Modern Principles
of Economics
Fifth Edition
Chapter 11:
COSTS AND PROFIT MAXIMIZATION UNDER COMPETITION
iClicker Questions
Tyler Cowen and Alex Tabarrok
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1. Which of these is NOT a characteristic of a
competitive market, according to economists?
A.
B.
C.
D.
The product being sold is similar across sellers.
There are many buyers.
There are many sellers or potential sellers.
The sellers try to gain strategic advantages over one another.
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1. Which of these is NOT a characteristic of a
competitive market, according to economists?
(Answer)
A.
B.
C.
D.
The product being sold is similar across sellers.
There are many buyers.
There are many sellers or potential sellers.
The sellers try to gain strategic advantages over one another. (correct
answer)
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2. Suppose there are
100,000 individual sellers
in the competitive world
market for oil. What price
should each seller charge?
A.
B.
C.
D.
A price greater than $50
Exactly $50
A price between $16.40 and $50
Exactly $16.40
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2. Suppose there are
100,000 individual
sellers in the
competitive world
market for oil. What
price should each seller
charge? (Answer)
A.
B.
C.
D.
A price greater than $50
Exactly $50 (correct answer)
A price between $16.40 and $50
Exactly $16.40
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3. Which costs should be considered when
making long-run decisions?
A.
B.
C.
D.
Variable costs only
Fixed and variable costs only
Fixed and sunk costs only
Fixed, variable, and sunk costs
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3. Which costs should be considered when
making long-run decisions? (Answer)
A.
B.
C.
D.
Variable costs only
Fixed and variable costs only (correct answer)
Fixed and sunk costs only
Fixed, variable, and sunk costs
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4. Which is greater: accounting profits or
economic profits?
A.
B.
C.
D.
Accounting profits, because they do not take into account implicit costs
Accounting profits, because they take into account implicit costs
Economic profits, because they do not take into account implicit costs
Economic profits, because they take into account implicit costs
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4. Which is greater: accounting profits or
economic profits? (Answer)
A. Accounting profits, because they do not take into account implicit costs
(correct answer)
B. Accounting profits, because they take into account implicit costs
C. Economic profits, because they do not take into account implicit costs
D. Economic profits, because they take into account implicit costs
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5. Based on the
data, what
quantity should
this producer
produce? (Tap
the quantity.)
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5. Based on the
data, what quantity
should this
producer produce?
(Answer)
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6. To maximize profits, a firm in a competitive
industry will increase output until:
A.
B.
C.
D.
marginal revenue equals price.
marginal revenue equals total revenue.
explicit cost equals variable cost.
price equals marginal cost.
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6. To maximize profits, a firm in a competitive
industry will increase output until: (Answer)
A.
B.
C.
D.
marginal revenue equals price.
marginal revenue equals total revenue.
explicit cost equals variable cost.
price equals marginal cost. (correct answer)
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7. If the average cost of producing 100 units is $5
and the average cost of producing 101 units is
$5.05, what is the marginal cost of the 101st unit?
A.
B.
C.
D.
$0.05
$5.00
$5.05
$10.05
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7. If the average cost of producing 100 units is $5
and the average cost of producing 101 units is
$5.05, what is the marginal cost of the 101st unit?
(Answer)
A.
B.
C.
D.
$0.05
$5.00
$5.05
$10.05 (correct answer)
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8. Which of these is a correct formula for
profit?
A.
B.
C.
D.
Profit = (Price × Quantity) – Average cost
Profit = (Price – Average cost) × Quantity
Profit = Price × (Quantity – Average cost)
Profit = Quantity – (Price × Average cost
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8. Which of these is a correct formula for
profit? (Answer)
A.
B.
C.
D.
Profit = (Price × Quantity) – Average cost
Profit = (Price – Average cost) × Quantity (correct answer)
Profit = Price × (Quantity – Average cost)
Profit = Quantity – (Price × Average cost)
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9. At which of the
labeled prices would
this firm exit as soon
as possible but stay
open in the
meantime?
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9. At which of the
labeled prices would
this firm exit as soon
as possible but stay
open in the
meantime?
(Answer)
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10. Which type of industry is the rarest?
A.
B.
C.
D.
An increasing-cost industry such as the oil industry
A constant-cost industry such as the domain name registration industry
A decreasing-cost industry such as the domain name registration industry
A decreasing-cost industry such as the carpet industry
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10. Which type of industry is the rarest?
(Answer)
A.
B.
C.
D.
An increasing-cost industry such as the oil industry
A constant-cost industry such as the domain name registration industry
A decreasing-cost industry such as the domain name registration industry
A decreasing-cost industry such as the carpet industry (correct answer)
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Decide which firms should produce more output, which should produce less, and
which are producing just the right amount:
a. WaffleCo, maker of generic-brand frozen waffles. Price = $4 per box, marginal
cost = $2 per box.
b. Rio Blanco, producer of copper. Price = $32 per ounce, marginal cost = $45 per
ounce.
c. GoDaddy.com, domain name registry. Price = $5 per website, marginal cost = $2
per website.
d. Luke’s Lawn Service. Price = $80 per month, marginal cost = $120 per month.
When P ˃ MC, produce more. When P ˂ MC, produce less. So produce more
in parts a and c, and produce less in parts b and d.
In the competitive electrical motor industry, the
workers at Galt Inc. threaten to go on strike. To
avoid the strike, Galt Inc. agrees to pay its
workers more. At all other factories, the wage
remains the same.
a. What does this do to the marginal cost curve
at Galt Inc.? Does it rise, does it fall, or is there
no change? Illustrate your answer in the figure.
b. What will happen to the number of motors produced by Galt Inc.?
Indicate the “before” and “after” levels of output on the x-axis in the
figure.
Solution
a, b. The marginal cost curve will shift up (a
shift to the left captures the same intuition).
The number of motors sold will fall.
c. In this competitive market, what will the Galt. Inc. labor agreement do
to the price of motors?
c. Nothing will happen to the price of motors. The fall in supply represented by
the higher cost at one firm, Galt Inc., is too small to raise the price of motors
noticeably.
d. Surely, more workers will want to work at Galt Inc. now that it pays higher
wages. Will more workers actually work at Galt Inc. after the labor agreement is
struck? Why or why not?
d. No, fewer workers will work at Galt Inc. after the deal is struck. The higher
marginal cost means fewer motors get sold, which means fewer jobs making
motors.
In the highly competitive TV-manufacturing industry, a new innovation makes it
possible to cut the average cost of a 50-inch LCD TV from $1,000 to $600. Most TV
manufacturers quickly adopt this new innovation, earning massive short-run profits.
In the long run, what will the price of a 50-inch LCD TV be?
a. P = AC in the long run in a competitive industry, so the price of 50-inch LCD TVs will
stay at $600.
b. In the highly competitive flash drive industry, a new innovation makes it possible
to cut the average cost of a 64-gigabyte flash drive, small enough to fit on your
keychain, from $5 to $4. In the long run, what will the price of a 64-gigabyte flash
drive be?
b. Since average cost has come down from $5 to $4, the price of 64-GB flash
drives in the long run will be $4 (equal to AC).
c. Assume that the markets in parts a and b are both constant cost industries. If
demand rises massively for these two goods, why won’t the price of the goods
rise in the long run?
c. If demand rises, price would generally rise, but this does not happen in the case
of constant cost industries because there are already many sellers in the market;
the presence of profits entices potential sellers to come and join the market,
thereby keeping the AC curve to its lowest and newer value.
d. In constant cost industries, does demand have any effect on price in the long run?
d. No, it doesn’t. Demand has an effect on quantity but not on price in constant cost
markets.
e. When average cost falls in any competitive industry, regardless of cost structure,
who gets 100 percent of the benefits of cost cutting in the long run: consumers or
producers?
e. Consumers get all of the benefits: Firms keep entering the industry as long as
profits are positive. Firms end up earning whatever profits they were earning due
to their innovation until now. Therefore, firms that consistently innovate and
improve will have an edge and can reap profits for a longer time. Consumers will
benefit from innovative products at reasonable prices.
On January 27, 2011, the price of Ford Motor Company stock hit an almost 10-year
high at $18.79 per share. (Two years prior, in January 2009, Ford stock was trading for
about a tenth of that price.)
a. Suppose that on January 27, 2011, you owned 10,000 shares of Ford stock (a small
fraction of the almost 3.8 billion shares). You offered to sell your stock for $18.85 per
share, just slightly above the market price. Would you have been successful?
a. You would fail. Your stock is no different from any of the other 3.8 billion shares out
there, so no one would pay a higher price for yours. If you could sell at $18.85 per
share, the price would be $18.85, not $18.79.
b. What if, on January 27, 2011, you wanted to sell your 10,000 shares of Ford
stock but you reduced your asking price to $18.75 per share? Would you have
found a lot of willing buyers?
b. Lots of people in the market would be eager to buy all of your shares because
at that price the buyer could buy all your shares and turn around and resell them
at $18.79 for a 4-cent-per-share profit, or $400 in total (minus transaction costs
of around $20).
c. What do your answers for parts a and b tell you about the demand curve that
you, as an individual seller of Ford stock, face?
c. The demand curve that an individual seller of the stock faces is horizontal—that is,
perfectly elastic. In other words, since there are plenty of perfect substitutes for any
seller’s shares, an individual trader (who is a small share of the market) can sell as
many shares as he or she wants at the market price.
Suppose Sam sells apples picked from his apple tree in a competitive market. Assume
all apples are equal in quality, but grow at different heights on the tree. Sam, being
fearful of heights, demands greater compensation the higher he goes: So for him, the
cost of grabbing an apple rises higher and higher the higher he must climb, as shown in
the Total Cost column in the following table. The market price of an apple is $0.50.
a. What is Sam’s marginal revenue for selling apples?
a. His marginal revenue is the same as the price: $0.50.
b. Which apples does Sam pick first? Those on the low branches or high branches? Why?
b. He would pick from the low branches first because those are cheapest for him to
harvest.
c. Does this suggest that the marginal cost of apples is increasing, decreasing, or
staying the same as the quantity of apples picked increases? Why?
c. The marginal cost is increasing as Sam is forced to climb greater and greater
heights.
d. Complete the table.
e. How many apples does Sam pick?
e. He picks four apples, where marginal revenue equals marginal cost.
How long is the “long run”? It will vary from industry to industry. How long would
you estimate the long run is in the following industries?
a. The market for pretzels and soda sold from street carts in New York
b. The market for meals at newly trendy Korean porridge restaurants
c. The market for electrical engineers
d. After 2012, the market for movies that are suspiciously similar to The Hunger
Games.
a. A few days at most: If there’s a big rise in demand because a new skyscraper is built,
then it will only take a few days for street carts from elsewhere in New York to move
down to lower Manhattan to sell pretzels and soda to the businesspeople. Word travels
fast, and carts travel faster.
b. This might take a year or two at most: If a new restaurant fad kicks in, other
restaurants can switch over to putting the trendy items on the menu immediately,
ethnic restaurants with only a few customers can change their name to “Porridge Shop
#2,” and within a year new restaurants can open up in empty spaces at the mall.
c. This takes several years, as most students should understand. Earning an engineering
degree takes a lot of time.
d. This takes several years, as well: There are often only a few firms that can use
cutting-edge filmmaking technologies, and it takes time for new people to be trained in
martial arts, special effects, new cameras, and so forth. Thus, for a few years, people
who worked on The Hunger Games probably earned large profits—before their skills
were replicated.
In this chapter, we discussed the story of Dalton, Georgia, and its role as the carpet
capital of the world. A similar story can be used to explain why some 60% of the motels
in the United States are owned by people of Indian origin or why, as of 1995, 80% of
doughnut shops in California were owned by Cambodian immigrants. Let’s look at the
latter case. In the 1970s, Cambodian immigrant Ted Ngoy began working at a doughnut
shop. He then opened his own store (and later, stores). Ngoy was drawn to the
doughnut industry because it required little English, startup capital, or special skills.
Speaking the same language as your workers, however, helps a lot.
a. As other Cambodian refugees came to Los Angeles fleeing the tyrannical rule of
the Khmer Rouge, which group—the refugees or existing residents—was Ngoy more
likely to hire from? Why?
b. Did this make it more or less likely that other Cambodian refugees would open
doughnut shops? Why?
c. As more refugees came in, did this encourage a virtuous cycle of Cambodianowned doughnut shops? Why?
d. At this point in the story, what sort of cost industry (constant, increasing, or
decreasing) would you consider doughnut shops owned by Cambodians to be? Why?
e. Why did this cycle not continue forever? What kind of cost structure are
Californian doughnut shops probably in now?
a. He was more likely to hire from the Cambodian refugee population since they share a language.
b. More likely, because these employees learned the trade from Ngoy and could then open their own shops.
c. Yes. There were more Cambodians hiring Cambodians, and thus more people learning to make doughnuts and
learning how to open their own shop. And with more Cambodians in the industry, this lowered the costs of being
a Cambodian doughnut shop owner.
d. Decreasing: As quantity expanded, the virtuous circle made the costs of being a Cambodian doughnut shop
owner fall.
e. Ngoy’s first doughnut shop lowered the costs for other Cambodians to become doughnut shop owners, but as
the industry grew, the advantages to other Cambodians of another Cambodian opening a doughnut shop
declined and eventually disappeared. Also, there are only so many Cambodian refugees to open shops and only
so much demand for doughnuts. Thus, Cambodians are likely to dominate the California doughnut industry for a
long time just like Dalton, Georgia, continues to dominate the carpet industry, but the costs of being a
Cambodian doughnut maker no longer fall when another Cambodian enters the industry. The cost structure is
now constant.
Ralph opened a small shop selling bags of trail mix.
The price of the mix is $5, and the market for trail mix
is very competitive. Ralph’s cost curves are shown in
the figure.
a. At what quantity will Ralph produce? Why?
b. When the price is $5, shade the area of profit or loss
in the graph provided and calculate Ralph’s profit or loss
(round up).
c. If all other sellers of trail mix have the same marginal
and average costs as Ralph, should he expect more or
fewer competitors in the future? In the long run, will the
price of trail mix rise or fall? How do you know? What
will the price of trail mix be in the long run?
a. Ralph will produce where marginal cost equals
marginal revenue, or at 15 bags of trail mix.
b. Profit is (P – AC) × Q. In this case ($5 − $4) × 15 =
$15 as shown in the figure above (rounding up
slightly).
c. His (and his competitors’) profits will attract
additional competition, which will push the price
down. Profits are the signal to other firms that they
should enter this market. The price of trail mix will
fall to the minimum of the AC curve, the point at
which profits are eliminated, or $4.
Paulette, Camille, and Hortense each own wineries in France. They produce inexpensive,
mass-market wines. Over the last few years, such wines sold for 7 euros per bottle; with a
global recession, however, the price has fallen to 5 euros per bottle. Given the
information below, let’s find out which of these three winemakers (if any) should shut
down temporarily until times get better. Remember: Whether or not they shut down,
they still have to keep paying fixed costs for at least some time (that’s what makes them
“fixed”).
To keep things simple, let’s assume that each winemaker has calculated the optimal
quantity to produce if they decide to stay in business; your job is simply to figure out if
she should produce that amount or just shut down.
a. First, calculate each winemaker’s profit.
b. Which of these women, if any, earned a profit?
c. Who should stay in business in the short run? Who should shut down?
d. Fill in the blank: Even if profit is negative, if revenues are _____________ variable costs, then
it’s best to stay open in the short run.
Winemaker
Fixed Costs
Variable Costs
Recession Revenues
Profits
Paulette
50,000
80,000
120,000
−10,000
Camille
100,000
40,000
70,000
−70,000
Hortense
200,000
250,000
200,000
−250,000
b. None of the women earned a positive profit; they have all suffered losses.
c. Paulette and Camille should stay in business in the short run. Hortense should shut down. Since the fixed costs
have to be paid whether or not the winemaker produces, the fixed costs show us the magnitude of the losses
from shutting down. If Paulette shuts down, she will lose her $50,000 fixed costs, but she only loses $10,000 by
producing, so producing is a better option. The same is true for Camille. However, if Hortense shuts down she will
lose only her $200,000 fixed costs, which is less than the $250,000 she loses by producing.
d. “Even if profit is negative, if revenues are greater than variable costs, then it’s best to stay open in the short
run.”
Sofia owns a firm with annual revenues of $1,000,000. Wages, rent, and other costs
are $900,000.
a. Calculate Sofia’s accounting profit.
b. Suppose that instead of being an entrepreneur, Sandy could get a job with one of
the following annual salaries: (i) $50,000, (ii) $100,000 or (iii) $250,000. Assume that
a job would be as satisfying to Sofia as being an entrepreneur. Calculate Sandy’s
economic profit under each of these scenarios.
a. Sofia has an accounting profit of $100,000.
b. To calculate Sofia’s economic profit we must subtract all costs from revenues,
including the opportunity cost of Sofia’s time, which is given by the potential salary that
Sofia could earn in alternative employment. Thus, under the three scenarios of annual
wages of (i) $50,000, (ii) $100,000 or (iii) $250,000, Sofia’s profits are:
i. $100,000 − $50,000 = $50,000
ii. $100,000 − $100,000 = $0
iii. $100,000 − $250,000 = −$150,000
Under scenario i, Sofia makes a profit, a return above her opportunity costs. In scenario
ii, Sofia earns a zero or normal economic profit. Notice that Sofia has no reason to
switch employment even though she is earning “zero” profit. Under scenario iii,
however, Sofia would be wise to close up shop and take the job. She is making a paper
profit but an economic loss, i.e., it becomes a loss once opportunity costs are correctly
taken into account.
Frequent moviegoers often note that movies are rarely based on original ideas. Most of
them are based on a television series, a video game, or, most commonly, a book. Why?
To help you answer this question, start with the following.
a. Does a movie or a book have a higher fixed cost of production?
b. Hollywood releases about 100 new movies every year while just one publisher,
Penguin Random House, releases about 15,000 book titles a year. How does your
answer in part a explain such a wide difference? Which is riskier: publishing a book or
producing a movie?
c. How does the difference in fixed costs and risk of failure explain why so many movies
are based on successful books? As a result, where do you expect to see more innovative
plots, dialogues, and characters: in novels or movies?
a. A movie has a much higher fixed cost of production; even a low-budget movie can cost
$1 million. A book can be published for much less.
b. The public’s moviegoing budget is limited so higher fixed costs mean fewer firms in the
industry. If a publisher pays for a book that does not sell, it may lose tens of thousands of
dollars. If a movie studio pays for a movie that does not sell, it can lose tens of millions of
dollars. Thus, the risks involved in making a movie are much greater than those involved in
making a book.
c. Using a proven success (at least in book format) mitigates some of the risk of movie
production, so investors are much more likely to be willing to gamble that a successful book
can be made into a movie than they are to gamble on a movie with no fan base. As a result,
we can expect to see more innovation in novels, the low-fixed-cost industry. Low costs
mean lots of entry. For more on the economics of the arts, see Cowen, Tyler and Alexander
Tabarrok. 2000. An economic theory of avant-garde and popular art, or high and low
culture. Southern Economic Journal 67(2): 232–253.
In Kolkata, India, it is very common to see beggars on the streets. Imagine that the
visitors and residents of Kolkata become more generous in their donations, what
will be the effect on the standard of living of beggars in Kolkata? Answer this
question using supply and demand, making assumptions as necessary.
We can think of donations as creating a demand for beggars (begging). The key
question is whether begging is an increasing, decreasing, or constant cost industry. In Kolkata, India, the best assumption is that begging is a constant cost
industry. In India, hundreds of millions of very poor people live in villages. If the
wages to begging rise even a little bit above the wages that can be earned by
subsistence farming, many people are ready and willing to move to the cities to
beg. Thus, the supply curve for begging in Kolkata is highly elastic at the
subsistence wage. An increase in demand, therefore, will increase the number of
beggars in Kolkata, but it will not raise their standard of living, as shown in the
following figure.
The supply of beggars to Kolkata is high elastic (constant cost industry) at the subsistence wage. Increased
generosity toward beggars will encourage people from the country to move to the city to beg and thus will
increase the number of beggars from N1 to N2 but will not raise the incomes of beggars. The answer does
not imply that all generosity in response to begging is foolish or counterproductive, but it does imply that
to work well, such generosity must be tempered with smarts. In particular, donations that raise the
productivity of workers may ultimately produce better results than donations to beggars. For example,
donations to build irrigation, improve eyesight with glasses or cataract surgery, to improve infant nutrition,
and so forth may be more effective at reducing poverty than giving handouts.