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Questions review 3

Questions review 3 - Ques%ons for review III Ch 8...

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Unformatted text preview: Ques%ons for review III Ch 8 Why would a firm that incurs losses choose to produce rather than shut down? •  Losses occur when revenues do not cover total costs. If revenues are greater than variable costs, but not total costs, the firm is be>er off producing in the short run rather than shuAng down, even though it is incurring a loss. The reason is that the firm will be stuck will all its fixed cost and have no revenue if it shuts down, so its loss will equal its fixed cost. If it con%nues to produce, however, and revenue is greater than variable costs, the firm can pay for some of its fixed cost, so its loss is less than it would be if it shut down. In the long run, all costs are variable, and thus all costs must be covered if the firm is to remain in business An increase in the demand for video films also increases the salaries of actors and actresses. Is the long ­run supply curve for films likely to be horizontal or upward sloping? •  The long ­run supply curve depends on the cost structure of the industry. If there is a rela%vely fixed supply of actors and actresses, as more films are produced, higher salaries must be offered. Therefore, the industry experiences increasing costs. In an increasing ­cost industry, the long ­run supply curve is upward sloping. Thus, the supply curve for films would be upward sloping. In long ­run equilibrium, all firms in the industry earn zero economic profit. Why is this true? •  The theory of perfect compe%%on explicitly assumes that there are no entry or exit barriers to new par%cipants in an industry. With free entry, posi%ve economic profits induce new entrants. As these firms enter, the supply curve shiJs to the right, causing a fall in the equilibrium price of the product. Entry will stop, and equilibrium will be achieved, when economic profits have fallen to zero.Some firms may earn greater accoun%ng profits than others because, for example, they own a superior source of an important input, but their economic profits will be the same. To be more concrete, suppose one firm can mine a cri%cal input for $2 per pound while all other firms in the industry have to pay $3 per pound. The one firm will have an accoun%ng cost advantage and will report higher accoun%ng profits than other firms in the industry. But there is an opportunity cost associated with the company’s input use, because other firms would be willing to pay up to $3 per pound to buy the input from the firm with the superior mine. Therefore, the company should include a $1 per pound opportunity cost for using its own input rather than selling it to other firms. Then, that firm’s economic costs and economic profit will be the same as all the other firms in the industry. So all firms will earn zero economic profit in the long run. What is the difference between economic profit and producer surplus? •  Economic profit is the difference between total revenue and total cost. Producer surplus is the difference between total revenue and total variable cost. So fixed cost is subtracted to find profit but not producer surplus, and thus profit equals producer surplus minus fixed cost (or producer surplus equals profit plus fixed cost). Why do firms enter an industry when they know that in the long run economic profit will be zero? •  Firms enter an industry when they expect to earn economic profit, even if the profit will be short ­lived. These short ­run economic profits are enough to encourage entry because there is no cost to entering the industry, and some economic profit is be>er than none. Zero economic profit in the long run implies normal returns to the factors of produc%on, including the labor and capital of the owner of the firm. So even when economic profit falls to zero, the firm will be doing as well as it could in any other industry, and then the owner will be indifferent between staying in the industry or exi%ng. Because industry X is characterized by perfect compeEEon, every firm in the industry is earning zero economic profit. If the product price falls, no firms can survive. Do you agree or disagree? •  Disagree. If the market price falls, all firms will suffer economic losses. They will cut produc%on in the short run but con%nue in business as long as price is above average variable cost. In the long run, however, if price stays below average total cost, some firms will exit the industry. As firms leave industry X, the market supply decreases (i.e., shiJs to the leJ). This causes the market price to increase. Eventually enough firms exit so that price increases to the point where profits return to zero for those firms s%ll in the industry, and those firms will con%nue to survive and produce product X. True or false: A firm should always produce at an output at which long ­run average cost is minimized. •  False.In the long run, under perfect compe%%on, firms will produce where long ­ run average cost is minimized. In the short run, however, it may be op%mal to produce at a different level. For example, if price is above the long ­ run equilibrium price, the firm will maximize short ­run profit by producing a greater amount of output than the level at which LAC is minimized as illustrated in the diagram. PL is the long ­run equilibrium price, and qL is the output level that minimizes LAC. If price increases to P′ in the short run, the firm maximizes profit by producing q′, which is greater than qL, because that is the output level at which SMC (short ­run marginal cost) equals price. Can there be constant returns to scale in an industry with an upward ­sloping supply curve? •  Yes. Constant returns to scale means that propor%onal increases in all inputs yield the same propor%onal increase in output. However, when all firms increase their input use, the prices of some inputs may rise because their supply curves are upward sloping. For example, produc%on that uses rare or deple%ng inputs will see higher input costs as produc%on increases. Doubling inputs will s%ll yield double output, but because of rising input prices, produc%on costs will more than double. In this case the industry is an increasing ­cost industry, and it will have an upward ­sloping supply curve. Therefore, an industry can have both constant returns to scale and an upward ­sloping industry supply curve ...
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