Chapter 6

Sellers and Incentives

Questions
1. How can you describe a price-taker? If a farmer raises cattle, can he be considered a price-taker?
What would happen if all cattle farmers decide to raise sheep? Explain.
Answer: A price-taker is an economic agent who is not big enough to influence the market price though
he sells identical goods on the market. A farmer who raises cattle is a price-taker because he sells only a
fraction of the total amount of cattle sold on the market, so his output decisions are not going to influence
the market outcome. If all cattle farmers decide to raise sheep, the price of sheep would fall dramatically
and the price of cattle would increase.
2. Do you think sellers in a perfectly competitive market can price their goods differently? Explain your
answer.
Answer: One of the assumptions of perfect competition is that all sellers sell identical goods. This implies
that sellers who increase the price of their products will lose market share and go out of business because
consumers will shift to other sellers who are offering the same goods. Besides, a seller in a perfectly
competitive market can sell any amount of the good at the given market price. Hence, they actually do not
have any incentive to deviate (increase or decrease) from the market price. Thus, all sellers in a perfectly
competitive market are price takers.
3. How does the marginal product change as a firm increases the number of workers employed? Explain
your answer.
Answer: According to the law of diminishing returns, at a certain point of successive increases in inputs,
the marginal product begins to decrease. With a fixed amount of physical capital, successive increases in
the number of workers eventually lead to lower marginal product, or change in total output per additional
worker.

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4. Use a graph to show the relationship between the marginal cost curve and the average total cost curve
for a competitive firm. What can you conclude about average total cost when marginal cost is less
than average total cost?
Answer: The following graph shows the marginal cost curve and the average total cost curve for a
competitive firm.

As long as marginal cost is less than average total cost, average total cost is declining. When marginal
cost exceeds average total cost, the average total cost is rising. The marginal cost curve intersects the
average total cost curve at its minimum point.
5. Why is it that the industry demand curve slopes downward when the demand curves faced by
individual firms in perfectly competitive markets are horizontal?
Answer: Market demand slopes downward because of the law of demand. However, each firm in a
competitive market is so small that it can increase production without affecting the price of the good, thus
it is as if the demand that this firm faces is perfectly inelastic. If a firm did notice a significant relationship
between price and quantity then it is likely a large part of the overall market, and thus the market would
not be competitive.
6. How does a firm in a competitive market decide what level of output to produce in order to maximize
its profit?
Answer: A firm can maximize profits by producing up to the point where the additional revenue earned
from one extra unit is equal to the additional cost of each unit, i.e. at the point where marginal revenue is
equal to marginal cost. For competitive firms, marginal revenue is equal to price, so these firms will
maximize profits by producing at the point where price is equal to marginal cost.
There are two caveats to the price equal to marginal cost rule. First, in the short run the firm price must be
at least as large as average variable cost; otherwise the firm will shut down. Second, in the long run price
must be as least as large as average cost; otherwise the firm will exit.
7. Define explicit and implicit costs with examples of each.
Answer: Examples provided by students will vary.
Explicit cost is a direct payment made on the course of running a business, such as wage, rent, lease, raw
materials. Explicit costs are taken into account when talking about accounting profit. Implicit cost is the
opportunity cost equal to what a firm must give up in order to use a factor of production for which it
already owns, such as loss of interest income on funds, depreciation of machinery, and the cost of hiring a
worker. It is the opposite of explicit cost and it represents the economic profit.

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8. The following graph shows three supply curves with varying degrees of price elasticity.

Identify the perfectly elastic, perfectly inelastic, and unit elastic supply curves.
Answer: Panel (a) shows a unit-elastic supply curve.
Panel (b) shows a perfectly inelastic supply curve: at every price level the same quantity is supplied.
Panel (c) shows a perfectly elastic supply curve: even a very small change in price leads to an infinite
change in quantity supplied.
9. Would a profit-maximizing firm continue to operate if the price in the market fell below its average
cost of production in the short run?
Answer: A profit-maximizing firm will continue to operate even if price falls below average cost, as long
as price is above average variable cost. This is because, even if price is less than average cost, as long as a
part of the fixed cost is covered, it makes sense to continue production since the alternative is to shut
down (and incur the entire fixed cost). Thus, a profit-maximizing firm will shut down only when price
falls below its average variable cost of production in the short run.
10. What is meant by sunk costs? Are fixed costs or variable costs considered as sunk costs in the short
run?
Answer: Sunk costs are costs that, once committed, can never be recovered and should not affect current
and future production decisions.
In the short run, fixed costs are considered sunk costs because these costs cannot change, no matter how
much the level of output changes. They cannot affect the relative costs and benefits of current and future
production decisions.
11. In each of the following cases, identify whether a competitive firm’s producer surplus will increase,
decrease, or remain unchanged.
i. The demand for the product increases
ii. The firm’s marginal cost of production increases
iii. The market price of the product falls
Answer:
i. An increase in the demand for a product will shift the market demand curve upward. This will
cause an increase in the market price, which in turn will shift the demand curve faced by the
firm (also the equilibrium price) upward. This upward shift in the equilibrium price will
cause the area between the supply curve and the price to increase. As a result, producer
surplus will increase.

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ii. An increase in the firm’s marginal cost of production will shift its supply curve to the left.
With market price remaining unchanged, this will reduce the area above the supply curve and
below the equilibrium price, causing producer surplus to fall.
iii. A decline in price will reduce the difference between the price that the consumer pays and
how much it takes to produce the good. This will reduce producer surplus for the firm.
12. The following graph shows the long-run average total cost curve for a perfectly competitive firm.

Refer to points A, B, and C on the graph and identify where the firm would experience economies of
scale, constant returns to scale, and diseconomies of scale.
Answer: If the firm is operating at point A, it will experience economies of scale as average total cost is
declining. At point B, the firm will experience constant returns to scale as average total cost is neither
increasing nor decreasing. At point C, the firm faces diseconomies of scale as average total cost is
increasing.
13. Explain the concept of zero profits in the long run with the help of an example.
Answer: Firms can earn zero profit in equilibrium. Economic profits are important when deciding if a
company should change its industry or not in order to maximize its profits. Free entry and exit from the
market forces prices to the minimum average total cost (ATC). The economic profits are consequently
zero in the long-run equilibrium. This happens because prices always return to the minimum ATC, and
because ATC does not change, prices are the same in the long run. For example, a company benefits from
the fact that when the market demand increases, the prices might temporarily rise. However, an entry of a
new company in the market shifts the supply curve to the right. In the long run, as other companies
continue to enter the market, the price falls back to the long-run minimum ATC, and the supply curve
becomes horizontal.
14. If some sellers exit a competitive market, how will this affect its equilibrium?
Answer: The market supply curve in a competitive market is a horizontal summation of individual supply
curves. As a result, when some sellers exit the market, the market supply curve will shift to the left. With
demand remaining unchanged, this will increase the equilibrium price and reduce the equilibrium quantity
sold.

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Problems
1. Fixing up old houses requires plumbing and carpentry. Jack (who is a jack of all trades but is a master
of none) is a decent carpenter and a decent plumber, but is not particularly good at either. He can fix
up two houses in a year if he does all of the carpentry and plumbing himself. His wage is $50,000 per
year.
a. What is Jack’s average total cost of fixing up two old houses?
b. George is an excellent plumber and Harriet is an excellent carpenter. George can do all of the
plumbing and Harriet can do all of the carpentry to fix up five houses per year. Each earns a wage
of $50,000 per year. If George and Harriet work together and fix up five old houses each year,
what is their average cost?
c. What does this problem tell you about one of the sources of economies of scale?
Answers:
a. Jack’s total cost for fixing up two houses is his wage, $50,000. Average cost equals total
cost divided by output, and so his average cost is $50,000 / 2 = $25,000.
b. If George and Harriet work together to fix up five houses their total costs will be will be
the sum of their wages, $100,000. Their average cost will be $100,000 / 5 = $20,000.
c. George and Harriet have a lower average cost than Jack working alone because of the
benefits of specialization. Specialization is an important source of economies of scale. In a small
firm, workers must be able to do several different jobs. In a large firm, workers can specialize in
just one or two jobs. The owner of a one-person firm, for example, would have to be responsible
for marketing, finance, and human resource decisions. A larger firm would have specialists to do
each of those jobs.
2. Ethanol has become one of the most important alternative fuels of the world. It is produced mainly
from grains and provides energy efficiency and independence. Assume that a small ethanol plant
from Illinois recorded good production over the past year. During the year, the plant’s fixed and
variable capital remained at the same level. Assuming that the only variable factor of production of
the plant is labor:
a. In the short run, what is the marginal product of each new worker?
b. In the long run, will the outcome be different? Explain your answer.
Answers:
a. The law of diminishing returns states that successive increase in inputs eventually leads to less
additional output. It implies that, since the number of plants and facilities is fixed in the short run,
the marginal product of workers will eventually decrease.
d. In the long run, the firm will have to increase its capital in its facilities in order to
increase workers’ productivity.

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3.

4. Fill in the ATC and MC columns in the following table.

Output Total Cost Average Total Marginal Cost

Cost

0 $14

1 15

2 18

3 24

4 36

a. Use the MC curve to determine how many units this firm will supply if the market price were
$10.
b. Assuming free entry and exit of other firms, based on the ATC curve, what will the price be in the
long run?
Answers:
Output (Q) Total Cost (TC) Average Total Cost (ATC) Marginal Cost (MC)

0 $14 -- --

1 15 $15 $1

2 18 9 3

3 24 8 6

4 36 9 12

Notice that ATC is not defined when Q = 0. Otherwise, it is total cost divided by quantity Q. MC is the
difference between TC in each row.
a. The firm would want to make the first 3 units since MC is less than $10, but not the 4th unit since
MC is greater than $10. In other words, the additional $12 cost is not worth it given it only brings
in $10 in extra revenue. If you want, you can calculate profit (Q times $10 minus TC) at each Q;
you will discover the maximum is $30 - $24 at Q = 3.
b. Due to entry and exit of firms, price will be driven to the minimum ATC in the long run. In this
case it is $8.
5. Jeremy worked at a bank with a monthly salary of $1,500. He decided to quit his job and open a
bookstore in his neighborhood. He now pays $500 in rent, $80 in utilities, and $120 in wages every
month.
a. Suppose Jeremy sells 100 books at the price of $30 every month.

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i. What is the monthly total revenue of Jeremy’s bookstore?

ii. How much accounting profit does Jeremy make every month?
iii. How much economic profit does Jeremy make every month?
b. If Jeremy had not quit his job at the bank, he could have been promoted and got a pay raise of 30
percent.
i. Will there be any changes in the monthly explicit and implicit costs of Jeremy’s
bookstore?
ii. Will there be any changes in the accounting profits of Jeremy’s bookstore?
iii. Will there be any changes in the economic profits of Jeremy’s bookstore?
Answer:
a.
i. The monthly total revenue = 100 × $30 = $3,000
ii. Accounting profits = total revenue – explicit costs = $3,000 – $500 – $80 – $120 =
$2,300
iii. Economic profits = total revenue – explicit costs – implicit costs = $3,000 – $500 – $80 –
$120 – $1,500 = $800
b.
i. There will be no changes in the explicit costs, but the implicit costs will increase from
$1,500 to $1,950 as after the 30 percent raise, Jeremy’s monthly income would be
$1,950.
ii. Since there are no changes in the explicit costs, there will be no changes in the
accounting profits.
iii. Since the implicit costs will increase from $1,500 to $1,950, the economic profits will
decrease from $800 to $350 ($2,300 – $1,950).
6. You are one of 5 identical firms (i.e., you all have the same costs) that sell widgets. Each day you
have a fixed cost of $9 to operate. The marginal cost of your first through fifth widgets are $1, $2, $3,
$7, and $8, respectively. You have a capacity constraint of 5, and you can only produce a whole
number of widgets.

a. What is the average variable cost (AVC) for a firm that produces 2 widgets?

b. What is the market-level quantity supplied given a price of $2.50?

c. Suppose the market-level demand is fixed at 18. In other words, there is perfectly inelastic
demand. What is the equilibrium price in the short run?

d. Given perfect competition, what will be the price in the long run?

Answers:

a. Two widgets have a variable cost of $1 + $2 = $3, so the average of this is $3/2 = $1.50.

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b. Each firm will want to supply 2 widgets each as a third widget has a marginal cost of $3 which is
greater than the price of $2.50. Given there are 5 firms; this means the supply will be 10.

c. For the market supply to be 18 each firm must be willing to supply either 3 or 4 (i.e. 2 firms will
supply 3 each and 3 firms will supply 4 each for a total of 18). The price that induces firms to
supply either 3 or 4 is exactly $7: Firms will be just indifferent between supplying the 4th widget
as the marginal cost exactly equals the price.

d. The minimum average total cost (ATC) is $5 at Q = 3. (At Q = 2, ATC is $6;  at Q = 4, ATC is
$5.50). Thus $5 is the long-run price.

7. There are many identical firms with a simple cost structure: Total cost for Q = 0 is $6 and  total cost
for Q = 1 is $8. Each firm is incapable of producing anything more; in other words, total cost is
infinite for any Q larger than 1.

a. What is the fixed cost? What is the marginal cost of the first unit?

b. In the short run, above what price will firms supply one unit each?

c. If firms are free to enter and exit this market, what will be the long-run price?

Answers:

a. Fixed cost is $6 as this is the cost of producing nothing.

b. The marginal cost of the first unit is $2, thus this is the lowest price at which firms will sell. At
any price below this the firm will shut down and produce Q = 0.

c. The minimum ATC is the only ATC that is defined: $8 at Q = 1, thus $8 will be the long-run
price. For any price below $8 firms will lose money, while for any price above $8 other firms will
want to enter the market.

8. For the Olympic Games, the demand to watch the sporting event live is always greater than the
number of seats available. After the event is sold out officially, people start to trade in the secondary
markets. However, the tickets sold through secondary sources are usually much more expensive than
their face value. Explain why.
Answer: Since the number of seats available at the field is fixed, the price elasticity of supply is zero,
which means the supply of the tickets is perfectly inelastic. As demand for the Olympic Games is
massive, with a vertical supply curve, the equilibrium prices for its tickets would be very high.
Assuming that fewer people trade in the secondary black-market than in the official market, the inelastic
supply curve for tickets shifts to the left. This pushes the equilibrium price further up. Thus, tickets sold
through secondary sources are usually much more expensive than their face value.
9. Daniel sells 500 hotdogs in a perfectly competitive market every week. The weekly fixed cost of his
shop is $1,000 and the variable cost is $500. If the price of each hotdog is $2, explain whether Daniel
is making a profit or a loss, and whether he should continue to operate his shop or shut it down.
Answer: The average total cost of producing 500 hotdogs is ($1000 + $500) / 500 = $3. As the price of
each hotdog ($2) is lesser than the average total cost ($3), Daniel is incurring a loss. However, since the
price of each hotdog ($2) is higher than the average variable cost ($500/500 = $1), Daniel should continue
to operate his shop.

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10. This problem asks you to think carefully about sunk costs.
a. The International Space Station (ISS) is a habitable satellite that was launched by NASA and
space agencies of other countries. In 2009, NASA was considering shutting down the ISS within
the next 5 to 6 years. Among those who were opposed to this idea of de-orbiting the ISS was
Senator Bill Nelson, who was quoted as saying, “If we've spent a hundred billion dollars, I don't
think we want to shut it down in 2015.” Identify the flaw in the Senator's reasoning.
b. You are planning to build an apartment building. Your market research department estimates that
your revenues will be $9.0 million. Your engineering department estimates the cost will be $6.0
million. You have started construction and spent $1.5 million to build the foundation when the
recession begins. This causes the market research department to revise its revenue estimates
downward to $4.0 million. Should you complete the apartment building?
Answer:
a. The Senator’s reasoning is flawed because the $100 billion already spent on the ISS represents a
sunk cost. Once they are committed, sunk costs should not affect current or future investment or
production decisions. The decision to de-orbit the satellite should be based on a cost-benefit
analysis. If the benefits in the future do not outweigh the costs in the future, then it would be a
good idea to shut the ISS down, irrespective of the costs already incurred.
See ‘Sunk Costs in Space’:
http://www.economist.com/blogs/freeexchange/2009/07/sunk_costs_in_space
b. The decision to continue a project should depend on the expected revenues and the marginal cost
of completing the project. It should not be based on the amount of money that has already been
invested. Based on this we can conclude that the construction of the apartment building should
not be completed. The marginal cost involved ($6.0 million total cost minus the $1.5 million
already spent, or $4.5 million) is higher than the expected revenue ($4.0 million); the money
already spent is irrelevant.
11. Larry Krovitz is a salesman who works at a used-car showroom in Sydney, Australia. It’s the last
week of July but he is yet to meet his sales target for the month. A customer, Harold Kumar, who
wants to buy a Ford Fiesta, walks in to the showroom. After taking one of the cars for a test drive,
Harold decides to buy it. While $11,000 was the least that Larry would have been willing to accept
for that car, he quotes a price of $15,000. After some bargaining, the car is sold for $12,000.
a. What is the producer surplus in this case?
b. If Larry bought the car for $8,000, what is his profit?
c. Is producer surplus always equal to profit? Explain your answer.
Answer:
a. The producer surplus is the economic surplus gained in the market, calculated as the difference
between a seller’s supply curve and the price the consumer pays. In this case, $11,000 is the price
represented by Larry’s supply curve, since that is the minimum he would want in order to sell the
car. Since he gets $12,000 for the car, his producer surplus is $12,000 – $11,000 = $1,000.
b. Larry’s profit is the difference between Larry’s revenues and costs. This is equal to $12,000 –
$8,000 = $4,000.
c. For a single unit of a good, profit is the difference between the price and the average total cost.
Producer surplus, on the other hand, is the difference between the seller's supply curve and the
price that the consumer pays. Since the supply curve in a competitive market is the upward-rising
portion of the marginal cost curve, producer surplus is the difference between the marginal cost

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and the price. This would mean that producer surplus is equal to profit when marginal cost is
equal to average cost.

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12. The following table shows the long-run total costs of four different firms:
Fir Firm Firm Firm
mA B C D
Output Total costs ($)
10 90 100 100 70
12 120 108 96 120
25 200 175 225 225
40 280 320 280 320
a. Calculate the ATC for these firms and explain if they experience economies or diseconomies of
scale.
b. Find the minimum efficient scale for each firm, given that the minimum efficient scale is the
lowest level of output at which long-run average cost is minimized.
Answer:
a.
ATC for ATC for ATC ATC for
TC for TC for TC for TC for
Output Firm A Firm B for Firm Firm D
Firm A Firm B Firm C Firm D
C
10 90 9 100 10 100 10 70 7
12 120 10 108 9 96 8 120 10
25 200 8 175 7 225 9 225 9
40 280 7 320 8 280 7 320 8
A firm experiences economies of scale when its average total cost is declining as more output is
produced. Diseconomies of scale occur when average total cost increases as output rises. Firm A
experiences diseconomies of scale for the second unit, then economies of scale for the next unit.
Firm B experiences economies of scale. Firm C experiences economies of scale, with a small
diseconomy of scale between unit 2 and 3. Firm D experiences economies of scale, with
diseconomy of scale when producing unit 2.
b. The long-run ATC is at its minimum when 4 units are produced by Firm A, 3 units are produced
by Firm B, 4 units are produced by Firm C, and 1 unit is produced by Firm D.

13. Suppose a firm is described by the following: Market demand is P = 50 – Q; ATC = 20 + 4Q; and MC
= 30 + 5Q.

a. Find the profit maximizing price and quantity.

b. What is the firm’s profit?

c. Suppose that the firm incurs additional costs and now needs to produce at the quantity where
price equals ATC. Calculate the new price and quantity.

Answers:

a. To maximize its profit, MR = MC. Thus, 50 – Q = 30 + 5Q → Q = 5. In this case, the price is: P =
50 – 5 = $45.

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b. To find what is the profit, we need TR and TC. We know that TR = P × Q → TR = 45 × 5 → TR =

225. We also know that TC = 20 + 3Q → TC = 20 + 15 = 35. Thus, the profit is: Profit = TR – TC
→ Profit = 225 – 35 = $190.

c. To find the quantity where price equals ATC, we use the demand curve and the average total cost
curve. Thus, 50 – Q = 20 + 4Q → Q = 6. Thus, the price is: P = 50 – Q → P = 50 – 6 = $44.

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