Ch. 11 Costs and Profit Maximization Under Competition

Imagine that you are the owner of a stripper oil well and that you want to maximize your profit. What three questions present themselves?

What price to set?
What quantity to produce?
When to enter or exit the industry?

True or false, you cannot sell any oil at the price above the market?

True

True or false, you cannot sell all your oil at the market price?

False, you can sell all your oil at the market price.

If you want to maximize your profit, at what price do you want to sell your oil?

Market

At the world price, how elastic is the demand for your oil that you want to sell?

Perfectly elastic

About ____________barrels are bought and sold every day.

82mil

What is the price per barrel of oil if you decide to sell 2, 7 or 10 per day?

Same as the market price

True or false, the competitive firm is a price taker because the price stays the same whether you decided to sell a different quantity of barrels per day?

True

True or false, generalizing a perfectly elastic demand curve for the firm output is a reasonable approximation when the product being sold is similar across different firms and there are many buyers and sellers, each small relative to the total market?

True

Long run

After all entries and exits has occurred.

Short run

the period before exit or entry can occur.

True or false, even when there are many sellers there are not many potential sellers?

False, even when there are many sellers there are many potential sellers.

What type of industry is it when firms do not have influence over the price of their product?

Perfectly competitive

What are the conditions for a perfectly competitive industry?

Many buyers and sellers, each small relative to the total market

Product sold is similar across sellers

Many potential sellers

When do firms have a lot of influence on the product of their price?

Not many sellers
Not many potential sellers

Sunk cost

a cost that has already been paid and cannot be recovered

True or false, Maximizing profit involves knowing what to ignore and what to consider?

True

What type of costs need to be ignored in the short run?

Sunk Fixed

What is the general principle of rational choice?

Ignore what you can't change and focus on what you can.

Fixed cost

Does not vary with the quantity produced

If you spend 5000$ to drill your oil well, what influence should that cost have on what quantity you produced?

None. The cost is a sunk cost.

True or false, you should ignore fixed costs when deciding what quantity to produce?

True

Should you ignore the cost of rent when choosing whether or not to exit?

No

Can fixed costs be changed in the long run?

Yes
Entry or exit

What is the difference between fixed costs and sunk costs?

Sunk costs can never be changed
Fixed costs can In the long run but not in the short.

Explicit cost

a cost that involves spending money

Examples of explicit costs?

Lian spends 10,000$ to buy flowers from a wholesaler to run her flower shop.

Rent for running her flower shop

Electricity for running her flower shop

A cost that does not require spending money?

Implicit costs

Are all examples of implicit costs.

The opportunity to earn 7000$ as a patent attorney which is a cost of running a flower shop if you choose one over the other.

Accounting profits

total revenue - explicit costs

Economic profits

Total revenue -total costs, including implicit opportunity costs.

Why is the distinction between accounting profit and economic profit so important?

Firms prefer to maximize economic profit.

What do you do when calculating the economic profit?

Include the opportunity cost of renting what you own to another firm.

Profit =

total revenue - total cost

Revenue

Price x Quantity

Total cost

fixed costs + variable costs

True or false, rent is a fixed cost?

True

Which costs do not vary with output?

Fixed

Which costs vary with output?

Variable

Examples of variable costs?

-salary payments
-energy, utilities
-raw materials
-insurance on merchandise and employees
-maintenance costs

Difference between total revenue and total cost?

profit

Marginal revenue = Marginal cost

Maximum profit

Marginal revenue

the change in total revenue from an additional unit sold

Marginal revenue formula

MR= change in total revenue/ change in quantity

What does marginal revenue = to for a firm in a competitive industry?

MR=Price

Marginal cost

change in total cost / change in quantity

A perfectly competitive industry exists under which of the following conditions?
I. The product sold is similar across firms.
II. There are many sellers, each small relative to the total market.
III. There are many sellers, each with total assets less than $2 million.
IV. The threat of competition exists from potential sellers that have not yet entered the market.

I and II only
I, III, and IV only
I, II, and IV only
I, II, and III only

I, II and IV only

What condition is necessary in a constant cost industry?

Prices of the industry's inputs decline as the industry expands.

Prices of the industry's inputs do not change as the industry expands.

Prices of the industry's inputs rise as the industry expands.

There are barriers that prevent new firms from entering such an industry.

Prices of the industry's inputs do not change as the industry expands.

If Tom sells 500 sandwiches for $7 and has an average cost of $5, what is his profit?

$3,500
$500
$2,500
$1,000

1000

The oil industry is an increasing cost industry because:

All of these statements are correct.

people buy more oil at lower prices.

because oil is a necessity good.

expanding output requires firms to use more
expensive production methods to find and extract oil from less desirable locations.

expanding output requires firms to use more
expensive production methods to find and extract oil from less desirable locations.

In competitive markets, the demand curve faced by the individual firm is:

equal to the market demand curve.
perfectly elastic.
downward sloping.
perfectly inelastic.

perfectly elastic.

In a competitive equilibrium, firms earn ______ economic profits.

positive
zero
negative
abnormal

zero

To maximize profits, a firm in a highly competitive industry should set its price:

lower than the market price.

at the market price.

higher than the market price.

it depends: sometimes at the market price but sometimes higher or lower.

at market price.

Which of the following statements is TRUE?

A firm should enter an industry if average costs are less than producer surplus.

Entry and exit from an industry depend on the firm's market share.

High profits in an industry give entrepreneurs an incentive to enter that industry.

Fixed costs fall as firms produce more output, the so called "spreading of the costs."

High profits in an industry give entrepreneurs an incentive to enter that industry.

In a constant cost industry, P = AC = $20. Which sequence of events follows an increase in demand?

P > AC, firms make an economic profit, existing firms expand output, new firms enter the industry, the short-run supply curve shifts right, price falls until profits return to $0

P > AC, firms make an economic profit, existing firms expand output, new firms enter the industry, the short-run supply curve shifts left, price falls until profits return to $0

P = AC, firms make no economic profit, existing firms leave output unchanged, new firms enter the industry, profits remain normal, P = AC = $20

P < AC, firms suffer an economic loss, existing firms reduce output, new firms enter the industry, the short-run supply curve shifts right, price falls until profits exceed $0

P > AC, firms make an economic profit, existing firms expand output, new firms enter the industry, the short-run supply curve shifts right, price falls until profits return to $0

Profit is maximized by producing until:

MR=MC

True or false, at some point, marginal cost must increase?

True

When should the owner of an oil well keep producing additional barrels of oil?

So long as the revenue from producing an additional barrel exceeds the cost of producing an additional barrel.

MR>MC

Where can we find the profit-maximizing quantity for a competitive firm?

P=MC

Average cost

the total cost divided by the quantity produced.
AC=TC/Q

Are high or low fixed costs going to change the profit maximizing quantity where P=MC?

No

True or false, fixed costs are irrelevant when determining to exit the firm?

False, fixed costs are relevant when determining when to exit the firm.

What are two other equations that profit is equal to?

(TR/Q - TC/Q)*Q

(P-AC)*Q

What point on the Average cost curve can you find the lowest price per barrel where a firm can make a profit?

The lowest point on the Average Cost curve.

When Price = Average cost how much profits will firms be making?

Zero

When are there no incentives to enter or exit the industry?

When Price = Average Cost

What are normal profits?

Zero profits

Price of output is just enough to pay labor and capital at:

Zero profits

Total cost=

fixed cost + variable cost

In the __________the fixed costs are an expense but not an economic opportunity cost so they should be ignored.

Short

Average Variable Cost

P < VC/Q

When should the firm exit as soon as possible?

If it cannot cover its variable costs

Where can we see the average variable cost on the graph?

Below AC and above AVC

Costs increase with greater industry output and this generates an upward-slopping supply curve.

Increasing cost industry

Constant cost industry:

costs do not change with changes in output (flat supply curve) costs

Costs decrease with greater industry output and this generates a downward-sloping supply curve.

Decreasing cost industry

True or false, as price increases, each firm expands output by moving along its marginal cost curve?

True

True or false, any industry that buys a large fraction of the output of an increasing cost industry is an increasing cost industry?

True

What type of elasticity does the long run supply curve of the domain name registrar industry?

Flat
Very elastic

When an increase in demand hits the domain name registrar industry in the short run, what happens to the price?

Increases

Each firm expands output by moving along which curve?

Marginal cost curve

True or false, entry is the third response to increase in demand?

False, entry is the second response to increase in demand.

______________is small relative to its input markets, so when the industry ___________expands, it does not push up the price of its inputs and thus industry costs do not____________.

Constant cost industry
Expands
Increase

Could firm costs decrease as the industry expands, creating a decreasing cost industry with a downward-sloping supply curve?

YES

If the demand for computers were to increase in silicone valley today, the price of computers will ________not________.

Rice not fall

Once the cluster of the decreasing cost industry is established _________or__________increasing costs are the norm.

Constant
Increasing

(Table: Barrels of Oil 2) Refer to the table. What is the marginal cost of producing the seventh barrel of oil?

90
36
126
50

Total cost of the 7th unit 126$- total cost of the 6th unit 90$=36

(Table: Barrels of Oil 2) Refer to the table. The maximum profit available to the company is:

$266.
$210.
$184.
$224.

MAXIMUM= MR=MC

Find where marginal revenue = marginal cost:
Unit 8 TR=400, TC= 176
subtract TR-TC= 224

A competitive market has which of the following characteristics? *

a. Lots of small-scale sellers
b. Lots of small-scale buyers
c. A product that is similar across sellers
d. A & C only
e. All of the above.

e. All of the above.

In a competitive market, sellers sell their product *

a. At the world price.
b. Just below the world price.
c. Just above the world price.
d. At a price dependent on the quantity chosen.

a. At the world price.

On January 27, 2011, the price of Ford Motor Company stock hit an almost 10-year high at $18.79 per share. (Two years prior, in January 2009, Ford stock was trading for about a tenth of that price.) Suppose that on January 27, 2011, you owned 10,000 shares of Ford stock (a small fraction of the almost 3.8 billion shares). Suppose you offered to sell your stock for $18.85 per share, just slightly above the market price. How many shares would you sell? *

a. 10,000
b. 7,300
c. 1
d. 0

0

Suppose instead that on January 27, 2011, you wanted to sell your 10,000 shares of Ford stock but you reduced your asking price to $18.75 per share? How many shares would you sell? *

a. 10,000
b. 7,300
c. 1
d. 0

10,000

Given your answer to the previous question, should you sell your shares at $18.75?

a. Yes
b. No

No

Should you produce more or less when MR< MC?

Less because you will increase your profit.

The economic definition of profit differs from the accounting definition of profit in that the economic definition includes *

a. Fixed costs.
b. Variable costs.
c. Opportunity costs.
d. Sunk costs.
e. None of the above.

c. Opportunity costs.

Whenever money is used to purchase capital, interest costs are incurred. Sometimes those costs are explicit—like when Alex borrowed the money from the bank—and sometimes those costs are implicit— like when Tyler had to forgo the interest he could have earned had he left his funds in a savings account. If an economist and accountant calculated Alex and Tyler's costs, for whom would they have identical numbers and for whom would the numbers differ? *

a. Economist and accountant would agree on Alex's costs and disagree on Tyler's.

b. Economist and accountant would agree on Tyler's costs and disagree on Alex's.

a. Economist and accountant would agree on Alex's costs and disagree on Tyler's.

In the aforementioned disagreement on cost of one of the activities, which profession would calculate a larger cost? *

a. Economist.
b. Accountant.

a. Economist.

Which type of cost is dependent on the amount of quantity produced by a firm? *

a. fixed costs
b. variable costs
c. sunk costs
d. none of the above

b. variable costs

A competitive firm maximizes profit by choosing a level of output where the world price is equal to the firm's *

a. Marginal revolution.
b. Marginal revenue.
c. Marginal cost.
d. Average cost.
e. Fixed costs.
f. Variable costs.

c. Marginal cost.

Fill in the blank: Even if profit is negative, if revenues are ______ variable costs, then it's best to stay open in the short run.
a. >
b.<

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