Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

Economics 3030: Intermediate Microeconomic Theory

Problem Set 5: Perfect Competition - Solutions
1. Consider a perfectly competitive industry. Write q for the output of one firm, measured in tons.
The total cost function of each firm, cost being measured in dollars, is given by:

()
C q = 3600 + 40q + 0.25q 2

(a) Find the average cost, the average variable costs, and the marginal cost of each firm as functions of q;

(b) Calculate the value of q that minimizes average cost;

(c) Find the minimum average cost;

(d) By the long run, we mean a situation where: (i) each firm can avoid its fixed cost by producing q = 0; (ii)
firms can enter or exit freely. Find each firm’s supply curve and the industry supply curve for this situation.
Be careful to specify the ranges of prices where the quantity is zero, positive but finite, and infinite;

(e) By the short run, we mean a situation where: (i) a given number of firms are in the market and new ones
cannot enter; (ii) a firm in the market cannot avoid its fixed cost even if it produces q = 0; and (iii) each firm
can vary its output to maximize profit. Find the supply curve of one firm in the market in this situation. Be
careful to specify for what range of prices the firm produces q = 0 and for what range it produces positive
output;

(f) The market demand function linking the total quantity Q demanded by consumers (measured in tons) and the
price p (measured in dollars per ton) is given by Q = 12000 - 60p. Suppose the industry is in long-run
equilibrium. Calculate the price, the total quantity, the quantity produced by each firm, the number of firms,
and the profit of each firm;

(g) Now suppose the demand suddenly shifts to Q = 8000 -50p. After this shift of demand occurs, consider a very
short run where: (i) new firms cannot enter; and (ii) each existing firm has committed itself to producing the
quantity of output it was producing in the original long run equilibrium; it cannot avoid any of the cost of this
production, and cannot expand its quantity of output either. Calculate the market price and the profit of each
firm;

(h) Next consider the short run after the shift of demand occurs. For this short run, find the industry supply
schedule. Calculate the market price, the output of each firm, and the profit of each firm;

(i) Finally consider the new long run equilibrium following upon the shift of demand. Calculate the market price,
the total quantity, the quantity produced by each firm, the number of firms, and the profit of each firm;

()
C q = 3600 + 40q + 0.25q 2

See Figure 1 following:

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

p
300

250 AC

200
AVC
150

100 MC

50

0 q
0 100 200 300 400 500

Figure 1

(a) Find the average cost, the average variable costs, and the marginal cost of each firm as functions
of q.

TC 3600
AC ≡ = + 40 + 0.25q
q q
TVC
AVC ≡ = 40 + 0.25q
q
∂TC
MC ≡ = 40 + 0.5q
∂q

(b) Calculate the value of q that minimizes average cost.

∂( AC) 3600
= − 2 + 0.25 = 0
∂q q
⇒
q = 120
⇒
∂ 2 ( AC) 7200
= 3 > 0 at q = 120
∂q∂q q

so we know that q=120 is a minimum.

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

(c) Find the minimum average cost.

Plugging q = 120 this into the formula for average cost:

3600
AC = + 40 + 0.25(120) = 100
120

(d) By the long run, we mean a situation where: (i) each firm can avoid its fixed cost by producing
0; (ii) firms can enter or exit freely. Find each firm’s supply curve and the industry supply curve
for this situation. Be careful to specify the ranges of prices where the quantity is zero, positive but
finite, and infinite.

For firm’s profit maximization, p =MC, MC is increasing and p ≥ min AC . Thus, an individual
firm’s supply function is:

⎧⎪ 2 p − 80 if p ≥ 100
S
qLR =⎨
⎩⎪ 0 if p < 100

Industry supply is perfectly elastic at minimum LAC vis:

⎧ 0 if p < 100
⎪
S
QLR = ⎨ 120n if p = 100 for n = 1,2,3,...
⎪ ∞ if p > 100
⎩

where n denotes the number of firms in the industry.

(e) By the short run, we mean a situation where: (i) a given number of firms are in the market and
new ones cannot enter; (ii) a firm in the market cannot avoid its fixed cost even if it produces 0;
and (iii) each firm can vary its output to maximize profit. Find the supply curve of one firm in the
market in this situation. Be careful to specify for what range of prices the firm produces 0 and for
what range it produces positive output.

Here profits are non-negative if p ≥ min AVC . At q = 0, the average variable cost is 40. This is the
smallest AVC with non-negative q. Thus, the firm’s supply function is:

⎧⎪ 2 p − 80 if p ≥ 40
S
qSR =⎨
⎩⎪ 0 if p < 40

(f) The market demand function linking the total quantity Q demanded by consumers (measured in
( )
tons) and the price p (measured in dollars per ton) is given by Q D p = 12000 − 60 p . Suppose the
industry is in long-run equilibrium. Calculate the industry price, the total quantity, the quantity
produced by each firm, the number of firms, and the profit of each firm.

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

In long-run equilibrium, industry price will be equal to minimum long-run average cost. Thus:

p = min LAC = 100

( )
Industry demand at a p = 100 is equal to Q d 100 = 12000 − 60 ∗100 = 6000 . Each firm will be
supply q = 2 ∗100 − 80 = 120 such that the number of firms in the industry is given by n = Q q = 50
, each of whom, of course, is making normal profit of π = 0 . Note also that MC = Min LAC at q =
120:

MC = 40 + 0.5(120 ) = 100

( )
(g) Now suppose the demand suddenly shifts to Q D p = 8000 − 50 p . After this shift of demand
occurs, consider a very short run where: (i) new firms cannot enter; and (ii) each existing firm has
committed itself to producing the quantity of output it was producing in the original long run
equilibrium; it cannot avoid any of the cost of this production, and cannot expand its quantity of
output either. Calculate the market price and the profit of each firm.

See Figure 2 following:

S
Very short run supply: QVSR = 6000 for p > 0 (since all costs are non-recoverable)

( )
Demand: Q D p = 8000 − 50 p = 6000 = QVRS
S
⇒ p = 40

SAC = min LAC = 100

⇒
( ) ( )
π = p − AC q = 40 − 100 ∗120 = −7200

(h) Next consider the short run after the shift of demand occurs – i.e. where existing firms can
change their level of output but where entry/exit into the industry is not possible. For this short run,
find the industry supply schedule. Calculate the market price, the output of each firm, and the profit
of each firm.

Short run industry supply:

⎧⎪ (2 p − 80)50 if p ≥ 40
S
QSR =⎨
⎩⎪ 0 if p < 40

Thus:

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

S
QSR = (2 p − 80)50 = −4000 + 100 p = 8000 − 50 p = Q D p( )
⇒
150 p = 12000
⇒
p = 80

S
qSR (80) = 2 p − 80 = 2 ⋅80 − 80 = 80
S
QSR = nqSR
S
= 50*80 = 4000

3600 3600
AC = + 40 + 0.25q = + 40 + 0.25∗80 = 45 + 40 + 20 = 105
q 80

( ) ( )
π = p − AC q = 80 − 105 ∗80 = −2000

(i) Finally consider the new long run equilibrium following the shift of demand. Calculate the
market price, the total quantity, the quantity produced by each firm, the number of firms, and the
profit of each firm.

Entry and exit in the long run will ensure that p = min LAC = 100 . Thus:

Q d ( p ) = 8000 − 50 ∗100 = 3000

⇒
S
QLR = 3000

Recall that output is demand determined in the long run. Each firm will therefore supply:
S
qLR = 2 p − 80 = 2 *100 − 80 = 120

Such that the number of firms is given by:

n = Q q = 3000 120 = 25

Each of which will be making normal profit:

( ) ( )
π = p − AC q = 100 − 100 ∗120 = 0

Note that consumer surplus is equal to Area C.

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

p S
QVSR = 6000
S
QSR = −4000 + 100 p

C E3 E0
100
S
QLR = Min LAC = 100

80 E2

E1
40 Q2D = 12000 − 60 p

Q1D = 8000 − 50 p

0 3000 4000 6000 Q

Figure 2

2. Consider the industry in question one. In the short run, following the shift in demand, assume
that the firms that were producing in the original equilibrium get together and persuade the
government to implement the following policy:
The price will be maintained at the original long-run equilibrium level. No new firms will be allowed
to come in. Each existing firm will be allowed to produce as much as it wants at this price; the cost of
production is specified as a function of output in question one. The government will buy any quantity
that is supplied by firms but not demanded by consumers. It is then resold to foreigners at the price of
50.

What is the difference between the consumer surplus, each firm’s profit, overall industry profit,
and the government’s net expenditure on its activities of buying from the firms and selling to
foreigners, when you compare the result under this policy from that under the following two
alternative standards of comparison without any government intervention:
(a) The short-run equilibrium under the new demand as found in part (h) of question one;
(b) The long-run equilibrium under the new demand as found in question one.

See Figure 3 following:

To maintain a price of p = 100 when supply is Q S = 6000 and demand is only Q D = 3000 , the
government must buy 3000. Compare this to:

(a) New short run

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

In the original short-run, price (quantity) fell to p = 80 (Q = 4000). Consumer surplus was thus
given by the sum of Area A + Area B + Area C. Under the government support mechanism, price
(quantity) are equal to p = 100 (Q = 3000). Consumer surplus is thus equal to Area C. The loss of
consumer surplus is thus equal to Area A + Area B = 70000. To be sure:

Area A: (100 – 80)*3000 = 60000

Area B: 0.5*(4000 - 3000)*(100 - 80) = 0.5*1000*20 = 10000

p S
QVSR = 6000
S
QSR = −4000 + 100 p

C E3 E0
S
QLR = Min LAC = 100
100

A B
80 E2

E1
40 Q1D = 12000 − 60 p

Q2D = 8000 − 50 p

0 3000 4000 6000 Q

Figure 3

Increase in industry profit = [0 - (-2000)]*50 = 1000001

Expenditure by government = (100 - 50)*3000 = 150000

(b) New long run

Consumer surplus and industry profits are same as in part (i) of question one above – i.e. AREA
C. Government expenditure is 150000. This policy described in the question is roughly how the
European Common Agricultural Policy Operates.

3. Once again consider the industry of question one above. In the short run following the shift in
the market demand, the firms that were producing in the original equilibrium get together and
persuade the government to implement the following policy:
1
New profit is zero - i.e. p = MC as per part (f) of question three. Subtract the profit from before the price support (-
2000) and multiply by the number of firms from part (f) of question two vis. 50

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

No new firms will be allowed to enter. Each existing firm will be restricted in its production and allowed
to produce only 80 units. The cost of production is as specified in question one.

Calculate the market price and the profit of each firm. What is the difference between consumer
surplus and firms’ profits when you make the same comparison as you were asked in do in question
two.

We have 50 firms each producing their quota output of q s = 80 . Thus, Q s = nq s = 50*80 = 4000 .
This just replicates the new short run in part (h) of question one. Thus, market price and the profit
of each firm is the same, consumer surplus is higher by 70000 whilst profits are lower by 100,000.
This is how government programs restricting agricultural output operate.

4. Sometimes countries experience famines. A popular solution to a famine is to provide massive

amounts of food aid to a country. Typically, a famine is precipitated by a drought, but it is often
observed that the need for food aid continues long past the end of the drought. Why is this?
To answer this question, we begin with a farm’s cost function. Let a representative farm
have the following cost function for producing food f measured in tons:

C = 4 f + 0.1 f 2 + 10

(a) Find the farm’s short-term supply curve. By the short run, we mean a situation where: (i) a given number
of farms are in the market and new ones cannot enter; (ii) a farm in the market cannot avoid its fixed
cost even if it produces q = 0; and (iii) each farm can vary its output to maximize profit. Let p be the
price of food.

(b) Find the industry supply curve when there are 500 identical farms producing food.

(c) Market demand is given by F D = 40000 − 2500 p . Find the equilibrium price of food and the quantity
of food demanded.

(d) Now consider the state of a famine. Market supply of food is zero. What is the new market price of
food?

(e) We are the World sends food aid to the country experiencing the famine. It sends 35000 tons of food
aid. What is the new market price of food?

(f) The drought ends and local food producers are able to farm again. They face the same cost function as
before. We are the World announces that they will continue their food shipments of 35000 tons until
the local market picks up to meet local demand: ‘Not a child will go hungry.’ Will local farmers begin
farming in order to meet local demand?

(a) In the short run, a farm produces at p=MC when MC is rising and p ≥ min AVC . AVC is
given by AVC = TVC f = 4 + 0.1 f and is minimised where f = 0. Thus, a farm produces if p ≥ 4
such that farm supply is given by:

p = MC = 4 + 0.2 f
⇒
f = 5 p − 20

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

Thus:

⎧5 p − 20 if p≥4
fs =⎨
⎩ 0 if p<4

(b) To get industry supply, we add up all of the individual farm supply curves:

⎧(5 p − 20 )500 if p≥4

F s = nf s = ⎨
⎩ 0 if p<4

(c) p* = 10; F* = 15000:

F S (p∗ )= −10000 + 2500 p∗ = 40000 − 2500 p∗ = F D (p∗ )

⇒
5000 p∗ = 50000
⇒
p∗ = 10

Thus:

F S (10 ) = −10000 + 25000 = 40000 − 25000 = F D (10 )

⇒
15000 = 15000
⇒
F ∗ = 15000
S
(d) A famine implies FFAMINE = 0 such that:

F D (p∗ )= 40000 − 2500 p∗ = 0 = F S (p∗ )

⇒
p∗ = 16

S
(e) Food aid implies FAID = 35000 such that:

F D (p∗ )= 40000 − 2500 p∗ = 35000 = F S (p∗ )

⇒
2500 p∗ = 5000
⇒
p∗ = 2

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

(f) If food aid ofF35000 tons continue, then local farmers will
p∗ not
= 2 resume farming in order to meet
AID = 35000
S

local demand implies a market price of , which is below the farmers’

p∗ = 2
minimum AVC = 4. So long as the market price for food is , it will never pay to begin
farming again. As a result, the area stays dependent on food aid.

5. Some years hence you graduate summa cum laude from Cornell and decide to set yourself up as
a private economic consultant to the great and the good. Your first assignment is on the planet
Zardoz where you are to advise Captain Vulcan, the Minister for Enterprise, on how Zardonian
firms might maximise profits. You know from your research that Zardonian firms operate as price
takers in product and factor markets, and you are given the following information for nine firms.
For each firm you are asked what action you would recommend from the options set out below:
(1) firm is now in correct position;
(2) firm should raise price;
(3) firm should lower price;
(4) firm should increase output;
(5) firm should decrease output;
(6) firm should close.

Case p q TR TC TFC TVC AC AVC MC Increasing q will

cause MC to:

A - - 10 9 - - 1.8 - 2 rise
B - 1 5 - 1.5 - - 5.5 5 rise
C - - 8 - 1 - 3.5 3 4.5 -
D - - 12 12 - 9 * 1.5 - -
E 3 - - - 6 8 3.5 * - -
F 4 2 - - - 7 4.5 - 4 rise
G - 1 3 - 1.5 - - 3.5 3 rise
H 1 10 - 8 - - * - - rise
I 3 2 - - 3 7 - - 3 fall

where p = price per unit of output; q = quantity of output (000's); TR = total revenue ($000's); TC
= total cost ($000's); TFC = total fixed cost ($000's); TVC = total variable cost ($000's); AC =
average cost ($); AVC = average variable cost ($); MC= marginal cost ($); * = at minimum level;
- = no information.

It may be useful to draw diagrams for each case.

(a) 1 - Firm is now in correct position.

AC = TC/X = $9000/X = $1.80
X = 5000
P = TR/X = $10000/5000 = $2
Thus: MR = P = MC = $2 > AC = $1.80

(b) 6 - Firm should close

P = TR/X = $5000/1000 = $5 = MC
But:
AC = TC/X = [TVC +TFC]/X = [X(AVC) + TFC]/X
= [1000($5.50) + $1500]/1000

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

= $7.00
Thus:
P = MC = $5 < AVC = $5.50 < AC = $7.00

(c) 5- Firm should decrease output.

TC = TVC + TFC = TVC + 1000
X(AC) = X(AVC) + 1000
3.5X = 3X + 1000
X = 2000
P = TR/X = $8000/2000 = $4.00
Thus:
MR = P = $4.00 < MC = $4.50

(d) 1 - Firm is now in correct position.

TC = TVC + TFC
$12000 = $9OOO + TFC
TFC = $3000
AVC = TVC/X
$1.50 = $9000/X
X = 6000
P = TR/X = $12000/6000 = $2.00

In equilibrium, if all firms are equally efficient, marginal cost equals the minimum value of long
run average cost:
AC = TC/X = $12000/6000 = $2.00
Thus:
MC = MR = P = $2.00 (But note that equilibrium is one of zero profit)

(e) 4 - Firm should increase output.

X = TR/P = TR/$3.00 = TC/AC = [TVC +TFC]/AC = 4000
MC = MINIMUM AVC
AVC = TVC/X = $8000/4000 = $2.00
Thus:
MR = P = $3.00 > MC = $2.00

(f) 1 - Firm is in correct position.

P = MC = $4.00
But:
P < AC = $4.50

However the firm should only shut down if it is not able to cover its average variable costs, since
these are only incurred when the firm is operating:
AVC = TVC/X = $7000/2000 = $3.50
Thus:
AVC < MR = P = MC < AC

(g) 6 - Firm should close.

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Economics 3030: Intermediate Microeconomic Theory Problem Set 5: Perfect Competition - Solutions

P = TR/X = $3000/1000 = $3.00

Therefore:
MR = P = MC
However:
P < AVC = $3.50
Thus:
MR = P = MC = $3.00 < AVC = $3.50

(h) 4 - Firm should increase output.

MC = MINIMUM AC
AC = TC/X = $8000/10000 = $0.80
Thus:
MR = P = $1.00 > MC = $0.80

(i) 6 - Unclear.
MR = P = MC = $3.00
However:
AC = TC/X = TVC/X + TFC/X = AVC + AFC
= $5 = $3.50 + $1.50
Thus:
MR = P = MC = $3.00 < AVC = $3.50 < AC = $5.00

This would imply the firm should close. But since an increase in output would entail a fall in MC,
a possible option facing the firm would be to raise output.

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