1. Many small boats are made of fibreglass, which is derived from crude oil. Suppose that the price
of oil rises.
a. Using diagrams, show what happens to the cost curves of an individual boat-making firm
and to the market supply curve.
b. What happens to the profit of boat makers in the short run? What happens to the
number of boat makers in the long run?
2. You go out to the best restaurant in town and order a lobster dinner for 40$. After eating half of
the lobster, you realise that you are quite full. Your date wants you to finish your dinner because
you can’t take it home and because “you’ve already paid for it.” What should you do?
3. Consider total cost and total revenue given in the following table:
Quantity
Total cost
Total revenue
0
$8
$0
1
9
8
2
10
16
3
11
24
4
13
32
5
19
40
6
27
48
7
37
56
a. Calculate profit for each quantity. How much should the firm produce to maximize
profit?
b. Calculate marginal revenue and marginal cost for each quantity. Graph them. (Hint: Put
the points between whole numbers. For example, the marginal cost between 2 and 3
should be graphed 2½.) At what quantity do these curves cross? How does this relate to
your answer to part (a)?
c. Can you tell whether this firm is in a competitive industry? If so, can you tell whether the
industry is in a long-run equilibrium?
4. From The Wall Street Journal (July 23, 1991): “Since peaking in 1976, per capita beef consumption
in the United States has fallen by 28.6 percent…[and] the size of the U.S. cattle herd has shrunk to a
30-year low.”
a. Using firm and industry diagrams, show the short-run effect of declining demand for
beef. Label the diagram carefully and write out in words all of the changes you can
identify.
b. On a new diagram, show the long-run effect of declining demand for beef. Explain in
words.
5. Assume that the gold-mining industry is competitive.
a. Illustrate a long-run equilibrium using diagrams for the gold market and for a
representative gold mine.
b. Suppose that an increase in jewellery demand induces a surge in the demand for gold.
Using your diagrams from part (a), show what happens in the short run to the gold
market and to each existing gold mine.
c. If the demand for gold remains high, what would happen to the price over time?
Specifically, would the new long-run equilibrium price be above, below, or equal to the
short-run equilibrium price in part (b)? Is it possible for the new long-run equilibrium
price to be above the original long-run equilibrium price? Explain.
1. The answers are as follows:
a. The rise in the price of crude oil increases production costs for individual firms and thus
shifts the industry supply curve up, as shown in Figure 1. The typical firm’s initial
marginal-cost curve is MC1 and its average-total-cost curve is ATC1. In the initial
equilibrium, the industry supply curve, S1, intersects the demand curve at price P1, which
is equal to the minimum average total cost of the typical firm. Thus, the typical firm
earns no economic profit. The increase in the price of oil shifts the typical firm’s cost
curves up to MC2 and ATC2, and shifts the industry supply curve up to S2. The equilibrium
price rises from P1 to P2, but the price does not increase by as much as the increase in
marginal cost for the firm. As a result, price is less than average total cost for the firm, so
profits are negative.
b. In the long run, the negative profits lead some firms to exit the industry. As they do so,
the industry-supply curve shifts to the left. This continues until the price rises to equal
the minimum point on the firm’s average-total-cost curve. The long-run equilibrium
occurs with supply curve S3, equilibrium price P3, industry output Q3, and firm’s output
q3. Thus, in the long run, profits are zero again and there are fewer firms in the industry.
Figure 1.
2. Once you have ordered the dinner, its cost is sunk, so it does not represent an opportunity cost.
As a result, the cost of the dinner should not influence your decision about whether to finish it or
not.
3. Here is the table showing costs, revenues, and profits:
Quantity
0
1
2
3
4
5
6
7
Total
cost
8
9
10
11
13
19
27
37
Marginal
Total
Marginal
cost
revenue revenue
--0
--1
8
8
1
16
8
1
24
8
2
32
8
6
40
8
8
48
8
10
56
8
Profit
-8
-1
6
13
19
21
21
19
a. The firm should produce five or six units to maximize profit.
b. Marginal revenue and marginal cost are graphed in Figure 2. The curves cross at a
quantity between five and six units, yielding the same answer as in Part (a).
Figure 2.
c. This industry is competitive because marginal revenue is the same for each quantity. The
industry is not in long-run equilibrium, because profit is not equal to zero.
4. The answers are as follows:
a. Figure 3 shows the short-run effect of declining demand for beef. The shift of the industry
demand curve from D1 to D2 reduces the quantity from Q1 to Q2 and reduces the price from
P1 to P2. This affects the firm, reducing its quantity from q1 to q2. Before the decline in the
price, the firm was making zero profits; afterwards, profits are negative, as average total
cost exceeds price.
Figure 3.
b. Figure 4 shows the long-run effect of declining demand for beef. Because firms were
losing money in the short run, some firms leave the industry. This shifts the supply curve
from S1 to S3. The shift of the supply curve is just enough to increase the price back to its
original level, P1. As a result, industry output falls to Q3. For firms that remain in the industry,
the rise in the price to P1 returns them to their original situation, producing an output level
of q1 and earning zero profits.
Figure 4.
5. The answers are as follows:
a. Figure 5 illustrates the gold-mining industry and a representative gold mine (firm). The
demand curve, D1, intersects the supply curve at industry quantity Q1 and price P1. Because
the industry is in long-run equilibrium, the price equals the minimum point on the
representative firm’s average total cost curve, so the firm produces output q1 and makes
zero profit.
a. The increase in jewellery demand leads to an increase in the demand for gold, shifting the
demand curve to D2. In the short run, the price rises to P2, industry output rises to Q2, and
the representative firm’s output rises to q2. Because price now exceeds average total cost,
the representative firm now earns positive profits.
a. Because gold mines are earning positive economic profits, over time other firms will enter
the industry. This will shift the supply curve to the right, reducing the price below. But it is
unlikely that the price will fall all the way back to P1, because gold is in short supply. Costs
for new firms are likely to be higher than for older firms, because they will have to discover
new gold sources. So it is likely that the long-run supply curve in the gold industry is upward
sloping. That means that the long-run equilibrium price will be higher than it was initially.
Figure 5.