BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY

Fall 2017 Smeal College of Business

ANSWERS TO PRACTICE PROBLEMS:
Module 3

13. Disagree. They should shut down because total revenues do not even cover all their variable costs (TR =
$110,000 < TVC = 120,000). Another way of saying the same thing is to note that losses are $90,000 if
they stay open and $80,000 if they shut down.

14. (b) In general, you want to set MR = MC. Because this is a competitive firm—which follows from the fact
that sales would fall dramatically if the firm tried to raise the price—we know that MR = P. At q = 100,
you are currently at a point where P = $8.50 > AVC = $7.00. Since P > AVC, you don't want to shut
down. Because P > MC = $8.00 and P < ATC = $9.00 (where ATC is AVC + AFC), you are functioning
at a point where you won't cover all your costs. You minimize your losses by increasing output to the
point where MC = P = $8.50. This means you should increase output from 100 to q*, as shown on the
graph below.

MC ATC
$

9
8.50 AVC
8

100 q* q

15. All of these statements are true in long-run equilibrium. Production should continue increasing to the
point where price equals long-run marginal cost in order to maximize firm profits. Market forces (entry
and exit) will drive the market price to the point of minimum long-run average cost, at which point
economic profits are zero.

16. While economic profit is the difference between total revenue and total cost, producer surplus is the
difference between total revenue and total variable cost. The difference between economic profit and
producer surplus is the fixed cost of production.

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BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERSITY
Fall 2017 Smeal College of Business
ANSWERS TO PRACTICE PROBLEMS:
Module 3

17. False. Although the demand curve for a perfectly competitive firm is perfectly elastic (horizontal), that
does not imply that the market demand curve is perfectly elastic. The demand curve for a firm is
horizontal at the going market price (i.e., the market equilibrium price) because each individual firm is an
insignificantly small part of the market and therefore acts as a price taker in the market. When a drought
kills half of the wheat crop in Europe, this is not an insignificant change. The supply of wheat decreases,
as shown below, and the market price increases.

Firm Market
$ S1
MC
$
S0

P1 d = MR1 P1

P0 d = MR2 P0

D
q Q

18. (c) The supply curve shifts back and to the left, causing a movement along the demand curve (similar to
the right panel in the figure above). The change in total revenue along the demand curve tells you about
the price elasticity of demand. The fact that revenue (earnings) rose implies that the demand curve is
relatively inelastic at the prevailing price and quantity.

19. Demand is not fixed over time. The university official is only observing the equilibrium price and
quantity over the last 15 years (where the equilibrium might be moving from point A to B to C in the
graph below). If demand is shifting upward at the same time as supply shifts upward, demand could have
any elasticity. More market research would be required to support the conclusion that demand is
completely price inelastic.

P S1997

S1987
C S1977

B
D1997
A

D1987

D1977

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