Optional Exam 3 Study Questions

Does the proprietor of a grocery store who owns the building in which his business is located have lower costs than a grocery store proprietor who must pay rent for the building in which his store is located?

No.

Explanation: The owner still incurs an opportunity cost equal to the rent he could have earned by leasing the building to someone else. Economic costs (explicit + implicit) are the same for both proprietors. Accountants often ignore the implicit rent; economists do not.

If a professor gives up her job to open a shoe store, which of the following costs would an accountant tend to ignore?

The opportunity cost of the professor’s forgone salary.

Explanation: Accountants record only explicit (out-of-pocket) costs. The salary the professor gave up is an implicit opportunity cost and is therefore ignored in accounting statements.

A necessary condition for “perfect competition” is

A large number of buyers and sellers, free entry and exit, a homogeneous product, and perfect information.

Explanation: These conditions ensure that individual firms are price takers, that no firm can earn long-run economic profits, and that resources can move freely.

A perfectly competitive firm’s supply curve follows the upward-sloping segment of its marginal cost curve above the:

Average variable cost (AVC) curve (specifically its minimum point).

Explanation: Below minimum AVC the firm shuts down and supplies zero output. Above that point the firm supplies along its marginal-cost curve. Thus the short-run supply curve is the portion of MC that lies above minimum AVC.

In the short run, a firm should shut down its operation if:

Total revenue is less than total variable cost (or equivalently, P < AVC).

Explanation: Fixed costs are sunk in the short run. The firm continues to operate as long as revenue covers variable costs and contributes something toward fixed costs. If TR < TVC, losses are minimized by producing zero.

Which of the following is NOT a condition of perfect competition:

Market barriers are in place.

Explanation: Perfect competition requires free entry and exit. The existence of significant barriers to entry is a defining feature of monopoly or imperfect competition, not perfect competition.

In a competitive industry the market-determined price is $12. A firm is currently producing 50 units of output; average total cost is $10, marginal cost is $15, and average variable cost is $7. In order to maximize profit, the firm should:

Produce less.

Explanation / Math:
P = $12, MC = $15 → the last unit added $15 to cost but only $12 to revenue, reducing profit by $3.
Profit is maximized where MC = P. Because MC > P, the firm should reduce output until MC falls to $12.
(Note: P > ATC, so the firm is still earning positive economic profit and should not shut down.)

Assume there is a decrease in the market demand for a good sold by price-taking firms that are initially producing the profit-maximizing level of output. For the individual firm, this would result in:

A decrease in both the market price and the firm’s profit-maximizing quantity of output.

Explanation: The market demand shift lowers the equilibrium price faced by every price-taking firm. Each firm then moves leftward along its MC curve to a lower optimal quantity and earns lower profit.

For a monopoly, the marginal revenue curve:

Is downward-sloping and lies below the demand (average-revenue) curve.

Explanation: To sell one additional unit a monopolist must lower the price on all units sold. Therefore marginal revenue is less than price at every quantity.

Which of the following is not considered a barrier to entry?

Diseconomies of scale.

Explanation: Diseconomies of scale raise long-run average cost as a firm grows larger; they do not prevent new firms from entering. Classic barriers include patents, exclusive resource ownership, government licenses, and economies of scale that create a natural monopoly.

For a monopolist to practice price discrimination, one necessary condition is that the product offered for sale must be:

Impossible (or very difficult/costly) to resell.

Explanation: If low-price buyers can easily resell to high-price buyers (arbitrage), the seller cannot maintain different prices. Preventing resale is therefore required for successful price discrimination.

A prisoner’s dilemma exists when:

All parties end up worse off than they would be if they could credibly agree to another set of actions.

Explanation: The dominant-strategy Nash equilibrium is Pareto-inferior to mutual cooperation. Each player has an incentive to defect even though both would be better off cooperating.

Fill in the blanks: A price discriminating firm will tend to charge a ________ price for the category of customer with the ________ elasticity of demand.

Higher; lower.

Explanation: The firm charges a higher price to the group with the lower (more inelastic) elasticity of demand and a lower price to the group with the higher (more elastic) elasticity.

The following represents the payoffs to two students (Student A & Student B) who have been caught cheating… What will be the Nash equilibrium if there is no interaction between the two students?

Both students confess.

Explanation / Math (payoff matrix – fines, so lower numbers are better):

	B Silent	B Confess
A Silent	–2, –2	–10, 0
A Confess	0, –10	–5, –5

• If B stays silent, A’s best reply is Confess (0 > –2).

• If B confesses, A’s best reply is still Confess (–5 > –10).

Confess is a dominant strategy for both players. The unique Nash equilibrium is therefore (Confess, Confess).

A firm with market power is producing a level of output at which price is $8, marginal revenue is $5, average variable cost is $6, and marginal cost is $10. In order to maximize profit, the firm should:

Increase price (which reduces output).

Explanation / Math:
MR = $5 < MC = $10 → the firm is producing too much. It should reduce quantity until MR = MC.
A firm with market power faces a downward-sloping demand curve, so a lower quantity corresponds to a higher price.
Shutdown check: P = $8 > AVC = $6, so the firm covers its variable costs and should continue operating (at the new lower quantity).

A drugstore offers a discount on prescriptions to senior citizens. This suggests that the absolute value of elasticity of demand for senior citizens is:

Greater than the absolute value of the elasticity of demand of other (non-senior) customers.

Explanation: Sellers charge lower prices to more price-sensitive (higher-elasticity) groups. The senior-citizen discount therefore indicates that seniors have the more elastic demand.
In price discrimination:

• Customers with more elastic demand are charged a lower price.

• Customers with less elastic demand are charged a higher price.

Therefore, the absolute value of senior citizens’ price elasticity of demand is likely larger.

Which of the following statements is not a characteristic of a perfectly competitive firm?
a. Perfectly competitive firms view each other as fierce rivals.
b. Firms are price-takers.
c. All firms produce a homogeneous product.
d. Perfectly competitive markets allow freedom of entry and exit.

a

Explanation: In perfect competition each firm is so small relative to the market that its own output decisions have no measurable effect on market price or on any other firm’s ability to sell. Therefore firms do not strategize against one another as rivals; they simply take the market price as given. The other three statements are definitional features of the model.

Since the firm’s demand curve is perfectly elastic for a price-taking firm,
a. P = MR
b. P = MRP
c. P = TR
d. both a and b.
e. both a and c.

a
Explanation: A horizontal demand curve means the firm can sell any quantity at the prevailing market price. Therefore the additional revenue from selling one more unit (marginal revenue) equals price: MR = P (Option b confuses product-market revenue with the factor-market concept of marginal revenue product.)

In the short run, a firm shuts down when

a. profit is negative.

b. TR < TVC.

c. MRP > ARP at the level of labor usage where $ MRP = w.

d. both b and c.

e. all of the above.

d

Explanation: Negative profit alone is not enough to shut down; the firm continues operating as long as revenue covers variable cost (so that some contribution remains for fixed cost). The precise shutdown condition is $ TR < TVC (or equivalently $ P < AVC). The labor-market condition in (c) is also a shutdown signal under the competitive factor-market version of the same logic.