Economics 101 (Spring 2005)
Answer Key: Practice Questions #4

1. Consider a perfectly competitive firm producing watches. Suppose that the firm’s marginal cost of production is 2Q, where Q is the level of output. The fixed cost of production is $100. The total cost is given by C=Q2+100. 

a.	If the price of watches is $60, the marginal revenue is also $60. The profit is maximized at the marginal revenue = the marginal cost, or 2Q=60. The output will be Q=30. 

b.	The profit will be total revenue minus total cost =$60(30)-(302+100)=1800-1000=800. 

c.	The firm produces in the short run as long as the average variable cost (AVC) > marginal cost (MC). The average variable cost (ACV) is Q, because AVC equals the total variable cost (Q2 ) divided by the quantity (Q). We know that the marginal cost (MC) is 2Q. This implies that for any positive Q, AVC>MC. Therefore the firm produces for any positive price. 

d.	The individual supply curve is P=2Q. The industry supply curve is P=(1/50)Q. If the market demand function is given by P=510-Q, the equilibrium price and quantity will be P=$10 and Q=500. 

e.	The change in the fixed cost of production does not affect the firm’s output choice, although the profit will decrease. 

2. At price $10, the market supply will be 40 (120) = 4800. The answer is D. 

3. The farmer produces 4 bushels of corn because the marginal cost equals the price at the output. Since the MC curve cut through the ATC curve at the output, there is no economic profit. The answer is A.

4. Since the price is below the AVC curve for all levels of output, the firm will choose to shut down in the short run and produce zero units of the good.  The firm will still incur its fixed costs and thus will have a loss equal to the amount identified in answer C. The answer is C.