Mankiw 5a: Costs of the Firm and Perfect Competition
Definitions Review and Syllabus Topics
Download Unit 2.3.1: Costs of Production.pdf and Unit 2.3.2: Perfect
Competition.pdf from http://welkerswikinomics.com/blog/ww-study-guides-3/.
Be sure you can explain each of these terms within your essays:
accounting profit
allocative efficiency
average fixed cost
average total cost
average variable cost
diseconomies of scale
economic profit
economies of scale
explicit cost
fixed cost
implicit cost
long run
long-run equilibrium
marginal cost
marginal product
marginal revenue
normal profit
opportunity cost
productive efficiency
short run
total cost
total product
unit cost
variable cost
Production and costs
• Distinguish between the short run and long run in the context of production.
• Define total product, average product and marginal product, and construct diagrams to show their
relationship.
• Explain the law of diminishing returns.
• Calculate total, average and marginal product from a set of data and/or diagrams.
• Explain the meaning of economic costs as the opportunity cost of all resources employed by the
firm (including entrepreneurship).
• Distinguish between explicit costs and implicit costs as the two components of economic costs.
• Explain the distinction between the short run and the long run, with reference to fixed factors
and variable factors.
• Distinguish between total costs, marginal costs and average costs.
• Draw diagrams illustrating the relationship between marginal costs and average costs, and explain
the connection with production in the short run.
• Explain the relationship between the product curves (average product and marginal product) and
the cost curves (average variable cost and marginal cost), with reference to the law of diminishing
returns.
• Calculate total fixed costs, total variable costs, total costs, average fixed costs, average variable
costs, average total costs and marginal costs from a set of data and/or diagrams.
• Distinguish between increasing returns to scale, decreasing returns to scale and constant returns
to scale.
• Outline the relationship between short-run average costs and long-run average costs.
• Explain, using a diagram, the reason for the shape of the long-run average total cost curve.
• Describe factors giving rise to economies of scale, including specialization, efficiency, marketing
and indivisibilities.
• Describe factors giving rise to diseconomies of scale, including problems of coordination and
communication.
Revenues
• Distinguish between total revenue, average revenue and marginal revenue.
• Draw diagrams illustrating the relationship between total revenue, average revenue and marginal
revenue.
• Calculate total revenue, average revenue and marginal revenue from a set of data and/or diagrams.
Profit
• Describe economic profit (abnormal profit) as the case where total revenue exceeds economic
cost.
• Describe normal profit (zero economic profit) as the case where total revenue is equal to total
economic costs or the situation in which the amount of revenue earned is just sufficient to keep
the firm in its current line of business.
• Explain that economic profit (abnormal profit) is profit over and above normal profit (zero
economic profit), and that the firm earns normal profit when economic profit (abnormal profit) is
zero.
• Explain why a firm will continue to operate even when it earns zero economic profit (abnormal
profit).
• Explain the meaning of loss as negative economic profit arising when total revenue is less than
total cost.
• Calculate different profit levels from a set of data and/or diagrams.
Goals of firms
• Explain the goal of profit maximization where the difference between total revenue and total cost
is maximized or where marginal revenue equals marginal cost.
• Describe alternative goals of firms, including revenue maximization, growth maximization,
satisficing and corporate social responsibility.
Perfect competition
• Describe, using examples, the assumed characteristics of perfect competition: a large number of
firms; a homogeneous product; freedom of entry and exit; perfect information; perfect resource
mobility.
• Explain, using a diagram, the shape of the perfectly competitive firm’s average revenue and
marginal revenue curves, indicating that the assumptions of perfect competition imply that each
firm is a price taker.
• Explain, using a diagram, that the perfectly competitive firm’s average revenue and marginal
revenue curves are derived from market equilibrium for the industry.
• Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic
profit (abnormal profit), normal profit (zero economic profit) or negative economic profit in the
short run based on the marginal cost and marginal revenue profit maximization rule.
• Explain, using a diagram, why, in the long run, a perfectly competitive firm will make normal profit
(zero economic profit).
• Explain, using a diagram, how a perfectly competitive market will move from short-run equilibrium
to long-run equilibrium.
• Distinguish between the short run shut-down price and the break-even price.
• Explain, using a diagram, when a loss-making firm would shut down in the short run.
• Explain, using a diagram, when a loss-making firm would shut down and exit the market in the long
run.
• Calculate the short run shutdown price and the breakeven price from a set of data
Efficiency
• Explain the meaning of the term allocative efficiency.
• Explain that the condition for allocative efficiency is P = MC (or, with externalities, MSB = MSC).
• Explain, using a diagram, why a perfectly competitive market leads to allocative efficiency in both
the short run and the long run.
• Explain the meaning of the term productive/technical efficiency.
• Explain that the condition for productive efficiency is that production takes place at minimum
average total cost.
• Explain, using a diagram, why a perfectly competitive firm will be productively efficient in the long
run, though not necessarily in the short run.
AP/IB Economics
Unit 5a Review Questions: Costs of the Firm & Perfect Competition
1.
2.
What is the assumed goal of any firm?
What is the relationship between a firm’s total revenue, profit, and total
cost?
3. What is the difference between fixed costs and variable costs? Give
examples.
4. Is labor a fixed cost or a variable cost? Explain.
5. Explain the difference between opportunity costs and accounting costs. Give
an example of an opportunity cost that an accountant might not count as a
cost. Why would the accountant ignore this cost?
6. Explain the difference between accounting profit, normal profit, and economic
[or supernormal] profit.
7. Your aunt is thinking about opening a hardware store. She estimates that it
would cost $500,000 per year to rent the location and buy the stock. In
addition, she would have to quit her $50,000 per year job as an accountant.
If she thinks she can sell $510,000 worth of merchandise in a year, should
she open the store? Explain.
8. What is the economist’s definition of the short run? The long run?
9. What is the marginal fixed cost? What is the marginal variable cost?
10. Draw a total cost curve, including both the fixed cost and variable cost
curves.
11.
12.
13.
14.
15.
16.
Draw a typical total product curve. Identify and describe the three typical
stages of productivity shown in the curve.
What is marginal product, and what does it mean if it is diminishing?
What is the connection between total product and marginal product?
Explain the law of diminishing returns from the perspective of production. Be
sure to distinguish between lower levels and higher levels of production.
Graph the law of diminishing returns from the perspective of production. Be
sure to distinguish between lower levels and higher levels of production.
A commercial fisherman keeps track of his hours spent fishing and the
quantity of fish he caught. The fisherman has a fixed cost of $10 for the
fishing pole, and the opportunity cost of his time is $5 per hour.
 Complete the table on the next page.
 When does diminishing marginal product set in? Why might this occur?
Hours
0
1
2
3
4
5
Quantity of Fish
(in pounds)
0
10
18
24
28
30
Marginal
Product
Fixed Cost
Variable Cost
Total Cost
17. Distinguish between MC, TC, FC and VC.
18. Distinguish between ATC, AFC, and AVC. Why is there no AMC?
19. Sketch the typical cost curves for a firm in the short-run. Label the point
where diminishing marginal returns begin.
20. What is another way to think about “average total cost”?
21. Why do marginal costs ultimately rise?
22. Why does ATC continue to fall at first even though MC is rising?
23. When does ATC start to rise? Why?
24. When does AVC start to rise? Why?
25. What does the gap between AVC and ATC represent? Why does this gap
always decrease as production increases?
26. A firm has an AVC of $10 at an output of 100,000 units. TFC are $1,500,000.
What is the ATC?
27. When increasing output from 5,000 units to 5,500 units, TC goes from
$100,000 to $130,000. What is the MC per unit?
28. Why does the falling marginal product curve show the same thing as a rising
marginal cost curve?
29. How do economists distinguish between the short run and the long run?
30. What does it mean when a firm changes its “scale”? How does this affect
fixed costs?
31. When should a firm start to think about increasing its scale?
32. Explain how the LRATC curve is derived from different SRATC curves
33. What does “economy of scale” mean? What are some things that cause
economies of scale?
34. What does “diseconomy of scale” mean? What are some things that cause
diseconomies of scale?
35. Using diagrams, carefully explain the difference between diminishing marginal
returns and diseconomies of scale.
36. On the next page is a table of long-run total costs for three different firms.
Calculate the LRATC and describe what occurs as each firm changes its scale.
Quantity
Firm A
LRATC
Firm B
LRATC
Firm C
LRATC
1
$60
2
$70
3
$80
4
$90
5
$100
6
$110
7
$120
$11
$24
$39
$56
$75
$96
$119
$21
$34
$49
$66
$85
$106
$129
37.
38.
39.
40.
41.
42.
43.
44.
45.
What is meant by a competitive firm? What are its characteristics?
What are some typical barriers to entry for a firm?
Why is price the same thing as marginal revenue for perfect competition?
Explain setting quantity where MR=MC maximizes profit.
Sketch a graph an explain a supernormal profit situation for a firm.
Sketch a graph an explain a break-even / normal profit situation for a firm.
Sketch a graph an explain a loss situation for a firm.
Sketch a graph an explain a shut-down situation for a firm.
A firm is operating at a loss. Explain why the firm might continue to operate
rather than exit the market.
46. Why will a firm exit the market if MR<AVC?
47. 2001 AP Essay 1
48. 2005 AP Essay 1
49. What is “productive” efficiency? What occurs when a market is productively
efficient?
50. How does a perfectly competitive market guarantee productive efficiency?
51. What is “allocative” efficiency. What three things occur when a market is
allocatively efficient?
52. How does a perfectly competitive market guarantee allocative efficiency?
53. How is deadweight loss a measure of the allocative inefficiency of a market?