Chapter 7: costs of production
True or False?
Fixed costs remain the same regardless of output level. Explain your answer.
True. Fixed costs (like rent or insurance) do not change with output, they’re paid even if production is zero.
True or False?
A perfectly competitive firm can influence market price. Explain your answer.
False, With many small firms and identical products, no single firm affects the market price.
Long-run economic profit = __________.
Explain your answer.
Zero, Entry/exit of firms drives profit to normal (zero) in long-run equilibrium.
What are barriers to entry for a monopoly
patents and licenses, natural barriers such as economies of scale and control over resources, and strategic barriers like predatory pricing and brand loyalty
True or False?
MC pricing requires subsidy because P < ATC.
True
- Setting P = MC covers variable costs but not fixed costs.
If total cost rises from $100 to $160 when output increases by 10 units, MC = ?
a) $6 b) $10 c) $16 d) $60
a) $6
MC = change in TC ÷ change in Q = ($160 − $100) ÷ 10 = $6 per unit.
If price < AVC, the firm should:
a) Continue producing b) Expand c) Shut down
What happens when a firm shuts down?
C) shut down
they still have to pay their fixed costs because their sunk costs
A cable company keeps prices low to deter entrants. What market does this represent?
a) Natural monopoly b) Contestable c) Competitive
in contestable markets, potential entry keeps prices close to competitive levels even if few firms exist.
Airlines charging business travelers more = ________.
a) Predatory b) Price discrimination c) Bundling
b) Price discrimination = charging different prices to consumers with different elasticities.
Regulation is appropriate when:
a) Gov failure b) Market failure c) Normal profit
b) market failure
When markets misallocate resources, government corrects inefficiency.
Describe how diminishing marginal product affects marginal cost.
As productivity falls, more input is needed for each extra unit, increasing the marginal cost curve. each additional unit of a variable input (like labor) produces less additional output, making it more expensive to produce each new unit of the good.
Why does entry continue until profits = 0? Explain the entire process.
New firms enter when profits exist; entry expands supply, lowering price until only normal profit remains.
new firms enter the market, the supply curve shifts right, profit gets squeezed til normal profit is reached, firms leave the market and the process repeats
How can innovation yield temporary profit?
It lowers cost or improves quality before others imitate.
Why does monopoly restrict output?
To raise price above MC; this yields profit but causes deadweight loss.
What real-world costs are created by regulation itself, and why do they matter for policy decisions?
Regulation imposes administrative, compliance, and efficiency costs. These use government resources, require firms to file reports or alter behavior, and can slow innovation. Policymakers must weigh these against potential benefits.
administrative costs are the expenses the government incurs to create, enforce, and manage policies or taxes. Compliance costs are the time and money individuals or businesses spend to follow those rules, such as filing taxes or keeping records. Efficiency costs (or deadweight loss) occur when taxes or regulations distort behavior, causing resources to be used less productively than they could be.
Jordan starts a small smoothie business while in college.
Jordan quits a part-time job that paid $12,000 per year to run the business.
The business earns $60,000 in total revenue for the year.
(out-of-pocket) costs include:
- Rent: $10,000
- Ingredients and supplies: $15,000
- Wages paid to helpers: $8,000
- Utilities and advertising: $7,000
Calculate the economic and accounting profit
accounting profit= 60,000- (10,000 +15,000+8000+7000)= $20,000
economic profit= 60,000 - (52000)= $8,000
How do per-unit taxes affect output? Explain your answer. Draw it out on a graph
They raise MC, shifting supply left → higher price, lower quantity.
Describe the difference between a shutdown decision and an exit decision, and give an example of each in a real-world context
Shutdown = short run, temporary halt (seasonal ski resort in summer). Exit = long run, permanent (a coal plant shutting down permanently due to unprofitability). In the long run, if the firm decides to exit the market (not just temporarily shut down), it does not have to pay fixed costs anymore, Remember that in the long run there are NO fixed costs
Why might some monopolies be justified despite higher prices and restricted output?
A. Because economies of scale allow one firm to produce at a lower cost than multiple smaller firms. Economies of scale allows the the firm to produce at a lower cost and because of that natural monopolies occur
B. Because monopolies naturally encourage more entrepreneurial innovation than small startups.
C. Because monopolies always produce higher quality products than competitive firms.
D. Because government regulation ensures all monopolies operate efficiently and fairly.
A) Economies of scale allows the the firm to produce at a lower cost and because of that natural monopolies occur
Explain the outcomes of an unregulated natural monopoly
Price is above marginal cost, violating efficiency.
- Output is too low, creating deadweight loss.
- The firm earns economic profit but they may violate our vision of equity
State where MC intersects AVC and ATC, and what happens to ATC when MC > ATC. Draw out the curves on a graph.
The MC intersects the AVC and the ATC at their MINIMUM points. If the MC>ATC then the ATC is rising. If MC<ATC then ATC is falling
A firm in a perfectly competitive market faces:
Price = $15
ATC at Q = 100 units is $10
MC intersects MR at Q = 100 units
Instructions:
Draw the firm’s cost curves (MC, ATC) and the horizontal MR = P line.
Indicate the profit area and highlight it on the graph.
Calculate the firm’s total profit or loss:
profit will be $500
A firm adopts a new efficient production process.
A) What effect does this have on the ATC curve?
B) What effect does this have on the MC curve?
C) How does this effect the firms profit?
A) ATC curve shifts down (costs are lower at every level of output)
B) MC curve also shifts down (it costs less to produce an additional unit)
C) ATC is now further below P, so profit increases
Contrast long-run outcomes in perfect competition vs. monopoly when current profits are high.
Competition: high profits attract entry -> supply shifts right -> price falls -> profits go to zero in the long run
Monopoly: entry barriers block entrants -> output/prices don’t adjust much -> positive profits persist as long as P>MC
Key thing is that barriers to entry allow economic profits to persist in monopolies where as low barriers to entry in perfect competition drive profits down in the long run
Draw and analyze the graph for an unregulated natural monopoly. Include: D, MR, MC, and ATC. Mark Qa and Pa where MR = MC and Pb on the demand curve.
an image of an unregulated monopoly