Topic 6 Practice Questions

1. Zach owns a small, perfectly competitive, fast-food restaurant in downtown Toronto. The market price of the combo meal is $20.

Zach’s total cost is as follows:

TC = 1500 + 0.0025Q²

Assume that the local government decides to impose a per-unit tax of $2.50 ONLY on Zach’s restaurant. Find Zach’s after-tax output and profit.

 

Answer:

The total cost function:

TC = 1500 + 0.0025Q²

The marginal cost function:

MC = 0.005Q

The after-tax total cost function:

TC = 1500 + 0.0025Q² + 2.5Q

The after-tax marginal cost function:

MC = 0.005Q + 2.5

Set P = MC

20 = 0.005Q + 2.5

20 – 2.5 = 0.005Q

17.5 = 0.005Q

Q = 3,500

Profit = TR – TC

TR = P × Q = 20 × 3,500 = $70,000

TC = 1500 + 0.0025(3500)² + 2.5(3500) = 1500 + 30625 + 8750 = 40,875

Profit = TR – TC = 70,000 – 40,875 = $29,125

 

2. Firm A operates in a perfectly competitive market. Its short-run total cost function is given as:

TC = 50 + 0.2Q²

Firm A’s product is sold at a market price of $20 a unit. What is Firm A’s profit-maximizing output decision for the short-run?

(A) Q* = 40; Firm A should shut down.

(B) Q* = 20; Firm A should continue to produce.

(C) Q* = 50; Firm A is indifferent about shutting down or producing.

(D) Q* = 50; Firm A should shut down.

(E) Q* = 50; Firm A should continue to produce.

 

Correct Answer: E

Steps:

MC = ΔTC / ΔQ = 0.4Q

Set P = MC

20 = 0.4Q

so Q = 50

TC = 50 + 0.2Q²

VC = 0.2Q²

AVC = VC / Q = 0.2Q

At Q = 50, AVC = 0.2 * 50 = 10

Since P = 20 > 10, Firm A will continue to operate and will produce 50 units of product.

 

3. A firm in a perfectly competitive market will have a marginal revenue curve that is _____.

(A) upward sloping

(B) vertical

(C) downward sloping

(D) horizontal

(E) below the AR curve

 

Correct Answer: D

Steps:

In a competitive market, an individual firm is a price taker, and it faces a demand that is perfectly elastic (i.e., horizontal).

 

4. Which of the following is not a basic assumption of a perfectly competitive market?

(A) Free entry and exit

(B) Price taking

(C) Price setting

(D) Product homogeneity

 

Correct Answer: C

 

5. The demand curve facing an individual competitive firm is:

(A) perfectly inelastic and equal to the marginal revenue curve.

(B) perfectly elastic and equal to the marginal revenue curve.

(C) perfectly elastic and equal to the marginal cost curve.

(D) perfectly inelastic and equal to the marginal cost curve.

(E) elastic and equal to the marginal cost curve.

 

Correct Answer: B

 

6. James owns a competitive hot dog stand in downtown Toronto. He sells hot dogs for $4 each. James’ cost for ingredients is $2.5 a hot dog, while the cost of his city permit to operate on the street averages $1.5 a hot dog. What should James do?

(A) Shut down his hot dog stand.

(B) Increase the price to $5 per hot dog.

(C) Continue to operate in the short-run.

(D) Need more information to answer this question.

 

Correct Answer: C

Steps:

P = $4, AVC = $2.5, AFC = 1.5

P > AVC, so James should continue to operate.

AC = AVC + AFC = $2.5 + $1.5 = $4

P = AC, so James breaks even and has zero economic profit.

 

7. Which of the following is NOT true at the long-run competitive equilibrium?

(A) No firm has an incentive to enter or exit the industry because every incumbent firm is earning zero economic profit.

(B) At the profit-maximizing output level, the price of the product is less than the average variable cost of production.

(C) All firms in the industry are maximizing their profits.

(D) The market price is determined where the market supply curve intersects the market demand curve.

 

Correct Answer: B

Steps:

At the long-run competitive equilibrium, every firm breaks even. P = LMC = LAC

 

8. When a competitive firm produces the profit-maximizing output in the short-run, which of the following statements must be true?

(A) MC = MR and MC is falling.

(B) MC = AVC and MC is rising.

(C) MC = ATC and MC is rising.

(D) MC = AR and MC is rising.

 

Correct Answer: D

Steps:

The profit-maximizing condition in the short-run is: MR = MC and the MC curve is rising. MR = AR.

 

9. Assume that firms are earning positive economic profit in a competitive market. Are the following statements true or false?

(A) The market price will soon fall, so firms should exit the industry immediately to avoid losing money.

(B) Long-run competitive equilibrium is achieved as all firms are maximizing profit.

(C) New entrants will enter the market until firms are earning negative economic profit.

(D) Positive economic profit implies that firms in this industry enjoy an above-normal return.

 

Correct Answer:

(A) False

(B) False

(C) False

(D) True

Explanation:

In a competitive market, a firm could have a profit, a loss, or break even in the short-run. In the long-run, every firm breaks even.

10. In a perfectly competitive market, the long-run market supply and demand are: P = 50 + 0.25Q_S and P = 80 – 0.05Q_D. The long-run marginal cost function for an individual firm in this market is: MC = 5 + 20q. How many firms are in this market?

 

Answer: Approximately 29 firms are in this market.

Steps:

Step 1: Find the equilibrium market price and quantity.

50 + 0.25Q = 80 – 0.05Q

P = 75, and Q = 100

Step 2: Determine the output level of individual firms.

Set P = MC

75 = 5 + 20q, q = 3.5

The number of firms = Q/q = 100/3.5 = 28.57

Approximately 29 firms are in this market.

 

11. Westdale Diner, a highly competitive eatery, sells donuts for $1.50. Its total and marginal cost functions are: TC = 1000 + 0.0005Q² and MC = 0.001Q, where Q refers to donuts sold per day. What is the total economic profit for the business?

(A) 275

(B) 125

(C) 150

(D) 225

 

Correct Answer: B

Steps:

Equate P = MC to find the profit-maximizing quantity.

1.5 = 0.001Q

Q = 1500

TC = 1000 + 0.0005(1500)² = $2,125

Economic profit = TR – TC = (1.5)(1500) – 2,125 = 2,250 – 2,125 = $125

 

12. A perfectly competitive firm has a cost function: TC = 200 + 0.5Q + 0.2Q². Assume the market price is $16.50 per unit. The firm should produce ____ units in the short-run to maximize its profit.

(A) 40

(B) 39

(C) 41

(D) 43

 

Correct Answer: A

Steps:

MC = ΔTC/ΔQ = 0.5 + 0.4Q

Equate P = MC to find the profit-maximizing output.

$16.5 = 0.5 + 0.4Q

Q = 40

Check the shut down condition.

Given TC = 200 + 0.5Q + 0.2Q²

VC = 0.5Q + 0.2Q²

AVC = 0.5 + 0.2Q

At Q = 40, AVC = 8.5

P > AVC

So, the firm should operate in the short-run.

 

13. In a perfectly competitive market, assume firms are making a profit in the short-run. Predict the impact on the market demand and supply curves in the long-run.

(A) Both curves will remain the same.

(B) The market supply curve will shift to the right.

(C) The market demand curve will shift to the right.

(D) The market supply curve will shift to the left.

 

Correct Answer: B

Steps:

No entry barrier is present in a competitive market. Thus, profit will attract new entrants. In addition, existing firms will have an incentive to expand production. The market supply will shift to the right.

 

14. The demand curve for a perfectly competitive firm is:

(A) perfectly elastic because a competitive firm is a price taker.

(B) the same as the average revenue curve but not the marginal revenue curve.

(C) the same as the marginal revenue curve but not the average revenue curve.

(D) the same as the market demand curve because the competitive firm is a price taker.

 

Correct Answer: A

Steps:

The demand curve for a perfectly competitive firm is horizontal (i.e., perfectly elastic). A competitive firm is a price taker. So, P = MR = AR. The demand curve faced by an individual competitive firm is the same as its average revenue curve and its marginal revenue curve.

 

15. A competitive light bulb store has a total cost of:

TC = 5Q² + 20Q

The light bulbs sold by this store have mercury in them, which is highly toxic and can be fatal. Assume a “health” tax of $1 per light bulb is imposed ONLY on this store. What is the store’s supply curve?

(A) 0.1P – 2.1

(B) 10P – 21

(C) 5P – 1

(D) 0.1P + 2

 

Correct Answer: A

Steps:

MC = 10Q + 20

With the addition of the tax, MC = 10Q + 20 + 1 = 10Q + 21

Equate P = MC to maximize profit.

P = 10Q + 21

10Q = P – 21

Q = 0.1P – 2.1

The store’s supply curve is: Q = 0.1P – 2.1

 

16. Assume that perfectly competitive firms in a decreasing-cost industry are earning economic profits. Determine the validity of the following statements. In the long-run:

(I) the market price will decrease.

(II) the marginal cost of production will decrease.

(A) Both I and II are false.

(B) I is true, and II is false.

(C) I is false, and II is true.

(D) Both I and II are true.

 

Correct Answer: D

Steps:

Profit will attract new entrants. In addition, existing firms will have an incentive to expand production. The market supply will shift to the right. In a decreasing-cost industry, input prices decrease when the industry output increases. Therefore, both MC and P will decrease in the long-run.

 

17. Answer the following questions:

(I) What is a competitive firm’s short-run supply curve?

(II) Suppose the Ontario government recently increased the minimum wage. What is the impact on a competitive firm’s profit if this firm continues to produce the same level of output?

 

Answer:

(I) A competitive firm’s short-run supply curve is the fraction of the firm’s marginal cost curve that lies above the minimum of AVC.

(II) This competitive firm’s profit will decrease if it produces the same output level after the minimum wage increases.