Number: 9

Question Type: Multiple Choice

1. Which one of the following is not an assumption of the competitive model?

a. Homogenous products
b. Unrestricted mobility of resources
c. Economies of scale
d. Perfect information

Answer: C

Difficulty Level: Easy

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

2. Which of the following is an assumption in the model of perfect competition?

a. The firms in a competitive industry produce a homogeneous product.

b. The firms in a competitive industry actively compete with each other by advertising.
c. There are no natural impediments to entry in a competitive industry, but there may be artificial
impediments such as licensing.
d. The firms in a competitive industry have a decreasing short-run marginal cost curve.

Answer: A

Difficulty Level: Easy

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

3. Product homogeneity implies that consumers:

a. buy goods from the lowest-priced source.

b. know which seller produces the highest quality goods.
c. cannot easily decide which seller to buy from.
d. can judge quality easily by price.

Answer: A
Difficulty Level: Medium
Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

4. Which of the following will reduce the competitive nature of the agricultural industry?

a. There are restrictions on price volatility in the agricultural market.

b. The output of the agricultural industry is more or less homogeneous.
c. The number of farms across the country is relatively large.
d. There are no import and export restrictions on agricultural products.

Answer: A

Difficulty Level: Medium

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

5. Resources are not free to move into and out of an industry when:

a. there are no differential impediments across firms in the mobility of resources.

b. a firm experiences economies of scale.
c. an incumbent firm has an exclusive government patent.
d. firms are price takers.

Answer: C

Difficulty Level: Medium

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

6. Which of the following is true of the economic model of perfect competition?

a. All the assumptions of a competitive model are satisfied in almost all real-world markets.
b. The efficient outcomes of competitive markets hold only in theory and not empirically.
c. Perfect competition is characterized by its impersonal nature.
d. The outcome of perfect competition is equitable.

Answer: C

Difficulty Level: Medium

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.
7. The model of perfect competition assumes that:

a. there is information asymmetry in the market.

b. individual suppliers face a downward sloping demand curve.
c. all goods in that market are homogeneous.
d. there are a small number of sellers in the market.

Answer: C

Difficulty Level: Easy

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

8. The assumptions of perfect competition _____.

a. are satisfied in most real-world markets

b. do not readily apply to most real-world markets
c. are hardly ever satisfied and therefore make the study of perfect competition unwarranted
d. if satisfied, lead to equitable outcomes

Answer: B

Difficulty Level: Medium

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

9. If firms in a perfectly competitive market produced dissimilar products:

a. the buyers in the market will be price takers.

b. price differentials will exist in equilibrium.
c. they will remain price takers.
d. price differentials between firms will be eliminated.

Answer: B

Difficulty Level: Medium

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

10. Assume that coffee shops operate in a perfectly competitive industry. A single coffee shop,
Brick & Mortar, decides to charge an entrance fee in addition to charges for its coffee and pastry.
Which of the following is most likely to happen?
a. Brick & Mortar can continue to charge the entrance fee in the long-run since there is free entry
into the coffee shop industry.
b. As long as the coffee shop industry is perfectly competitive, customers will be willing to pay the
extra charges.
c. Brick & Mortar will not be able to sustain the extra charges as customers will move to coffee
shops that are cheaper.
d. Brick & Mortar can charge their customers extra because there are a large number of buyers and
sellers in the coffee shop industry.

Answer: C

Difficulty Level: Medium

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

11. According to the _____ principle, firms that do not approximate profit maximization will not
succeed in competitive markets.

a. equity
b. successor
c. survivor
d. winner-takes-all

Answer: C

Difficulty Level: Easy

Section Reference: Profit Maximization
Learning Objective: Explain why it is appropriate to assume profit maximization on the part of
firms.

12. The survivor principle in competitive markets implies that:

a. the outcome of a competitive market will not be profit-maximizing.

b. profit maximization need not be the only objective of a firm.
c. all firms follow the objective of profit maximization.
d. firms that do not undertake profit maximization will be driven out of the market.

Answer: D

Difficulty Level: Medium

Section Reference: Profit Maximization
Learning Objective: Explain why it is appropriate to assume profit maximization on the part of
firms.
13. The demand curve of a perfectly competitive firm is determined by:

a. the quality of the goods the firm produces.

b. the intersection of the market demand and supply curves.
c. the reputation of the firm.
d. the price taking behavior in the market.

Answer: D

Difficulty Level: Medium

Section Reference: The Demand Curve for a Competitive Firm
Learning Objective: Show why the fact that a competitive firm is a price taker implies that the
demand curve for the firm is perfectly horizontal.

14. The competitive firm is known as a price taker because:

a. it sets the highest price it can charge.

b. it can vary its price based on variations in its cost.
c. it produces output at a level that minimizes its marginal cost.
d. it accepts the market price as a given.

Answer: D

Difficulty Level: Easy

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

15. A perfectly competitive firm is a price taker. This implies that:

a. price does not change in a perfectly competitive market.

b. price is not determined by supply and demand in a competitive market.
c. price only changes when market conditions change.
d. output of a firm is the only factor that can change prices.

Answer: C

Difficulty Level: Medium

Section Reference: The Demand Curve for a Competitive Firm
Learning Objective: Show why the fact that a competitive firm is a price taker implies that the
demand curve for the firm is perfectly horizontal.

16. For a perfectly competitive firm, the demand curve:

a. coincides with the marginal revenue curve.
b. is parallel to the vertical axis.
c. is upward sloping.
d. is convex to the origin.

Answer: A

Difficulty Level: Easy

Section Reference: The Demand Curve for a Competitive Firm
Learning Objective: Show why the fact that a competitive firm is a price taker implies that the
demand curve for the firm is perfectly horizontal.

17. The perfectly competitive firm's demand curve is horizontal because:

a. the firm faces a constant-cost supply curve.

b. the demand for its goods is infinitely elastic.
c. firms in competitive industries collude and set the same prices.
d. the firm can change prices by varying its output.

Answer: B

Difficulty Level: Medium

Section Reference: The Demand Curve for a Competitive Firm
Learning Objective: Show why the fact that a competitive firm is a price taker implies that the
demand curve for the firm is perfectly horizontal.

18. A perfectly competitive firm faces a horizontal demand curve, which implies that:

a. the price in the market never changes.

b. the firm cannot affect price by any action it takes.
c. the quantity of output produced by the firm is indeterminate.
d. the firm makes zero accounting profits.

Answer: B

Difficulty Level: Medium

Section Reference: The Demand Curve for a Competitive Firm
Learning Objective: Show why the fact that a competitive firm is a price taker implies that the
demand curve for the firm is perfectly horizontal.

19. The competitive firm's demand curve is:

a. unit elastic over the relevant range of output.

b. perfectly elastic over the relevant range of output.
c. perfectly inelastic over the relevant range of output.
d. elastic above the market price and inelastic below the market price.

Answer: B

Difficulty Level: Medium

Section Reference: The Demand Curve for a Competitive Firm
Learning Objective: Show why the fact that a competitive firm is a price taker implies that the
demand curve for the firm is perfectly horizontal.

20. The following figure shows the total cost and total revenue for a firm when it prices its products
at $8 and $10.

Refer to Figure 9-1. At a price of $10, the profit maximizing level of output for the firm is _____.

a. OA
b. OC
c. OF
d. OG

Answer: D
Difficulty Level: Medium
Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

21. The following figure shows the total cost and total revenue for a firm when it prices its
products at $8 and $10.

Refer to Figure 9-1. When the firm is producing the profit-maximizing level of output at a price of
$10:

a. total fixed costs are OA.

b. economic profits equal BH.
c. average cost equals DG divided by OG.
d. total cost is minimized at B.

Answer: A

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

22. The following figure shows the total cost and total revenue for a firm when it prices its
products at $8 and $10.
In Figure 9-1, if the market price fell to $8 the firm would:

a. decrease production to OJ and would be operating at a loss.

b. decrease production to OJ and would be earning a normal return.
c. decrease production to OF where it would break even.
d. incur losses and shut down.

Answer: B

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

23. The following figure shows the total cost and total revenue curves for a firm.
Refer to Figure 9-2. At which of the following output levels is the firm incurring its highest loss?

a. 1 unit
b. 2 units
c. 3 units
d. 4 units

Answer: A

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

24. The following figure shows the total cost and total revenue curves for a firm.
Refer to Figure 9-2. At which of the following levels of output is the firm maximizing profit?

a. 1 unit
b. 2 units
c. 3 units
d. 4 units

Answer: C

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

25. The following figure shows the total cost and total revenue curves for a firm.
Refer to Figure 9-2. The firm’s profits are positive:

a. from output level 1 to 2.

b. only at output level 2.
c. from output level 2 to 4.
d. only at output level 1.

Answer: C

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

26. A competitive firm maximizes profit at the output level where:

a. the difference between price and average total cost is the largest.
b. the slope of the total revenue curve equals the slope of the total cost curve.
c. the average total cost equals marginal cost.
d. the marginal revenue exceeds marginal cost by the greatest amount.

Answer: B

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

27. The competitive firm maximizes its profit by operating at the point where _____ and price is
greater than average variable cost.

a. average cost is at a minimum

b. total revenue is at a maximum
c. profit per unit is at a maximum
d. marginal cost equals price

Answer: D

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

28. The perfectly competitive firm maximizes profits by producing at the rate of output where:

a. marginal revenue and marginal cost are equal.

b. marginal revenue exceeds marginal cost by the greatest amount.
c. the profit per unit is the highest.
d. marginal cost is at its minimum.

Answer: A

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

29. The following figure shows the marginal cost curve, average total cost curve, average variable
cost curve, and marginal revenue curve for a firm for different levels of output.
Refer to Figure 9-3. Assuming that price at 0R is $10, the profit maximizing level of output for the
firm is _____.

a. OA where marginal cost just covers AVC

b. OB where average profit per unit is the greatest
c. OC where marginal cost equals the $10 price
d. OK where average cost equals marginal revenue and the firm earns a normal rate of return

Answer: C

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

30. The following figure shows the marginal cost curve, average total cost curve, average variable
cost curve, and marginal revenue curve for a firm for different levels of output.
Refer to Figure 9-3. At the profit-maximizing level of output:

a. the firm is earning economic profit.

b. profits per unit are the highest.
c. profit equals ZC.
d. costs exceed revenue.

Answer: A

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

31. The following figure shows the marginal cost curve, average total cost curve, average variable
cost curve, and marginal revenue curve for a firm for different levels of output.
At the profit-maximizing level of output in Figure 9-3, the profit of the firm is equal to the area
given by _____.

a. RLMG
b. RGZW
c. RGCO
d. RGHS

Answer: B

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

32. The following figure shows the marginal cost curve, average total cost curve, average variable
cost curve, and marginal revenue curve for a firm for different levels of output.
At the output level of OC in Figure 9-3, average profit per unit of output is equal to _____.

a. GZ
b. MG
c. ZM
d. GC

Answer: A

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

33. The following figure shows the marginal cost curve, average total cost curve, average variable
cost curve, and marginal revenue curve for a firm for different levels of output.
In Figure 9-3, maximum profit per unit is equal to _____.

a. GZ
b. ZM
c. GM
d. FH

Answer: D

Difficulty Level: Hard

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

34. The following figure shows the marginal cost curve, average total cost curve, average variable
cost curve, and marginal revenue curve for a firm for different levels of output.
Refer to Figure 9-3. At the output level OB, total profits equal the area given by _____.

a. FTDE
b. GMLR
c. FHSR
d. FBOR

Answer: C

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

35. The following figure shows the marginal cost curve, average total cost curve, average variable
cost curve, and marginal revenue curve for a firm for different levels of output.
Refer to Figure 9-3. At the output level OC, average fixed cost is equal to _____.

a. ZM
b. GZ
c. GM
d. MC

Answer: A

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

36. The following figure shows the marginal cost curve, average total cost curve, average variable
cost curve, and marginal revenue curve for a firm for different levels of output.
Refer to Figure 9-3. If the market price is $10, average revenue _____.

a. is greater than $10

b. is less than $10
c. equals $10
d. is equal to $10 – GZ

Answer: C

Difficulty Level: Easy

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

37. Profits are maximized at the output level where:

a. marginal revenue equals marginal cost.

b. price equals average total cost.
c. price is greater than marginal cost.
d. marginal cost equals average total cost.

Answer: A

Difficulty Level: Easy

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

38. A profit-maximizing firm expands output until marginal revenue equals the _____ of
producing the last unit.

a. marginal cost
b. average variable cost
c. average total cost
d. average fixed cost

Answer: A

Difficulty Level: Easy

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

39. The following figure shows the marginal cost curve, the average cost curve, the average
variable cost curve, and the demand curve for a firm over different levels of output. The market
price is $P.

Refer to Figure 9-4. At a price of $P, the firm will produce the output level _____.
a. OA where marginal cost just covers AVC
b. OB where marginal cost equals the price
c. OC where marginal cost equals ATC
d. OD where the price just covers AVC

Answer: B

Difficulty Level: Easy

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

40. Figure 9-4 shows the marginal cost curve, average cost curve, average variable cost curve, and
demand curve for a firm over different levels of output and at a market price of $P.

Refer to Figure 9-4. The firm’s average fixed cost at the output level OB is _____.

a. KT
b. GT
c. GB
d. GK

Answer: B

Difficulty Level: Easy

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

41. Figure 9-4 shows the marginal cost curve, average cost curve, average variable cost curve, and
demand curve for a firm over different levels of output and at a market price of $P.

Refer to Figure 9-4. At the output level OB the total fixed cost is equal to _____.

a. TBOV
b. KTVP
c. GKPS
d. GTVS

Answer: D

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

42. Figure 9-4 shows the marginal cost curve, average cost curve, average variable cost curve, and
demand curve for a firm over different levels of output and at a market price of $P.
Refer to Figure 9-4. The firm’s average variable cost at the output level OB is _____.

a. BG
b. GT
c. BT
d. BK

Answer: C

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

43. In the short-run, if a competitive firm finds itself operating at a loss, it will:

a. have to shut down and exit the market.

b. continue to operate as long as price is greater than average variable cost.
c. liquidate all its assets to ensure cash flow.
d. reduce the size of its plant to lower fixed costs.

Answer: B

Difficulty Level: Easy

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

44. In the short-run, if the price falls, the firm will respond by:

a. liquidating its assets and shutting down.

b. producing at the output level where average variable cost is equal to marginal revenue.
c. reducing output along its marginal cost curve as long as marginal revenue exceeds average
variable cost.
d. increasing its output in order to sell higher quantities.

Answer: C

Difficulty Level: Hard

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

45. If market price is below a competitive firm’s average total cost, the firm should:

a. shut down only if the price is above its average variable cost.
b. shut down immediately.
c. remain open as long as its average revenue is greater than its average variable cost.
d. expand output in the short-run and expand its production capacity.

Answer: C

Difficulty Level: Easy

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

46. The following figure shows the marginal cost curve, the average cost curve, the average
variable cost curve, and the demand curve for a firm over different levels of output. The market
price is $P.
Refer to Figure 9-4. Given that the market price is $P, the firm will be operating at a loss of _____.

a. TBOV
b. RZOA
c. KTVP
d. GKPS

Answer: D
Difficulty Level: Medium
Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

47. The following figure shows the marginal cost curve, the average cost curve, the average
variable cost curve, and the demand curve for a firm over different levels of output. The market
price is $P.
Refer to Figure 9-4. If the firm chooses to shut down when the market price is $P, what is the loss it
would incur?

a. KTVP
b. GTVS
c. GKPS
d. TBOV

Answer: B

Difficulty Level: Hard

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

48. The following figure shows the marginal cost curve, the average cost curve, the average
variable cost curve, and the demand curve for a firm over different levels of output. The market
price is $P.
Refer to Figure 9-4. The total revenue for the firm at the output level OB is _____.

a. OVTB
b. OSGB
c. OPKB
d. GTVS

Answer: C

Difficulty Level: Hard

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

49. The short-run supply curve for the firm operating in a perfectly competitive industry is:

a. its marginal cost curve.

b. its marginal cost curve above the minimum of average variable cost.
c. its marginal cost curve above the minimum of average total cost.
d. the average variable cost curve above average revenue curve.

Answer: B

Difficulty Level: Easy

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

50. The following figure shows the marginal cost curve, the average cost curve, the average
variable cost curve, and the demand curve for a firm over different levels of output. The market
price is $P.

Refer to Figure 9-4. The firm should shut down if the price falls to _____.

a. OP
b. OR
c. OS
d. OV

Answer: B

Difficulty Level: Medium

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

51. The following figure shows the marginal cost curve, the average cost curve, the average
variable cost curve, and the demand curve for a firm over different levels of output. The market
price is $P.
Refer to Figure 9-4. The total variable cost for the firm at output level OB is _____.

a. BT
b. BKPO
c. BK
d. BTVO

Answer: D
Difficulty Level: Hard

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve

Learning Objective: Describe the firm’s short-run supply curve.

52. The perfectly competitive firm minimizes losses by shutting down whenever:

a. price is below average fixed costs.

b. price is below the minimum point of the average cost curve.
c. total variable costs are greater than total fixed costs.
d. price is below the minimum point of the average variable cost curve.

Answer: D

Difficulty Level: Medium

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

53. The supply curve of a competitive firm in the short-run is:

a. the marginal cost curve.

b. the marginal cost curve above the minimum of average variable cost.
c. the marginal cost curve above the minimum of average cost.
d. the negatively sloped portion of the marginal cost curve.

Answer: B

Difficulty Level: Easy

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

54. Abe’s Taxi Company operates in a perfectly competitive market. Gasoline is a variable input in
the taxi services industry. As the price of gasoline decreases, the short-run marginal cost curve for
Abe’s Taxi Company:

a. shifts up and to the left.

b. shifts down and to the right.
c. remains unchanged.
d. becomes flatter.

Answer: B

Difficulty Level: Medium

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

55. During the 1970s, oil prices reached historical highs, causing many competitive industries to
reduce the supply of goods and services. Which of the following is the most likely explanation for
this reduction in supply?

a. The total fixed cost of the firms would have increased due to the higher price of oil.
b. The marginal cost curves of the firms most likely shifted upward.
c. The supply curves of firms may have shifted downward.
d. The average total cost of these firms mostly likely shifted downward due to the high inflation.

Answer: B

Difficulty Level: Hard

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.
56. In a perfectly competitive market, if the product price remains unchanged, a fall in the price of
an input used by a firm will:

a. cause the firm to substitute away from this input.

b. reduce the quantity of output it produces.
c. shift the marginal cost curve downward.
d. reduce the price of the product.

Answer: C

Difficulty Level: Medium

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

57. Assume that labor is the variable input for a firm. Which of the following will occur if the
wage rate increases?

a. Its average variable cost, average fixed cost, average total cost, and marginal costs will increase.
b. Its average variable cost and average total costs will increase and profits will decrease.
c. Its marginal cost, average total costs, and output will increase.
d. Its marginal cost and average variable costs will increase.

Answer: D

Difficulty Level: Hard

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

58. A significant decrease in the price of a variable input causes the:

a. marginal, average, and total cost curves to shift downward.

b. average total cost curve to shift downward, causing a fall in output.
c. average variable cost curve to shift downward while leaving the output level unchanged.
d. marginal cost curve to shift downward.

Answer: D

Difficulty Level: Medium

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.
59. Following a significant decrease in the price of a variable input, at the initial output level:

a. marginal revenue is higher than average revenue.

b. marginal cost is higher than marginal revenue.
c. marginal cost is lower than average revenue.
d. marginal cost is still equal to marginal revenue.

Answer: C

Difficulty Level: Hard

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

60. The short-run supply curve for a perfectly competitive industry is:

a. downward sloping because of the law of diminishing marginal returns.

b. derived by summing the individual firms’ marginal cost curves horizontally.
c. perfectly elastic in the case of homogeneous products.
d. the negatively sloped portion of the marginal cost curve.

Answer: B

Difficulty Level: Medium

Section Reference: The Short-Run Industry Supply Curve
Learning Objective: Explain how the short-run industry supply curve is derived.

61. The short-run supply curve for a competitive industry is derived by summing the _____ for
each firm in the industry.

a. portion of the marginal cost curves above average variable cost

b. upward sloping portion of the average variable cost curve
c. downward sloping portions of the marginal cost curve
d. upward sloping portion of the average total cost curve

Answer: A

Difficulty Level: Easy

Section Reference: The Short-Run Industry Supply Curve
Learning Objective: Explain how the short-run industry supply curve is derived.

62. The short-run supply curve for a perfectly competitive industry:

a. is less elastic than the long-run industry supply curve.

b. is derived by vertically summing the individual firms’ marginal cost curves.
c. reflects zero economic profits at all points on the curve.
d. is typically upward sloping.

Answer: D

Difficulty Level: Medium

Section Reference: The Short-Run Industry Supply Curve
Learning Objective: Explain how the short-run industry supply curve is derived.

63. The short-run supply curve for a competitive industry:

a. is subject to the law of diminishing returns.

b. is the industry’s marginal cost curve.
c. coincides with the marginal revenue curve.
d. is horizontal because there are many buyers and sellers.

Answer: A

Difficulty Level: Medium

Section Reference: The Short-Run Industry Supply Curve
Learning Objective: Explain how the short-run industry supply curve is derived.

64. The short-run supply curve for a competitive industry is upward-sloping because:

a. firms must pay more for inputs as more are hired. /firms must incur higher costs the more inputs
they hire.
b. the efficiency of the variable inputs decreases as more such inputs are employed in production.
c. new firms enter the industry as product prices increase.
d. of the law of diminishing marginal utility.

Answer: B

Difficulty Level: Medium

Section Reference: The Short-Run Industry Supply Curve
Learning Objective: Explain how the short-run industry supply curve is derived.

65. Zero economic profit occurs when:

a. price equals minimum average variable cost.

b. a firm has existed for long enough to make normal profit.
c. price equals long-run average cost.
d. a firm operates at the minimum of its long-run marginal cost curve.
Answer: C

Difficulty Level: Easy

Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.

66. Which of the following is a condition for long-run equilibrium in a competitive industry?
a. Each firm in the industry is earning zero economic profit.

b. The inputs employed in the industry earn less than they would had they been used elsewhere.
c. Each firm in the industry will produce that level of output at which marginal cost is the lowest.
d. The number of new entrants into the industry is positive.

Answer: A

Difficulty Level: Medium

Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.

67. At the profit maximizing level of output in a competitive industry, the firm is:

a. making economic profit.

b. losing money on each unit sold.
c. making zero accounting profit.
d. making abnormal profits

Answer: A

Difficulty Level: Medium

Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.

68. In the long-run, firms in a competitive industry earn only a normal rate of return because:

a. decreasing returns to scale causes per unit costs to rise.

b. input prices will rise in the long-run and eliminate abnormal profits.
c. entry of new firms will eliminate abnormal profits.
d. profit per unit declines in the long-run.

Answer: C

Difficulty Level: Medium

Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.

69. Which of the following is true of a long-run competitive equilibrium?

a. The market has a horizontal long-run supply curve.

b. Inputs employed in the industry cannot earn more in other industries.
c. Firms in the market earn high abnormal profits.
d. Firms face constant input costs irrespective of the output level.

Answer: B

Difficulty Level: Medium

Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.

70. If price remains above the average total cost for firms in a competitive industry:

a. existing firms will exit that industry.

b. new firms will enter that industry.
c. the number of firms in the industry will neither increase nor decrease.
d. the existing firms will be making zero economic profit.

Answer: B

Difficulty Level: Medium

Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.

71. As long as there is free entry into a market:

a. firms in that market can sustain prices above average total cost.
b. firms in that market can maintain market power.
c. economic profits are not sustainable.
d. accounting profits will be zero.

Answer: C

Difficulty Level: Easy

Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.
72. Which of the following will occur in response to an unexpected increase in demand in a
constant-cost, competitive industry?

a. Resources will move out of the industry.

b. The output of the industry will remain constant.
c. The output will increase with input prices remaining unchanged
d. The existing firms will not be able to expand output sufficiently without incurring huge costs.

Answer: C

Difficulty Level: Medium

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

73. Which of the following is true of a constant cost industry?

a. Along the industry’s long-run supply curve, firms in the industry earn a positive economic profit.
b. The long-run supply curve for a constant cost industry is horizontal.
c. The industry’s long-run supply curve is derived by horizontally summing the long-run supply
curves of the individual firms.
d. In the long run, the industry experiences an increase in the price of inputs.

Answer: B

Difficulty Level: Easy

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

74. In an increasing-cost industry, the slope of the long-run supply curve is _____.

a. zero
b. negative
c. positive
d. infinity

Answer: C

Difficulty Level: Medium

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

75. In a constant-cost industry, the slope of the long-run supply curve is _____.

a. zero
b. negative
c. positive
d. infinity

Answer: A

Difficulty Level: Medium

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

76. Suppose a constant-cost competitive industry produces widgets using labor and capital in fixed
proportions. A firm in the industry faces:

a. a vertical supply curve for labor and capital.

b. a downward sloping supply curve for labor and capital.
c. a horizontal supply curve for labor and capital.
d. an upward sloping supply curve for labor and capital.

Answer: C

Difficulty Level: Hard

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

77. If a competitive industry is characterized by increasing cost, which of the following will occur
in response to an unexpected increase in demand?

a. New firms will enter the industry.

b. Economic profit will remain zero.
c. Input prices will remain constant.
d. The price of the product will remain unchanged.
Answer: A

Difficulty Level: Medium

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

78. In the long run, if the input procurement prices increase as the output supplied by firms in an
industry rises:

a. the firms are operating in an increasing-cost industry.

b. the firms’ profit margins will increase.
c. the firms are making positive economic profits.
d. the firms’ cost curves shift will downward.

Answer: A

Difficulty Level: Easy

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

79. In an increasing cost industry, as output increases:

a. firms’ cost curves shift downward.

b. input prices increase.
c. profit per unit increases.
d. the price of the product in the market increases.

Answer: B

Difficulty Level: Easy

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

80. The slope of the long-run supply curve in a decreasing-cost industry is _____.

a. zero
b. negative
c. positive
d. infinite

Answer: B

Difficulty Level: Medium

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

81. Which of the following is constant along the industry long-run supply curve?

a. Technology
b. Number of firms
c. Input prices
d. Price of output

Answer: A

Difficulty Level: Easy

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

82. The demand for corn has increased over the past few decades to satisfy the increasing demand
from the food and ethanol industries. The primary beneficiaries of an expansion in the output of
corn are owners of farmland suitable for corn production. What can you conclude about the nature
of the corn industry?

a. The corn industry is not competitive.

b. The corn industry is an increasing-cost industry.
c. The long-run corn supply curve is horizontal.
d. There are barriers to entry in the corn industry.

Answer: B

Difficulty Level: Hard

Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.
83. The presence of a relatively large number of firms in an industry does not ensure perfect
competition if:

a. they sell products that are standardized.

b. there are also a large number of consumers.
c. they collude to set prices in the market.
d. the industry is an increasing-cost industry.

Answer: C

Difficulty Level: Medium

Section Reference: When Does the Competitive Model Apply?
Learning Objective: Analyze the extent to which the competitive market model applies.

84. Firms in an industry are unlikely to have pricing power if:

a. elasticity of demand for the product is high.

b. the product is not homogeneous.
c. the firms’ elasticity of supply is high.
d. there are barriers to entry in the market.

Answer: A

Difficulty Level: Medium

Section Reference: When Does the Competitive Model Apply?
Learning Objective: Analyze the extent to which the competitive market model applies.

85. Eggs, which are standardized products, are sold within a city at higher prices than in the
suburbs. Given that firms in the city are able to sustain the higher prices but do not make higher
profits than firms in the suburbs, this means that:

a. the egg industry is a constant-cost industry.

b. the egg industry is not competitive as the prices of perfectly substitutable goods are different.
c. consumers do not have perfect information which leads to price differentials.
d. the convenience of buying eggs in the city weakens the homogeneous product assumption.

Answer: D

Difficulty Level: Hard

Section Reference: When Does the Competitive Model Apply?
Learning Objective: Analyze the extent to which the competitive market model applies.
86. Which of the following correctly explains the effect of a price ceiling in a market?

a. The sales of the product will increase.

b. The demand for the product will exceed supply resulting in a shortage.
c. The number of new firms in the market will increase.
d. The output produced in the market will increase.

Answer: B

Difficulty Level: Medium

Section Reference: When Does the Competitive Model Apply?
Learning Objective: Analyze the extent to which the competitive market model applies.

87. Assume a competitive industry produces widgets using labor and capital in fixed proportions.
Both input supply curves slope upward. The government considers the equilibrium price of widgets
to be too high and imposes a price ceiling that is below the equilibrium price. Which of the
following is most likely to occur?

a. The sales of widgets will increase and the prices and employment of both inputs will rise.
b. The sales of widgets will decline and the prices and employment of both inputs will remain
unchanged.
c. The sales of widgets will decline and the prices and employment of both inputs will fall.
d. The sales of widgets will increase and the prices and employment of both inputs will fall.

Answer: C

Difficulty Level: Hard

Section Reference: When Does the Competitive Model Apply?
Learning Objective: Analyze the extent to which the competitive market model applies.

88.Consider a perfectly competitive firm facing the following conditions: TR = 150Q and
TC = 500 + 3Q + Q2. What is the firm’s profit maximizing output?

a. 50
b. 73.5
c. 87.5
d. 102

Answer: B

Difficulty Level: Hard

Section Reference: The Mathematics Behind Perfect Competition*
Learning Objective: Describe the mathematics behind perfect competition.
89. Consider a perfectly competitive firm facing the following conditions: TR = 150Q and
TC = 500 + 3Q + Q2. What is the firm’s marginal cost when Q = 50?

a. 50
b. 78
c. 103
d. 150

Answer: C

Difficulty Level: Medium

Section Reference: The Mathematics Behind Perfect Competition*
Learning Objective: Describe the mathematics behind perfect competition.

90. Consider a perfectly competitive firm facing the following conditions: TR = 150Q and
TC = 500 + 3Q + Q2. What is the firm’s marginal revenue when Q = 50?

a. 50
b. 78
c. 103
d. 150

Answer: D

Difficulty Level: Easy

Section Reference: The Mathematics Behind Perfect Competition*
Learning Objective: Describe the mathematics behind perfect competition.

Question Type: Essay

91. Examine the following markets with respect to the assumptions of perfect competition. Explain
your answer.

a) The market for U.S. dollars

b) The market for public utilities
c) The newspaper market
d) The healthcare market
e) The market for breakfast cereal

Answer:
a) For a market to be considered perfectly competitive it needs to have large number of buyers and
sellers, free entry and exit, product homogeneity, and perfect information. Further, any individual
firm in the market should be a price taker.
1. Number of buyers and sellers: There are a large number of buyers and sellers in the dollar market
such as companies, institutional investors, brokers, hedge funds, traders, central banks, etc.
2. Entry and exit: There are hardly any barriers to entry in the dollar market.
3. Nature of the product: A dollar is standardized and does not vary across countries.
4. Information: Information on factors that drive the value of the dollar is easily available.
All the buyers and sellers in the dollar market are not always price takers; a very large buyer or
seller can influence the price of the dollar, although it would not be possible for a single seller or
buyer to sustain the price change for a long period of time.

b) Public utilities usually refer to water, electricity, public transport, and postal services.
1. Number of buyers and sellers: In most countries, public utilities are provided by a single seller,
usually the government. There are a large number of buyers of public utilities.
2. Entry and exit: There are significant barriers to entry in the public utilities market. High fixed
costs are a deterrent to new entrants. Also, some governments prohibit entry by law.
3. Nature of the product: The nature of public utilities like water and electricity provided to
different homes is the same.
4. Information: Information on the product is easily available to consumers.
Since there is usually only one seller, only buyers are price takers, not sellers.

c)1. Number of buyers and sellers: There are a small number of sellers in the newspaper market
with a large number of buyers.
2. Entry and exit: High fixed costs of printing presses and economies of scale present barriers to
entry in the print newspaper market. In the online newspaper market however, barriers to entry are
almost completely eliminated.
3. Nature of the product: Newspapers are not perfectly substitutable; they can be broadly divided
into tabloids, business newspapers, local dailies, etc.
4. Information: Buyers usually have perfect information about the prices of the various newspapers.

d) 1. Number of buyers and sellers: The healthcare market has a large number of buyers and sellers.
2. Entry and exit: Entry is restricted by high fixed costs like the investment required to set up a
hospital, the advanced educational qualifications required to work in the healthcare industry, etc.
3. Nature of the product: The product is not perfectly homogenous but is differentiated.
4. Information: Information about the product is asymmetric with healthcare providers possessing
more information than patients about the products and services that need to be provided.

e) 1. Number of buyers and sellers: The number of sellers is large. Although the brands of cereal
available are large, the number of sellers who own these brands are not many.
2. Entry and exit: Huge advertising budgets as well as the need for strong distribution networks
form barriers to entry in this industry.
3. Nature of the product: The product is highly differentiated.
4. Information: Consumers have perfect information about the product.

Difficulty Level: Hard

Section Reference: The Assumptions of Perfect Competition
Learning Objective: Outline the conditions that characterize perfect competition.

92. Suppose the total revenue (TR) and total cost (Tc. curves of a perfectly competitive firm are
given by the following set of equations: TR = 100Q and TC = Q2 + 4Q + 5, where Q is the output.
Derive the firm’s profit maximizing output and calculate the total and average profit earned by the
firm at this level of output.

Answer: Since TR = 100Q, marginal revenue [MR] and average revenue [AR] will both be equal to
100 at the profit maximizing level of output. Also, given that TC = Q2 + 4Q + 5, marginal cost
[MC] will be equal to (2Q + 4). We know that in a perfectly competitive market, profit is
maximized at the output where MR = MC. This implies, the profit maximizing output of the firm
will be derived as follows:
100 = 2Q + 4
or Q = (100 – 4)/2 = 48.
Substituting the value of Q in the TR and TC equations we get:
TR = 100 × 48 = 4,800.
TC = (48)2 + 4 × 48 + 5 = 2,501
Now total profit = TR – TC = 4,800 – 2,501 = 2,299 and average profit per unit = 2,299 ÷ 48 = 47.9
(approx.).

Difficulty Level: Medium

Section Reference: Short-Run Profit Maximization
Learning Objective: Explain a competitive firm’s optimal output choice in the short run and how
the firm’s shortrun supply curve may be derived through this output selection.

93. On the graphs below, demonstrate the circumstances that would prevail in a perfectly
competitive market where the representative firm is experiencing economic losses. Draw the
relevant cost curves (marginal, average total, and average variable costs; use U-shaped curves), the
marginal revenue curve, and the market supply and demand curves. Shade in the area of total
revenue and the area of economic loss. As you’ve drawn it, will the firm shut down in the short-run
or choose to continue production? Explain your answer.
Answer:

The loss and revenue are identified in the graph for the representative firm. The loss is the rectangle
ABP0F [ = (AR-ATc.q]. This is an economic loss because the AR (equal to P for a competitive
firm) is less than ATC. This price P0 is taken from the market. Note that MC intersects ATC and
AVC at the minimum of both the ATC and AVC curves. Recall the relationship between
“marginal” and “average”.
Total revenue = AR*q and this is shown by the rectangle P0Bq*O. Note that total cost (TC =
ATC*q) would be rectangle ABP0F plus rectangle P0Bq*O, hence this firm is experiencing
economic losses (which doesn’t mean they are making negative accounting profits; it means they
could be doing better in some other business).
This firm will continue production because P0 > AVC at the profit-maximizing level of output, q*.
They would be worse off by shutting down since they would lose their TFC which are greater than
the current economic losses (rectangle ABP0F). In P0 was AVC, then the firm would be better off
by shutting down (TFC would be less than economic losses).

Difficulty Level: Medium

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

94. Answer the following:

a) Jack’s lawn-mowing service is a profit-maximizing, perfectly competitive firm. Jack mows

lawns for $27 each. His total cost each day is $280, of which $30 is total fixed cost. He mows 10
lawns a day. Will Jack exit the industry in the short-run? Why or why not?

b) Will Jack exit the industry in the long-run? Why or why not?

Answer:
a) Jack will exit the industry in the short-run if the price (P) is not above his average variable cost
(AVc.. TC = TVC + TFC  $280 = TVC + $30  TVC = $250. Thus, AVC = TVC/Q = $250/10
lawns = $25 per lawn. So, P = $27 per lawn > AVC = $25 per lawn and Jack will not shut down in
the short-run.

b) In the long-run, assuming that market conditions remain the same (and there is not an increase in
the demand for mowed lawns for some reason), Jack will exit the industry if P < ATC, that is, if he
is earning negative economic profit.
ATC = TC/Q = $280/10 lawns = $28 per lawn > P = $27 per lawn, therefore Jack is earning
negative economic profit and will exit the lawnmowing business in the long-run, seeking to do
something else with his time and assets like opening a lemonade stand.

Difficulty Level: Medium

Section Reference: The Perfectly Competitive Firm’s Short-Run Supply Curve
Learning Objective: Describe the firm’s short-run supply curve.

92. The long-run cost function faced by each producer in a perfectly competitive industry is given
by: MC(Q) = 20 - 6Q + Q2. The corresponding long-run average cost function is AC(Q) = 20 – 3Q
+ Q2/3. The market demand curve for the product is D(P) = 1100 – 50P.
a) What is the long-run equilibrium price in this industry? At this price, how much would an
individual firm produce?

Answer: In the long-run all firms earn zero economic profit. This implies price [P] = average cost
[AC], and each firm produces where P = MC. Thus,
20 – 6Q + Q2 = 20 – 3Q + Q2/3, solving which we get Q = 4.5. Substituting the value of Q in the
MC equation we get P = 20 – 6 × 4.5 + (4.5)2 = 13.25. This implies, at a price of 13.25, each firm
will produce 4.5 units.

Difficulty Level: Medium

Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.

95. Explain the difference between diminishing marginal returns to factor and a decreasing-cost
industry.

Answer: The upward slope of the short-run industry supply curve (the portion of the marginal cost
curve above the average variable cost curve) is due to diminishing marginal returns. Diminishing
marginal returns operates in the short-run when one input is fixed. It implies that as the
employment of an input is increased, the additional output that is produced with the help of the
additional input decreases.
A decreasing-cost industry is one where the long-run supply curve is downward sloping. This
means that output expands at a lower cost. Lower cost is due to the fall in input prices as more is
demanded.

Difficulty Level: Easy

Section Reference: The Short-Run Industry Supply Curve; The Long-Run Industry Supply Curve
Learning Objective: Explain how the short-run industry supply curve is derived.

96. Fair trade coffee is a movement designed to increase the price coffee growers in developing
countries receive for their output. Retailers such as supermarkets and coffee shops charge their
customers extra for either brewed coffee or coffee beans, promising to remit the additional charge
to coffee growers in developing countries.

a) Assuming entry costs for growing coffee are sufficiently low, which presumably they are,
explain why the fair trade coffee program is not likely to benefit the growers, notwithstanding
coffee retailers’ promises to do so.

b) Who would you predict benefits most from the fair trade subsidy that seeks to improve the living
standards of coffee growers?

Answer:
a) The fair trade coffee program acts as a subsidy to coffee growers, which creates economic profit
that would then be competed away. If barriers to entry are sufficiently low and firms in the
wholesale coffee market are price takers, both of which are true, then any residual paid to existing
coffee growers creates economic profit, which attracts new entrants into the market. The new
entrants then, drive down the existing price of coffee so that the new price plus the residual paid to
coffee growers by the retailers, either brewed or in bean form, equals the original price before the
fair trade program began paying the subsidy.
Suppose coffee beans are selling in the wholesale market without the subsidy for $3 per pound and
that a coffee retailer (i.e., a supermarket) sells the roasted and flavored beans for $10 per pound. In
order to boost the price received by coffee growers, retailers begin charging, say, and extra $2 per
pound under the fair trade program, promising their customers that they will remit the additional $2
per pound to the coffee growers in order to raise their standard of living. Coffee growers now
receive $5 per pound for their coffee beans on the wholesale market, $3 per pound for the coffee
and the $2 per pound fair trade subsidy.
This $2 per pound increase in the earnings of coffee growers around the world means that they now
earn economic profits – a residual payment greater than their opportunity costs of producing coffee.
This attracts new entrants (i.e., marginal growers and those in other markets earning less than the
coffee growers benefiting from the subsidy) seeking some of the economic windfall accruing to
coffee growers, whose additional output in the market drives down the wholesale price to $1 per
pound. That $1 per pound, plus the $2 fair trade subsidy, leaves coffee growers earning no more
than the original $3 per pound they were earning without the fair trade subsidy. And now that there
are more people producing more coffee, it’s likely that the wholesale price actually falls below $1
per pound, leaving the original coffee growers worse off with the fair trade subsidy than without.

b) The demand curve faced by wholesale coffee growers may indeed be highly, if not perfectly,
elastic, but that of the coffee retailers is probably not. This means that the wholesale price falls to
$1 per pound, as noted above, but the retail price of $12 per pound ($10 plus the $2 fair trade
subsidy) does not. In fact, it may serve to better price discriminate (to be discussed in Chapter 12),
thus being at least mostly internalized by the coffee retailers.

Difficulty Level: Hard

Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.

97. Answer the following:

a) Assume that the gold-mining industry is perfectly competitive. On the diagrams below, illustrate
the long-run equilibrium in the overall gold market and for a representative gold mine. Draw the
industry supply and demand curves as well as the firm’s marginal cost curve. Indicate the
equilibrium prices and quantities in both markets (at the industry-level and at the firm-level).

b) Assume an increase in the demand for jewelry causes a surge in the demand for gold. Using
your diagrams, show what happens in the short-run to the gold market and to each existing gold
mine. Specifically, are individual firms earning positive, negative, or zero economic profits?
Indicate their profit on your graph.

c) If the demand for gold remains high, what would happen to the price over time? Specifically,
would the new long-run equilibrium price be above, below, or equal to the short-run equilibrium
price in part (b)? What causes this change in price, if any?
d) Would the new long-run equilibrium price be above, below, or equal to the original long-run
equilibrium price? That is, as you’ve drawn it, is the long-run supply curve in the gold industry
upward-sloping, horizontal, or downward-sloping? Explain why it would have this shape.

Answer:
a) The demand curve, D1, intersects the supply curve at industry quantity Q1 and market price is P1.
Since the industry is in long-run equilibrium, the price equals the minimum point on the
representative firm’s average total cost (ATc. curve, so the firm produces output q1 and makes zero
economic profit.

b) The increase in jewelry demand leads to an increase in the demand for gold, shifting the demand
curve to D2. In the short-run, the prices rises to P2, industry output rises to Q2, and the
representative firm’s output rises to q2. Since price now exceeds ATC, the representative firm now
earns positive economic profits equal to area P2abc.
c) Since gold mines are earning positive economic profits, over time other firms will enter the
industry. This will shift the supply curve to the right, reducing the price below P2. But it’s unlikely
that the price will fall all the way back to P1, since gold is in short supply.
Difficulty Level: Medium
Section Reference: Long-Run Competitive Equilibrium
Learning Objective: Define the conditions characterizing long-run competitive equilibrium.

Answer: Costs for new firms are likely to be higher than for older firms, since they’ll have to
discover new gold sources. Thus, the MC and ATC curves of the representative firm shift upward.
So it’s likely that the long-run supply curve in the gold industry is upward-sloping indicating that
this is an increasing-cost industry. That means the long-run equilibrium price, PLR, will be higher
than it was initially but less than the short-run equilibrium price (higher than P1 but less than P2).

Difficulty Level: Medium

Section Reference 01: Long-Run Competitive Equilibrium
Section Reference 02: The Long-Run Industry Supply Curve
Learning Objective 01: Define the conditions characterizing long-run competitive equilibrium.
Learning Objective 02: Understand how the long-run industry supply curve describes the
relationship between price and industry output over the long run, taking into account how input
prices may be affected by an industry’s expansion/contraction.

98. Given below are the input supply curves for the housing and pencil industries, respectively.
Graphically illustrate the long-run supply curve for the two industries and comment on the nature
of the housing and pencil industries.
Answer: (1) The housing industry: In an increasing-cost competitive industry, increases in output
(in response to increased demand) bid up input prices. Therefore input supply curves are upward
sloping; as more houses are built the inputs that are used in housing are acquired at a higher cost.
The cost curves of the firms in the industry shift upward with increases in output.

(2) The pencil industry: In a constant-cost competitive industry, increases in output (in response to
increased demand) do not affect input prices. Therefore input supply curves are horizontal straight
lines; as more pencils are produced the wood, eraser, and graphite used to produce a pencil are
acquired at the same cost. This is because the demand for wood from the pencil industry is too
small to affect the price of wood. The cost curves of the firms in the industry do not shift with an
increase in output.
Difficulty Level: Medium
Section Reference: The Long-Run Industry Supply Curve
Learning Objective: Understand how the long-run industry supply curve describes the relationship
between price and industry output over the long run, taking into account how input prices may be
affected by an industry’s expansion/contraction.

99. Derive the first-order and second-order conditions for perfect competition.

Answer: The first-order condition for perfect competition is that price should equal marginal cost.
The total profit of the firm is the difference between total revenue and total cost.
Π=R–C
Total revenue is price times quantity; R = PQ. Substituting,
Π = PQ – C
The first-order condition for finding the profit-maximizing output requires that the first derivative
of the total profit function be equal to zero.
 Q C
P – 0
Q Q Q
C
Given that equal marginal cost, P – MC  0
Q
R
Since price remains constant for a competitive firm, marginal revenue given by equals P.
Q
Therefore MR = MC.
The second-order condition for profit maximization requires that the second derivative of the total
profit function be negative:
 2  2C
 0 – 0
Q 2 Q 2
Difficulty Level: Medium
Section Reference: The Mathematics behind Perfect Competition
Learning Objective: Delineate the mathematics behind perfect competition.