MSci 607: Applied economics for management

Managerial Economics and Strategy (2017) by Perloff and Brander

Topic 3 (Firm decision and competitive market)

Chapter 7 Solutions

2.1. Joshua is correct. A firm’s marginal costs are always avoidable: The firm only pays the
variable costs such as marginal costs if it operates. In contrast, the firm’s short-run fixed cost is
usually unavoidable: the firm incurs the fixed cost whether or not it shuts down. Therefore, the
firm should ignore the plant’s fixed cost. Instead, it should move production to the plant to avoid
paying the higher marginal cost at the other plants.

2.2 A firm sets its output where MR(q) = MC(q). Marginal revenue is MR = 100 – 6q, and
marginal cost is MC = 10.
100 – 6q = 10  q = 15 units.
Profit = R(q) – C(q) = 100(15) – 3(15)2 – 100 – 10(15) = $575.

2.4. Only $200 of the fixed cost is sunk. The firm should shut down if its revenue is less than the
avoidable cost. Avoidable cost in this case is $1,100 and revenue is $1,000. As revenue is less
than the avoidable cost the firm should shut down. Shutdown rule 1: The firm shuts down only if
it can reduce its loss by doing so.

2.5. With a 25 percent tax on revenue, (1 – 0.25)MR(q) = MC(q).

7.1. Try it. You can also solve them analytically.

Chapter 8 Solutions

2.2. Suppose that a U-shaped marginal cost curve cuts a competitive firm’s demand curve (price
line) from above at q1 and from below at q2. By increasing output to q1 + 1, the firm earns extra
profit because the last unit sells for price p, which is greater than the marginal cost of that last
unit. Indeed, the price exceeds the marginal cost of all units between q1 and q2, so it is more
profitable to produce q2 than q1. Thus, the firm should either produce q2 or shut down (if it is
making a loss at q2). We can also derive this result using calculus. The second-order condition,
Equation 8.3, for a competitive firm requires that marginal cost cut the demand line from below
at q*, the profit-maximizing quantity: dMC(q*)/dq > 0.

2.5. The firm’s profit is

π = pq – (10 + 10q + q2).
To find the profit-maximizing output level, take the derivative of the profit function with respect
to q, set the derivative equal to zero, and then solve for q. The profit-maximizing quantity is

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 p  10
q .
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If p = 50, then q = 20. Note that the firm should indeed produce because it is profitable, with
profit of $390.

2.6. The marginal cost before tax is Cq = 20 + 2q. Setting this equal to price and solving for
quantity, the profit-maximizing quantity is
p = 20 + 2q  q = 0.5p – 10.
If p = $60, then q = 20 units. With the tax (t = 2), the total cost is
C = 30 + 20q + q2 + tq = 30 + 20q + q2 + 2q.
Marginal cost is MC = 22 + 2q. The profit-maximizing quantity for the firm to produce is
p = 22 + 2q  q = 0.5p – 11.

2.8. In the long run, the average cost curve will shift down by the amount of a per-unit subsidy,
and the firm’s marginal cost curve, or supply curve, will shift right. Because the market price
will not change significantly with lower costs for one firm, the firm will increase its output to
where its new marginal cost equals market price, and its profits will go from the market
equilibrium of zero to a positive amount.

2.11. a. Assuming that the average cost and marginal cost all have a U-shape, a firm’s marginal
and average costs are likely to rise with extra business, at least in the short term.
b. As shown in the figure below, because the increased demand is only seasonal, it will not affect
firms’ long-run supply curve and the number of firms in the market if there is considerable entry
cost. During peak demand period, firms will operate to the right of the minimum of the short-run
average cost curve.

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3.2. The shutdown notice reduces the firm’s flexibility, which matters in an uncertain market. If
conditions suddenly change, the firm may have to operate at a loss for six months before it can
shut down. This potential extra expense of shutting down may discourage some firms from
entering the market initially.

3.4. The demand for generic art is represented by D. Suppose that without Chinese art, the supply
of generic art is represented by S1, where Western artists must receive $W per painting to be
willing to supply art. The market equilibrium is represented by point e1, where the market price
is $W per painting and the equilibrium quantity is Q1.
Assume Chinese artists are willing to supply up to QC generic paintings for a price of $C per
painting. The entry of Chinese artists shifts the market supply curve out horizontally to QC at $C.
The intersection of the long-run market supply and demand curves determines the long-run
competitive equilibrium. At the new market equilibrium (with Chinese artists), the market price
is above the minimum amount Chinese artists must receive to be willing to supply their art but is
below the minimum amount Western artists must receive to be willing to supply their art.
Therefore, in this instance, only Chinese artists supply art.

3.5. Assume each firm uses the same size plant in the short and long run. Before the change in
demand, the market will have reached a long-run equilibrium, where each firm produces Q1 at
the minimum average cost, the market produces where the long-run supply curve intercepts the

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demand curve, and there will be N1 firms producing. When demand shifts to D2, in the short run
each firm will increase production to Q2. If the shift is expected to be permanent, in the long run
more firms will enter increasing their number to N2, each producing once again Q1. If the shift is
temporary, demand will eventually shift back down, and the number of firms and quantity will
revert to the original levels.

4.2. The consumer surplus at a price of 30 is 450 = 1/2 (30 × 30).

4.5. PS = 20  10 + (20  20)/2 = 400. Draw a graph of the supply function to verify.

4.8. A binding minimum wage raises the market wage. At a higher wage, employers demand less
labor, so the market equilibrium employment level decreases. The minimum wage reduces
employment below the competitive equilibrium level. Total surplus decreases because the
minimum amount workers require to be willing to supply their labor between the competitive
level and the employment level with the minimum wage is less the value employers place on it.
The reduction in surplus is equal to the area between the supply curve and demand curve for
units between the competitive equilibrium quantity and the employment level with the minimum
wage. Consumer surplus decreases because the market wage is higher and employment is lower.
Producer surplus likely increases, however, because those who keep their jobs receive higher
wages, although there is a partially offsetting decrease in producer surplus from reduced
employment. (Consumers are the ones who demand labor, and producers are the ones who
supply labor. Thus, consumers are the employers, and producers are the workers.)

4.9. a. With the price ceiling, the equilibrium will be p = 3 and Q = 30.
b. The consumer surplus increases by 2  30 – 2  (50 – 30)/2 = 40, producer surplus decreases
by 2  (50 + 30)/2 = 80. So, the social deadweight loss is 40.

5.4. In perfectly competitive markets in the long run, individual firms will produce the level of
output that occurs at the lowest point on their long-run average cost curve. Market supply is the
sum of the supply of individual firms. The competitive market equilibrium is where market
demand equals market supply. At the long-run equilibrium, the market price will equal the

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minimum long-run average cost of production. Otherwise, if firms were earning economic
profits, then new firms would enter, and if firms were incurring losses, existing firms would exit.
A specific, per-unit tax will shift each firm’s long-run average cost curve up by an amount equal
to the size of the tax. The quantity produced by an individual firm will not change because the
minimum point on the long-run average cost curve will occur at the same quantity. Absent any
other changes, the market price would be below the long-run average cost of production, so firms
would incur losses. This will prompt firms to exit the industry, reducing market supply, until the
market price again equals the minimum long-run average cost of production. Thus, at the new
market equilibrium, the market price will have increased by an amount equal to the size of the
tax and the market equilibrium quantity will have decreased, although the amount produced by
an individual firm will remain unchanged.

Competitive firms operating where price equals marginal cost maximizes total surplus at the
competitive equilibrium. Total surplus is maximized at the competitive equilibrium because the
marginal cost of production equals the marginal value to consumers.