Review Questions: A Firm's Profit-Maximizing Choices

1) Is the number of sellers in the market the only thing that is different in each of the four
market types economists study?
Answer: No, the number of sellers is not the only factor that differs; the degree of
similarity of each firm's product also plays a role. For instance, in a perfectly competitive
market, each firm sells an identical product whereas in a monopolistically competitive
market, each firm sells a slightly different product.

2) Why do you never see firms in a perfectly competitive market advertise their product?
Answer: Advertising has costs and benefits for the typical firm. The cost is the expense
of running the advertising and the forgone value of the next best use of the firm's funds.
The benefit of advertising is the increased probability that the firm can increase the
demand for its good or service. Therein lies the problem for perfectly competitive firms.
Perfectly competitive firms sell an identical product. Who is going to believe an
asparagus farmer in California that runs a television ad proclaiming that her asparagus is
better than other farmers? If demand is not increased by the ad, which is likely, the only
thing that is certain is that the farmer's costs have increased. Along with the higher costs
comes decreased profit and an increased likelihood of going out of business.

3) What are the four types of markets? Give a brief description of each type.
Answer: The four types of markets are perfect competition, monopoly, monopolistic
competition, and oligopoly.
∙ Perfect competition has many firms selling identical products to many buyers, with no
barriers to entry or exit.
∙ Monopoly has one firm selling a good with no close substitutes and a barrier that blocks
the entry of new firms.
∙ Monopolistic competition has many firms making similar but not identical products with
no barriers to entry or exit.
∙ Oligopoly has a small number of generally large firms producing either identical or
differentiated products.

4) What four conditions define a perfectly competitive market?

Answer: The four conditions are that:
a. many firms sell an identical product to many buyers.
b. there are no restrictions on entry into (or exit from) the market.
c. established firms have no advantage over new firms.
d. sellers and buyers are well informed about prices.

5) Does a perfectly competitive producer have any incentive to lower its price so it is below
the current market price? Explain your answer
Answer: A perfectly competitive producer has no incentive to lower its price because the
producer can sell all he or she produces at the going market price. In this case, a producer
will not lower the price he or she charges because no additional sales can be garnered.
Hence it is nonsensical to undercut the market price because the lower price means lower
revenue and hence lower profit

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6) Why are perfectly competitive ranchers in Montana price takers?
Answer: Because one farmer's beef is identical to another farmer's, each farmer's beef is
a perfect substitute for all other farmers' beef. In addition, there are over one million
ranchers in the United States. As a result, no individual rancher can impact the market
price by increasing or decreasing production. Therefore each rancher faces a perfectly
elastic demand. Each can sell all of the beef desired at the market price, but not one
penny more. Once the market sets the price, the rancher must take as given whatever the
price might be.

7) If a perfectly competitive firm manufacturing chairs produces 100 more chairs, what
happens to the market price of a chair?
Answer: The price will not change. Any one perfectly competitive firm is such a small
part of the market that a change in its output has virtually no effect on the price. This
result is why the firm's marginal revenue equals its price: No matter how much (or how
little) the firm produces, the marginal revenue from one more unit always equals the price
of the product.

8) Why does the profit-maximizing level of production occur at the point where marginal
revenue equals marginal cost?
Answer: If a firm produces at a level where marginal revenue is greater than marginal
cost, more profit could be gained by increasing output. Why? Because the added revenue
(the marginal revenue) from producing another unit exceeds the added cost (the marginal
cost) of producing the unit. Therefore the firm should increase production until no more
additional profit can be earned, which occurs where marginal revenue equals marginal
cost.

Similarly, if a firm produces at a level where marginal cost exceeds marginal revenue, the
firm's profit would rise by decreasing output. In this case, the saved costs (the marginal
cost) exceed the lost revenue (the marginal revenue). Therefore the firm should decrease
production until the point at which marginal cost equals marginal revenue.

9) If the market price faced by a perfectly competitive firm increases, in the short run how
does the firm respond?
Answer: If the market price rises, a perfectly competitive firm increases its output.
Essentially the firm moves upward along its marginal cost curve, thereby increasing the
quantity the firm will supply.

10) If the price received by a perfectly competitive firm is less than its average variable cost,
what will the firm do in the short run? Why?
Answer: If the price is less than the average variable cost, the firm will shut down in the
short run. By shutting down, the firm will incur an economic loss equal to its fixed cost.
Whereas if the firm operated, its economic loss would be larger. Therefore the firm
minimizes its loss by shutting down.

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11) Will a perfectly competitive firm ever produce in the short run even though it is suffering
an economic loss?
Answer: Yes, a perfectly competitive firm will continue to produce even though it is
suffering an economic loss if the price exceeds the minimum average variable cost. In
this case, even though the firm has an economic loss, if it shut down, its economic loss
would be larger.

12) What must be the case if a perfectly competitive firm's economic loss is less by shutting
down rather than by producing and selling some output?
Answer: If a firm's economic loss is greater when it produces and sells some output than
when it shuts down, it is the case that the price of the product is less than the average
variable cost. When the price is less than the average variable cost, the firm's economic
loss is less if it shuts down than if it produces and sells output.

2.

13) Pete is a perfectly competitive rose grower. The above table gives quantities and the price
for which Pete can sell his roses.
a. What is Pete's total revenue if he sells 1 dozen roses? 2 dozen roses? 3 dozen
roses? 4 dozen roses?
b. What is the marginal revenue of the 2nd dozen roses sold? Of the 3rd dozen? Of
the 4th dozen?
Answer:
 The total revenue when 1 dozen roses is sold is $12. When Pete sells 2 dozen
roses, the total revenue is $24. When 3 dozen roses are sold, the total revenue is
$36. And the total revenue when 4 dozen roses are sold is $48.
 The marginal revenue is always $12 per dozen roses.

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 14) Farmer Brown produces corn in a perfectly competitive market. Farmer Brown produces
and sells 500 bushels of corn. The market supply and demand curves are illustrated in the
above figure.
a. What is Farmer Brown's total revenue?
b. What is Farmer Brown's marginal revenue?
Answer:
a. Total revenue = price × quantity. The price is determined by the intersection of the demand
and supply curves, $6 a bushel. As a result, Farmer Brown's total revenue is $6 × 500 = $3,000.
b. For a perfectly competitive firm, the marginal revenue equals the price, so Farmer Brown's
marginal revenue is $6.

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 15) The table below gives Amy's total cost schedule for producing holiday wreaths. Amy is a
perfect competitor and can sell each wreath for $9.
a. Complete the table by calculating Amy's total revenue and her profit or loss schedule.

b. When Amy is producing 4 wreaths, what is her total cost? What is her total revenue? What is
her economic profit or economic loss?
c. What number of wreaths maximizes Amy's profit?
Answer:

a. The completed table is above.

b. When Amy is producing 4 wreaths, her total cost is $28, her total revenue is $36, and her
economic profit is $8.
c. Amy can produce 6 or 7 wreaths, with a maximum economic profit of $14.

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 16) Jimmy grows corn. His total revenue and total cost are in the above table. What quantity
of corn maximizes his profit and what is his profit? What is the marginal revenue and
marginal cost at this quantity?
Answer: Jimmy's profit is greatest if he grows either 40,000 or 50,000 bushels of corn. His
(economic) profit at either amount is $10,000 a week. Between 40,000 and 50,000 bushels of
corn, Jimmy's marginal revenue is $30,000, or $3 per bushel and his marginal cost is $30,000, or
$3 per bushel.

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 17) The table below shows the total cost schedule for a perfectly competitive firm. The
market price is $250 per unit. Complete the table.

Answer:

The completed table is above.

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 18) Acme is a perfectly competitive firm. It has the total cost schedule given in the above
table. Acme's product sells for $8.00 per unit. What amount of output is the most
profitable and what is Acme's economic profit or economic loss?
Answer: Acme's profit-maximizing level of output is 7 units. Acme's total economic profit
equals its revenue, $56.00 ($8.00 per unit × 7 units), minus its total cost, $49.80 at this level of
output, or $56.00 - $49.80 = $6.20.

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 19) Acme is a perfectly competitive firm. It has the cost schedules given in the above table
and has a fixed cost of $12.00. The price of Acme's product is $14.20. What is Acme's
most profitable amount of output? What is Acme's total economic profit or loss?
Answer: The profit maximizing level of output is either 7 or 8 units. Acme's total economic
profit is the economic profit per unit times the number of units produced. The economic profit
per unit equals the price minus the average total cost. To calculate average total cost, note that
when Acme produces 8 units, the average variable cost per unit is $6.50 and the average fixed
cost is $1.50, so Acme's average total cost equals $8.00. Thus Acme makes an economic profit of
$14.20 - $8.00 = $6.20 per unit. Hence Acme's total economic profit is ($6.20) × (8 units) =
$49.60. Acme's total economic profit when it makes 7 units is (except for rounding) identical.

20) Acme is a perfectly competitive firm. It has the cost schedules given in the above table
and has a fixed cost of $12.00. The price of Acme's product is $4.00. What is Acme's
most profitable amount of output? What is Acme's total economic profit or loss?
Answer: Acme's most profitable (which means, in this case, minimum loss) is output of 0 units.
The price is below Acme's minimum average variable cost, so Acme shuts down. Acme's
economic loss equals its fixed costs, $12.00.

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27) The above figure illustrates a perfectly competitive wheat farmer.
a. What will be the firm's profit-maximizing price and output?
b. When the farmer produces 25,000 bushels of wheat, the difference between the firm's
average total cost and the price is at its maximum. Explain why this amount of wheat either is or
is not the profit-maximizing quantity.
Answer:
a. The firm will maximize its profits by producing where its marginal revenue equals its
marginal cost, or 30,000 bushels of wheat. The price will equal the marginal revenue, $3.00 a
bushel.
b. At 25,000 bushels, the difference between average cost and price (which is the average
revenue) is indeed at the maximum, but choosing 25,000 will maximize the profit per bushel of
wheat, not the total profit. The firm is interested in maximizing the total profit not the profit per
bushel. At 30,000 bushels of wheat, the total profit is maximized because this is the amount of
output where the difference between total revenue and total cost is at a maximum.

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 21) The above diagram shows the cost curves for a perfectly competitive wheat farmer. At
what price does the wheat farmer shut down?
Answer: The wheat farmer shuts down if the price is less than the minimum average variable
cost. So in the figure, the wheat farmer shuts down if the price is less than $2 per bushel.
Topic: Shut down point
Skill: Level 3: Using models
Section: Checkpoint 15.1
Status: CD
AACSB: Analytical reasoning

Review Questions: Output, Price, and Profit in the Short Run

1) Can a perfectly competitive firm make an economic profit in the short run? Can it incur
an economic loss?
Answer: In the short run, a perfectly competitive firm can make an economic profit or incur an
economic loss. Indeed, the firm also can make a normal profit in the short run. Basically, any
profit or loss outcome is possible in the short run.

2) If the market price is less than a perfectly competitive firm's average total cost, what sort
of profit or loss is the firm earning?
Answer: If the price is less than the average total cost, the firm is incurring an economic loss.

3) What is the relationship between the price, P, and the average total cost, ATC, for a firm
in perfect competition that makes an economic profit? That makes zero economic profit?
That incurs an economic loss?
Answer: If the price is greater than the average total cost, P > ATC, the firm makes an economic
profit. If the price equals the average total cost, P = ATC, the firm makes zero economic profit. If
the price is less than the average total cost, P < ATC, the firm incurs an economic loss.

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 4) John keeps beehives and sells 100 quarts of honey per month. The honey market is
perfectly competitive, and the price of a quart of honey is $10. John has an average
variable cost of $5 and an average fixed cost of $3. At 100 quarts per month, John's
marginal cost is $10.
a. Is John maximizing his profit? If not, what should John do?
b. Calculate John's total revenue, total cost, and total economic profit or economic loss when he
produces 100 quarts of honey.
Answer:
a. Yes, John is maximizing his profit because marginal revenue (price) equals marginal cost.
b. Total revenue equals price times quantity = $10 × 100 = $1,000. Total cost equals average
total cost times quantity = ($5 + $3) × 100 = $800.Economic profit equals total revenue minus
total cost = $1,000 - $800 = $200.

5) The above diagram shows the cost curves for a perfectly competitive wheat farmer. At
what price(s) does the wheat farmer earn an economic profit? Earn a normal profit? Incur
an economic loss? How many bushels of wheat does the farmer produce if the price is $3
per bushel? If the price is $0.50 per bushel?
Answer: At any price that exceeds the minimum of the average total cost the farmer makes an
economic profit. So the farmer makes an economic profit if the price is greater than $2 per
bushel. The farmer makes zero economic profit if the price equals the minimum total cost. So the
farmer makes zero economic profit if the price is $2 per bushel. Finally, the farmer incurs an
economic loss if the price is less than the minimum average total cost. So the farmer incurs an
economic loss if the price is less than $2 per bushel.
If the price is $3 per bushel, the farmer produces 30,000 bushels of wheat per year. If the price is
$0.50 per bushel, the farmer has shut down because the price is less than the minimum average
variable cost and so the farmer produces 0 bushels per year.

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Review Questions: Output, Price, and Profit in the Long Run

1) "For a perfectly competitive market, an economic profit attracts new

firms. But when these firms enter the market, the price falls and the
economic profit is eliminated." Are the previous statements correct or
incorrect? What is the long-run profit or loss outcome for firms in a
perfectly competitive market?
Answer: The statements are correct. As the statements point out, in the long run the economic
profit of perfectly competitive firms is eliminated by entry. Similarly, an economic loss will be
eliminated by exit. Therefore the long-run equilibrium profit for a perfectly competitive firm is a
normal profit.

2) In the long run, perfectly competitive firms cannot make an economic

profit. Why?
Answer: An economic profit attracts entry by new firms. As new firms enter the market, the
market supply increases and the market supply curve shifts rightward. The increase in supply
decreases the price. And, as the price falls, the economic profit is eliminated.

3) The U-pick berry market is perfectly competitive. Suppose that all U-

pick blueberry farms have the same cost curves and all are making an
economic profit. What happens as time passes? What is the long-run
equilibrium outcome?
Answer: The presence of economic profit attracts new firms into the U-pick blueberry market.
As the new firms (the new farmers) enter the market, the supply of U-pick blueberries increases.
The increase in the supply drives the price lower and decreases the economic profits of the
existing farmers. New farmers continue to enter the market as long as there is the possibility of
an economic profit. Eventually enough new firms enter so that the price is driven so low that the
economic profit is eliminated. All the firms make zero economic profit, which will keep them in
business but will provide no incentive for new firms to enter the market. At this point, the long-
run equilibrium has been reached.

4) Pumpkin growing is a perfectly competitive industry. Suppose that

pumpkin growers are all incurring an economic loss. What happens as
time passes? What is the long-run equilibrium outcome?
Answer: Because the firms are incurring an economic loss, as time passes some firms will exit
the market, perhaps by switching to other crops, or perhaps by closing entirely. As farmers leave
the market, the supply of pumpkins decreases. The supply curve shifts leftward and the price of a
pumpkin rises. As the price rises, the economic losses of the remaining firms decrease.
Eventually enough farmers leave the market so that the price rises sufficiently so that the
remaining firms make zero economic profit and no longer incur an economic loss. At that point,
the long-run equilibrium is reached because there is no further incentive for any firms to leave
the market.

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 5) Suppose a farmer raising beef is making a normal profit. Then, because
of a scare about mad cow disease, the demand for beef decreases
drastically. What happens to the profits of the beef farmer in the short
run and in the long run?
Answer: In the short run, the fall in beef prices will decrease the farmer's profits. With the fall in
price, the farmer will incur an economic loss. If the price is high enough so the revenue covers
the farmer's variable costs, the farmer will continue to operate. In the long run, if demand
continues to remain depressed, some farmers will exit the market until the remaining farmers
earn a normal profit once again.

6) During the middle of the 2000s, the price of gasoline soared and there
was a movement to switch to fuels made from a mixture of gasoline and
ethanol. Ethanol can be made from corn. The price of corn skyrocketed
and then, after a couple of years, the price decreased. What might have
led to these price changes in the corn market?
Answer: There are thousands upon thousands of corn farmers in the United States. In the middle
of the 2000s, high gasoline prices led to movement to incorporate ethanol into gasoline. Ethanol
can be made from corn so the demand for corn increased. As a result of the increase in market
demand for corn, the price of corn increased dramatically. Corn farmers were getting a high price
and making large economic profits.
In the long run, unable to prevent the flow of information to prospective corn farmers, the word
got out that economic profit was possible in this arena. Over time, more farmers switched to
growing corn, so more corn farmers entered the market, which led to a large increase in the
supply of corn. As supply increased, the price of corn dropped.
Thus the higher price was the short-run result of an increase in demand. The falling price
reflected the adjustment to the long-run equilibrium, as new corn farmers entered the market.

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 7) The above figure shows the cost curves of a profit-maximizing perfectly
competitive firm. If the price equals $7,
a. how much will the firm produce?
b. how much is the firm's average total, average variable, and marginal costs?
c. how much is the firm's total, total variable, and total fixed costs?
d. how much is the firm's total revenue and economic profit?
e. what will happen in this market in the long run?
Answer:
a. The firm will produce 40 units of output because that is where the marginal revenue equals
the marginal cost.
b. The firm's average total cost equals $4, its average variable cost equals $3, and its marginal
cost equals $7.
c. The firm's total cost is $160 (= $4 × 40), its total variable cost is $120 (= $3 × 40), and its
total fixed cost is $40 (= $160 - $120).
d. The firm's total revenue is $280 (= $7 × 40) and its economic profit is $120 (= $280 - $160).
e. In the long run, firms will enter the market in response to the economic profit. The market
supply curve will shift rightward, the price will fall, and the economic profit will be eliminated.

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 8) American restaurants receive their supply of baby back-ribs from
American farms and from farms in Denmark. In the figures above, the
left diagram shows the perfectly competitive market for baby back ribs
in the United States. The right figure shows the situation at Premium
Standard Farm in Kansas, one of the many U.S. farms supplying these
ribs.
Now assume that the United States imposes a ban on European meat in response to the foot-and-
mouth disease that has infected livestock in Europe. (Which the United States did a few years
ago.) In particular, suppose that the U.S. ban decreases the supply by 40 tons a year. Using the
figure on the left, show the impact of this ban on the baby back rib market. Using the figure on
the right, show the impact on Premium Standard Farm in Kansas.

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Answer:

The ban on European meat decreases the supply of baby back ribs and shifts the supply curve
leftward, as shown by the shift from S1 to S2. The price rises to $4 a pound. As the figure on the
right shows, the MR curve for the Premium Standard Farm will shift upward, from MR1 to MR2.
As a result, the farm increases its production to 40,000 pounds of ribs. Because the price exceeds
the average total cost, the Premium Standard Farm makes an economic profit.

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