1. It is extremely important for a firm to be able to identify a set of “optimal

Question

1. It is extremely important for a firm to be able to identify a set of “optimal production methods or technologies”. Explain why this is necessary. Be specific.

2. It has been suggested that a profit maximizing firm should possess and master an information or knowledge set that includes among many things, the selling price of its output. Explain why this is necessary. Be specific.

3. Why is it the case that a firm’s total variable cost curve begins at the origin AND slopes upwards from left to right? Explain both scenarios. Be specific.

4. What circumstance or development in the production function discussed in Chapter 7 of the text best explains the various segments of the firm’s marginal cost curve? Explain fully. Be specific.

5. Describe the term “price taker” and explain why it applies to the perfectly competitive firm. Explain fully. Be specific.

6. Explain why marginal revenue is so important to any firm. Be specific.

7. Suppose that a firm is in the “shut-down” mode and is facing all of the requisite conditions associated with it. Describe two (2) scenarios wherein the firm might decide open again and resume production. Be specific.

8. In the case of a firm’s long run average total cost curve: 1) identify the INdependent and DEpendent variables and 2) describe the behavior of costs per unit in its downward-sloping segment.

9. Describe the long-run impact/role of profits and losses in any industry. Be specific

10. Describe: 1) the process a firm should use in determining whether a particular production method should/should not be used AND 2) a factor or circumstance that could change the choice of production methods. Be specific in providing an appropriate response.

Explanation / Answer

1. Identifying the set of optimal production methods and technologies is how a firm maximizes profit. That is, the marginal product of a technology divided by its marginal cost must be the same for all technologies employed (MPKi/ri = MPKj/rj for all i not equal to j). Obviously, the firm wants to maximize profit. Profit is the reason for doing business. More importantly, a firm that does not maximize profits will be driven out of business in a competitive market. 2. A. Suppose a firm operates in a competitive market. The firm should know the market price of its output. If the firm chooses a price above market price, it will sell no produce and incur the costs of production. If the firm chooses a price below market price, it could have earned more by selling at market price because it could have sold all that it wanted at market price. B. Suppose the firm operates with market power. Now, the firm will face a downward sloping demand curve that determines prices. It is important for the firm to know the shape of the demand curve so that it can determine where marginal revenue intersects marginal cost. This will yield the profit-maximizing quantity, which will be associated with the profit maximizing price. 3. A) The variable cost is the portion of cost dependent on quantity produced. Therefore, it must always begin at the origin. That is, if the quantity is zero, then there can be no costs dependent on quantity. B) Additional units cannot erase costs from previous units. So, the variable cost of X units must be greater than or equal to the variable cost of X - n units. 4. I don't know what Chapter 7 of your book says, but the marginal cost curve has three portions. The marginal cost curve is convex. Generally, the first portion of the marginal cost curve is downward sloping. This occurs until the marginal cost curve reaches a minimum. The second portion is between the minimum of marginal cost and the intersection of marginal cost and marginal revenue. In these first two segments, profit is increasing. The third portion is after the intersection of marginal revenue and marginal costs. Profit is decreasing in this portion. Alternatively, we could think of the marginal cost being broken up into two portions. The first is to the left (and below) of the minimum of average total cost. In this portion, there are "increasing returns to scale." The second portion is to the right (and above) of the minimum of average total cost, where there are "decreasing returns to scale." 5. A price taker is a firm that cannot affect the price of a good by producing more or less of the good. In a perfectly competitive, there are an infinite number firms all selling the exact same good. So, each firm produces a portion of the total production essentially equal to zero. Remember "perfectly competitive" is a theoretical concept. We don't live in a perfect world. How might this sort of thing happen? Customers buy from whoever is cheaper, caring only about price. So, an individual firm can capture the entire market by lowering his or her price just below market price. So, firms do this back and forth until they reach a price equal to marginal cost. They won't go below marginal cost because then they would be losing money on each sale. 6. The marginal revenue is important to a firm because that is the additional revenue that the firm receives from producing one additional good. And at any given time, that is exactly the decision the firm is making. Produce more? Produce less? The firm should produce an additional unit so long as the marginal revenue of that unit is greater than or equal to its marginal cost. This makes sense. You shouldn't produce a unit if it is going to cost you more than you can sell it for. 7. If the firm is in shut-down mode, that either means that price is below the average total cost in the long run or below the average variable cost in the short run. Since there is some way to come back, I guess we are assuming this is the short run. A) Demand increases. This will push the price up and could potentially push the price above average variable cost and enable the firm to maintain a positive profit margin. If the demand increase is sufficiently large and unexpected, the price may increase above average total cost, enabling the firm to remain in business in the long run. B) Costs fall. If the marginal cost falls, this will pull down the average variable cost and average total cost. If they are pulled down below price, then the firm may be able to earn a positive profit margin or a positive economic profit and become able to survive in the short run or the long run. 8. A) ATC = VC/Q + FC/Q VC is variable cost. FC is fixed cost. Q is quantity. Here, the dependent variable is ATC. The independent variables are VC, FC, and Q. That is, ATC is depends on VC, FC, and Q. VC depends on Q but is independent of F. F is independent of VC and Q. B) In the downward sloping segment, ATC is falling. This implies that each additional unit lowers the ATC. That is, the marginal cost must be below the ATC. This is intuitive. Think of your grade in a class. If you have a 90 average and you make an 80 on a test, that is going to bring your average down. 100 will bring your average up. And 90 will not affect the average. This implies that ATC and MC intersect at the minimum of ATC because that's where the derivative of ATC with respect to Q must be zero. 9. If a firm in a competitive market earns an economic profit. In the long run, other firms will enter the market and replicate the firm. In the process, those profits will be eaten up through competition and all firms will earn a normal profit (zero economic profit) and charge a price equal to marginal cost. If a firm earns an economic loss in the long run, it will go out of business and produce an optimal quantity of q = 0. 10. A) i) The firm must be able to afford it. sum(ki*ri) = C ii) The choice must be optimal MPKi/ri = MPKj/rj for all i not equal to j The derivation and explanation of these appears in a question I just answered for you a second ago. B) If the rent for a particular process increases, we should do less of it. If the productivity of a particular process increases, we should do more of it. If our budget constraint increases, we should employ more of all of our production methods and perhaps more that we couldn't afford before.

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