Midterm 2

Question 1

What is an isocost line?

Answer 1

A collection of input bundles that have the same cost. Bundles above the isocost line cost more, and those below cost less.

Question 2

How is cost minimization different in the long run?

Answer 2

In the long run, all inputs can be varied

Question 3

What is the equation of an isocost line?

Answer 3

px * x +py * y =C

Question 4

What are the formulas for average cost (AC) and marginal cost (MC)?

Answer 4

AC(q) = C(q) / q

MC (q) = dC(q) / dq = C’(q)

Question 5

How does marginal cost (MC) affect average cost (AC)?

Answer 5

If MC(q) > AC(q), then AC(q) increases

If MC(q) < AC(q), then AC(q) decreases

Question 6

What is the first-order condition (FOC) for profit maximization?

Answer 6

MR(q) = MC(q)

Question 7

When should a firm shut down in the short run?

Answer 7

Revenues < Variable costs + Avoidable fixed costs

𝑝 ≤ MinimumAAC(q)

Question 8

Under a perfectly competitive market:

Answer 8

𝑅(𝑞) = 𝑝𝑞
𝑀𝑅(𝑞) = 𝑝

firm maximizes profit by choosing q such that 𝑝 = 𝑀𝐶(𝑞) which is MR(q) = Mc(q)

Question 9

Average avoidable cost: 𝐴𝐴𝐶(𝑞)

Answer 9

The sum of average variable cost and average avoidable fixed cost

Question 10

Steps to Find the Supply Function

Answer 10

Step 1: Find the shutdown price
- shutdown price is p-bar = minimum of 𝐴𝐴𝐶(𝑞)

Step 2: Find the q* that maximizes profit given that firm operates
- Set q such that 𝑀𝑅(𝑞) = 𝑀𝐶(𝑞)

Question 11

Pareto efficiency

Answer 11

Pareto efficient if there is no potential transaction that will make someone better off without making someone else worse off.

Question 12

Inverse Demand and Supply

Answer 12

Inverse demand 𝑝𝐷(𝑄) represents consumers’ marginal willingness to pay (WTP)

Inverse supply 𝑝𝑆(𝑄) traces firms’ marginal cost (MC)

We can continue producing and consuming until we reach 𝑄* where marginal WTP = MC

Question 13

Total Welfare

Answer 13

Total Welfare= Consumer Surplus + Producer Surplus

Question 14

Effect of Increase in Demand in Perfect Market

Answer 14

• Increase in price
• Positive profits attract new entrants so supply increases
• price decreases until it is back to min AC and profits are down to 0

Question 15

Effect of Small Decrease in Demand

Answer 15

Price decrease but is still above p = min AAC (q) so firms continue to operate

Question 16

Large decrease in demand

Answer 16

• price decreases below min AAC(q)
• Some firms stop producing and leave the market, so market supply decreases
• Price increases back to min AAC

Question 17

Finding shutdown price

Answer 17

solve for q where dAAC(q) / dq = 0

then plug q value back into original AAC(q) equation = shutdown price

Question 18

Solving for supply function

Answer 18

• Find shut-down price
• set that equal to MC(q) – = dC(q) / q
• solve for q with p in the answer
• done. supply function should look like:

q(p) = 0 if p <= 16, and p/8 for p>16

Question 19

Verifying firm profits/losses at a certain price

Answer 19

• use supply function to determine q and revenue
• plug q into cost function
• profit - cost = revenue
• confirm if revenue is more or less than sunk costs