Universidad Carlos III de Madrid – Department of Economics

Principles of Economics - Problem Set 3

Conceptual Questions

1. Explain the relationship between decreasing marginal returns and a firm’s product
supply. Provide examples which show the law of diminishing marginal returns.

2. Explain the relationship between total cost, marginal cost and average cost. Give
examples where the average cost increases or decreases depending on whether marginal
cost is above or below average cost.

3. What is the difference between a movement along the supply curve and a shift of
the supply curve? Give some examples where factors that affect the supply change the
quantity supplied (movements along …) or change the supply itself (shift of...).

4. What is the price elasticity of supply and the price elasticity of demand? Give
examples of supply and demand curves which are very elastic or very inelastic.

5. Given the supply function Q = 4p – 20, compute the elasticity when the offered
quantity equals 380 units.

Problems

6. The cost of one additional barrel of oil for the company Skull-Oil is 10 dollars if it
produces up to 1 million barrels and 50 dollars if it produces between 1 and 4 million. Its
maximum production capacity is 4 million barrels.

a. What is the supply curve of Skull-Oil, if the oil market is perfectly competitive?
b. If there are 20 companies like Skull-Oil in the market, what is the supply curve of
the market?
c. The price elasticity of supply in the long run is usually greater than that in the short
run. Explain why this is true in general, and also in the particular case of Skull-Oil.
d. Skull-Oil produces the first million barrels in Nigeria, and the rest in Norway. What
will happen to the oil supply curve of Skull-Oil if for various reasons the cost of
producing an additional barrel of oil in Nigeria is now $20 instead of $10?

7. The marginal cost of every company in the potato market is 20 cents per kilo, and there
are 10 firms with identical cost in the market. With this information we can say that:

a) Individual supply is horizontal at price of 19 cents per kilo.

b) Individual supply and market supply are vertical at the quantity of 20 tons.
c) Individual supply and market supply are horizontal at the same price.
d) Individual supply is horizontal at a price of 20 cents and the market supply at a price
of 200.

8. José is the owner of a construction firm. The following table shows the monthly total
cost of the firm as a function of the number of houses built each month.

1
 Marginal cost (Cost
Houses built Total monthly cost in
of building an
during a month thousand Euros
additional house)
0 0
1 50
2 80
3 110
4 140
5 173
6 211
7 254
8 303
9 356
10 413

a) Complete the table above and comment on the shape of the marginal cost.
b) If the house price is €53.000 and José knows that he can sell as many houses as he
wants at that price but no one at a higher price (that is, he is a price-taker), how many
houses per month should he build in order to maximize its profits? Compute José’s profit.
c) Answer the previous question for house prices of €43.000 and €33.000.
d) Find the supply curve for José’s firm.
e) Obtain the supply curve of the house market if there are 50 firms identical to José’s
company.
Other questions

1 If a firm in a perfectly competitive market decides to increase its price above the
market price, then…
a) Its total revenue will increase. b) Its profit will increase. c) It will not sell
anything. d) None of the previous answers is correct, as the demand curve of the firm
has a positive slope.

2. The marginal cost of a tennis school only depends on the wage of its instructors. The
tennis instructors’ labour union negotiates a 7% increase in instructors’ wages. Then,
a) The supply curve shifts towards the left. b) The supply curve shifts towards the right.
c) The supply curve changes its slope from positive to negative, because of the reduction
in the number of clients due to the higher cost. d) None of the above.

3. The introduction of electronic books makes the demand of paper books:

a) More elastic. b) More inelastic. c) It depends on the particular point of the curve
considered. d) Elasticity does not change, the curve simply shifts back.