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Department of Economics Professor Kenneth Train University of California, Berkeley Spring 2006 Midterm 1 Suggested Answers Question 1: (20 points, 10 minutes) a)A profit maximizing firm always chooses to produce at the minimum of the average cost curve. False. A profit maximizing firm chooses to produce where marginal revenue is equal to marginal cost; this is where profits are highest. If average total cost is not at its minimum at that point, the firm would not want to change production, because to do so would lower profits. Consider the following graph for a competitive firm: the firm faces a constant marginal revenue (determined by the market price) and rising marginal cost. The firm will choose to produce every unit that has positive profit; that is, it will choose to produce up until the quantity where marginal revenue is equal to marginal cost. This point will not necessarily correspond to the minimum of the ATC curve; as shown here, the firm prefers to produce at a point where ATC is above its minimum. However, it is the case that as the industry moves toward stage two equibrium, entry and/or exit will move the industry toward production at the minimum average cost. The minimum of the ATC curve is the level of production where there are zero economic profits, as required by stage two equilibrium. Since the marginal cost curve crosses the ATC curve at its minimum by definition, in stage two equilibrium, the firm will be producing at minimum ATC. But firms are not choosing that point because ATC is lowest; they are choosing to maximize profits by producing where MR=MC. b)If AC > MC at the firm’s chosen output level, then the firm is producing on the upward sloping part of its AC curve. False. If marginal cost is below average cost, then the marginal unit has a lower cost than the average unit, and average cost including the marginal unit must be therefore be lower than average cost without it. Thus, average cost must be falling, and the firm must be producing on the downward sloping part of the AC curve. $ q MC AC AC > MC; AC falling AC < MC; AC rising $ q P1MC AC q1MR
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