Econ 100A-Spring 2010
Problem Set 3 Answers
Department of Economics
University of California
PROBLEM SET 3 ANSWER SHEET
Provide brief but complete explanation for each of the below statements.
An individual firm that sells in a market that satisfies competition conditions faces a perfectly elastic
demand curve and yet the market demand curve is price elastic.
Answer: In a competitive market, if an individual firm were to attempt to charge a price higher than the
market price several things would happen.
All of its customers would shift their purchases to other
suppliers since they would be offering the identical product at a lower price.
If, instead, all firms raised
their price the same about simultaneously, consumers as a group would cut back on their purchases.
Even then, however, if there is free entry, this attempt to raise price in unison would be defeated as
entrants would undercut the incumbents and take all their business.
A firm’s profit and the producer surplus in a market may or may not be equal.
Answer: Profit equals producer surplus when the firm has no fixed costs. Producer surplus can be
thought of as the gains from trade.
In the short run, if the firm produces any output, it earns profit equal
to revenue minus variable costs minus fixed costs. If the firm shuts down, it incurs the fixed costs. The
producer surplus equals the profit from trading minus the profit or loss from not trading, revenue minus
If no fixed costs exist, then profit will equal the producer surplus.
For each on of the following industries, explain why you think it is either a constant, increasing or
decreasing-cost industry: (a) Coffee bean industry; (b) Crude oil industry, (c) Automobile industry.
(a) The coffee industry is a likely to be a constant-cost industry as usable land is essential input
needed while scaling up coffee production, and such land is abundantly available in part because coffee
can be grown on rocky hillsides that cannot support other crops.
Further, the cost of planting and caring
for trees is likely to be proportional to acreage under production.
Note that if the industry was confined
to a single country that did not import or export coffee beans, then it may run out of usable land and
costs would eventually increase.
(b) Crude oil production depends on known, recoverable reserves on land and under the sea.
and with cumulative production, available reserves eventually begin to shrink, causing the crude oil to be
an increasing-cost industry. In addition, as the known reserves become depleted, the cost of recovering
the remaining oil is increasingly costly as more secondary and tertiary techniques are used (e.g., forcing
steam into the oil fields to drive up the oil).
On the other hand, more sophisticated geological
technologies may be able to locate other reserves that were not known, and drilling techniques can
expand the oil fields that are usable (e.g., deep water drilling).