ECON Chapter 6 Review Questions - KEY

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1 ECON Chapter 6 Review Questions - KEY 1. Jane quit her job at Research in Motion where she earned $50,000 a year. She cashed in $50,000 in corporate bonds that earned 10% interest annually to buy a mini-bus. Jane has decided to buy the mini-bus and set up a commuter service between Waterloo and Toronto. There are 1000 people who will pay $400 a year each for the commuter service; $280 from each person goes for gas, maintenance, insurance, depreciation, etc. Complete the following questions: What are Jane s total revenues? $400,000 What are Jane s explicit costs? $280,000 What is her accounting profit? $120,000 List two important implicit costs that Jane has not included. Salary foregone at RIM ($50,000) & interest on invested savings ($5,000) = total implicit costs = $55,000 What is Jane s pure economic profit (loss)? $400,000 (280,000+55,000) = $65, Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop, and materials cost $20,000 per year. Gomez has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per year if alternatively invested. Gomez has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from pottery sales is $72,000. Calculate accounting profits and economic profits for Gomez s pottery. Explicit costs: $37,000 (= $12,000 for the helper + $5,000 of rent + $20,000 of materials). Implicit costs: $22,000 (= $4,000 of forgone interest + $15,000 of forgone salary + $3,000 of entrepreneurship). Accounting profit = $35,000 (= $72,000 of revenue - $37,000 of explicit costs); Economic profit = $13,000 (= $72,000 - $37,000 of explicit costs - $22,000 of implicit costs). 1

2 3. Which of the following are short-run and which are long-run adjustments? (a) Wendy s builds a new restaurant LR; (b) Acme Steel Corporation hires 200 more production workers SR; (c) A farmer increases the amount of fertilizer used on his corn crop SR; and (d) An Alcan plant adds a third shift of workers SR. 4. Quantity of Labour Total (Q) Product Marginal Product Average Product a. Explain why marginal product first rises, then declines, and finally becomes negative? MP first rises because the fixed capital gets used more productively as added workers are employed. Each added worker contributes more to output than the previous worker because the firm is better able to use its fixed plant and equipment. As still more labour is added, the law of diminishing returns takes hold. Labour becomes so abundant relative to the fixed capital that congestion occurs and marginal product falls. At the extreme, the addition of labour so overcrowds the plant that the marginal product of still more labour is negative total output falls. 2

3 b. What bearing does the law of diminishing returns have on short-run costs? When MP is rising, MC is falling until diminishing returns set in and MP falls, thus MC rises. Note: Law of diminishing returns refers to the downward sloping section of the MP curve associated with the upward sloping section of the MC curve. 5. a. Why can the distinction between fixed and variable costs be made in the short run? The distinction can be made because there are some costs that do not vary with total output. These are the fixed costs that, fundamentally, are related to the scale or size of the plant. In the short run, by definition, the scale of the plant cannot change: The firm cannot bring in more machinery or move to a larger building. All costs that are related to the scale of the plant costs that continue to be incurred even though the firm s output may be zero are fixed costs. On the other hand, the firm can increase its output by using its plant its fixed capital more intensively, that is, by hiring more labour, or by using more materials. But by doing so, it will increase its operating costs, its variable costs. b. Which of the following costs are fixed and which are variable? fuel v interest on company-issued bonds f shipping charges v payments for raw materials v real estate taxes f executive salaries f insurance premiums f wage payments v sales taxes v rental payments on leased office machinery f 3

4 c. Why are there no fixed costs in the long run? In the long run, the firm can, by definition, get out of paying all of its short-run fixed costs; its lease is up, it can fire its executives without penalty, the insurance has run out, and so on. All of its costs at this moment are variable. The firm can decide to continue producing at the same scale and thus reassume all its previous fixed costs for the next short-run period; or it can decide to increase its scale and thus increase its fixed costs; or it can decide to go out of business and thus have no costs at all. 6. At what point does marginal product equal average product? A) where average product is equal to its minimum value B) where average product is equal to its maximum value* C) where marginal product is equal to its minimum value D) where marginal product is equal to its maximum value 7. A fixed cost is: A) associated with any productive factor of production whose price is fixed. B) any cost which increases proportionately with output. C) any cost which a firm would incur even if output was zero. * D) associated with all inputs whose short-run supply is perfectly inelastic. 8..If you know that when a firm produces 10 units of output, total costs are $1,030 and average fixed costs are $10, then total fixed costs are: A) $5. B) $100. * C) $1,020. D) $1,040. 4

5 9. Refer to the graph. Total fixed cost is measured by: A) 0B. B) AC. C) CD. * D) DE. Use the following to answer questions 10 & 11: Input workers Output TFC TVC Total cost Refer to the table above. If output is zero, total cost is: A) $90. B) $50. * C) $40. D) $ Refer to the table above. The total cost of producing 20 units of output is: A) $50. B) $80. C) $120. D) $130. * 5

6 12. The accompanying table shows average total costs (ATC) for a manufacturing firm whose total fixed costs are $10: Output ATC 1 $ The total cost of producing 4 units of output: A) is $31. B) is $87. C) is $124. * D) is $ Suppose that, when producing 10 units of output, a firm's AVC is $22, its AFC is $5, and its MC is $30. This: A) firm's ATC is $35. B) firm's ATC is $57. C) firm's total cost is $270. * D) firm's total cost is $ The Sunshine Corporation finds that its costs are $40 when it produces no output. Its total variable costs (TVC) change with output as shown in the accompanying table. Output TVC 1 $ The average fixed cost of 3 units of output: 6

7 A) is $ * B) is $ C) is $40. D) is $ Refer to the diagram. This firm's average fixed costs are: A) not shown. B) the vertical distance between AVC and MC. C) the vertical distance between AVC and ATC. * D) equal to the per unit change in MC. 16. If the total variable cost of 9 units of output is $90 and the total variable cost of 10 units of output is $120, then: A) the average variable cost of 10 units is $10. B) the average variable cost of 9 units is $10. * C) the marginal cost of the tenth unit is $90. D) the firm is operating in the range of increasing marginal returns. 17. With fixed costs of $400, a firm has average total costs of $3 and average variable costs of $2.50. Its output is: A) 200 units. B) 400 units. C) 800 units. * D) 1,600 units. 18. Marginal cost is the: A) rate of change in total fixed cost which results from producing one more unit of output. 7

8 B) change in total cost which results from producing one more unit of output. * C) change in average variable cost which results from producing one more unit of output. D) change in average total cost which results from producing one more unit of output. 19. Which of the following holds true? A) There is no relationship between AP and AVC. B) When MP is rising AVC is falling, and when MP is falling AVC is rising. C) When AP is rising AVC is falling, and when AP is falling AVC is rising. * D) When AP is rising AVC is rising, and when AP is falling AVC is falling. 20. The short-run average total cost curve is U-shaped because: A) average fixed costs decline continuously as output increases. B) of increasing and diminishing returns. * C) of economies and diseconomies of scale. D) minimum efficient scale is encountered. 21. At which point of the graph is the MP the greatest? A) point A* B) point B C) point C D) point D 22. If a technological advance reduces the amount of variable factors of production needed to produce any level of output, then: A) the AVC curve will shift downward. 8

9 B) the MC curve will shift downward. C) the ATC curve will shift downward. D) all of the above. * 23. If all factors of production used in the production of a product are increased by 5 percent and output increases by more than 5 percent, then the firm is experiencing: A) economies of scale. * B) diseconomies of scale. C) constant returns to scale. D) increasing average total costs. 24. Diseconomies of scale: A) pertain to the long run. * B) pertain to the short run. C) are synonymous with diminishing returns. D) are synonymous with increasing returns. 25. If the minimum efficient scale (MES) in an industry is 20 percent of the total consumption of a product, how many MES plants could be supported profitably in that industry? A) 5* B) 10 C) 20 D) 100 9