Behind the Supply Curve: Profit, Production, and Costs — Hard Practice Quiz
A Microeconomics cheat sheet for Behind the Supply Curve: Profit, Production, and Costs — every key formula with its symbols defined — plus a hard-level practice quiz to test recall.
Formulas & key concepts
A cost that requires an actual outlay of money, such as wages, materials, or rent paid to others.
The value of benefits forgone, which involves no money changing hands, such as the salary an owner gives up by running his or her own business.
Total revenue minus explicit costs and depreciation; the profit figure used for taxes and financial statements.
Total revenue minus both explicit and implicit costs; a truer measure of whether a business is worth running than accounting profit.
The income an owner forgoes by tying up his or her own money in the business instead of investing it elsewhere.
An economic profit of exactly zero, meaning the business just covers all costs including implicit ones, so the owner does as well as in the next-best alternative.
The rule that the best quantity of an activity is the one at which the marginal benefit of the last unit equals its marginal cost.
The additional revenue a firm earns from selling one more unit of output.
A firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost.
A graph of how the cost of producing one more unit changes as output rises; it usually slopes upward.
A graph showing a firm's marginal revenue at each level of output.
The relationship between the quantity of inputs a firm uses and the quantity of output it can produce.
An input whose quantity cannot be changed during the relevant time period.
An input whose quantity the firm can adjust as it changes its output.
The time period long enough that all inputs, including those fixed in the short run, can be varied.
The time period during which at least one of a firm's inputs is fixed.
A graph showing how total output depends on the amount of the variable input, holding all other inputs fixed.
The extra output generated by adding one more unit of an input.
As more of a variable input is added while others stay fixed, each additional unit eventually raises output by less than the previous unit did.
A cost that does not vary with output and must be paid even when the firm produces nothing.
A cost that rises and falls with the quantity of output the firm produces.
The sum of fixed cost and variable cost at a given level of output.
A graph of how total cost increases with output; it grows steeper as diminishing returns set in.
Total cost divided by the quantity produced; the per-unit cost of output, also called average cost.
Average total cost usually falls and then rises as output increases, tracing out a U shape.
Fixed cost divided by output; it declines as output rises because the fixed cost is spread over more units (the spreading effect).
Variable cost divided by output; it tends to increase with output because of diminishing returns (the diminishing-returns effect).
At low output the spreading effect of falling average fixed cost dominates, while at high output the rising average variable cost from diminishing returns dominates.
The output level at which average total cost is lowest, at the bottom of the U-shaped curve, where the marginal cost curve crosses it.
A curve showing the lowest average total cost attainable at each output level once all inputs can be adjusted.
A situation, also called increasing returns to scale, in which long-run average total cost falls as output rises, often due to large fixed setup costs or specialization.
A situation, also called decreasing returns to scale, in which long-run average total cost rises as output rises, often from the difficulty of managing a very large firm.
A situation in which long-run average total cost stays the same as output changes.
A cost already incurred that cannot be recovered; because it is unrecoverable, it should be ignored when deciding what to do next.
A firm whose output decisions have no effect on the market price, so it treats the price as fixed and beyond its control.
A buyer whose purchases are too small to influence the market price.
A market in which all buyers and sellers are price-takers.
An industry in which every firm is a price-taker.
The fraction of total industry output produced by a particular firm.
A good that buyers view as identical regardless of who makes it, so they don't care which firm they buy from.
The condition that firms can enter or leave an industry without major obstacles; a typical feature of perfectly competitive industries.
A market controlled by a single seller (a monopolist) of a good that has no close substitutes.
Something that keeps other firms out of an industry and lets a monopoly persist, such as control of a scarce resource, economies of scale, technological superiority, or legal protection.
A case in which one firm can supply the entire market at lower average cost than several firms could, because of large economies of scale.
A temporary legal monopoly giving an inventor the exclusive right to make and sell a new product for a set time.
A legal monopoly granting the creator of an original written, musical, or artistic work exclusive rights over it.
A market structure with only a few sellers, called oligopolists, each large enough to affect the market.
A market structure between perfect competition and monopoly in which firms compete but each holds some power over price.
A measure of market power equal to the combined market share of the largest few firms in an industry.
A measure of industry concentration calculated by summing the squares of each firm's percentage market share.
A market with many firms selling differentiated products, with free entry and exit in the long run.
Making a product distinct from competitors' offerings through differences in style or type, location, or quality.
Adding more programmers to a delayed software project can actually slow it further, a well-known illustration of diminishing returns to labor.
Practice quiz
Sarah quits her $60,000$ per year job to start a consulting business. She uses $100,000$ of her savings, which could have earned $5\%$ interest annually, to buy equipment. Her explicit costs for the first year are $40,000$. Her total revenue is $120,000$. What are Sarah's accounting profit and economic profit for the first year, respectively?
- Accounting Profit: $80,000$; Economic Profit: $15,000$
- Accounting Profit: $80,000$; Economic Profit: $20,000$
- Accounting Profit: $15,000$; Economic Profit: $15,000$
- Accounting Profit: $120,000$; Economic Profit: $55,000$
Answer: Accounting Profit: $80,000$; Economic Profit: $15,000$
A firm determines its profit-maximizing output by producing where marginal revenue ($MR$) equals marginal cost ($MC$). If the firm's fixed costs suddenly double, but its variable costs and market price remain unchanged, how will its profit-maximizing output and total economic profit be affected in the short run?
- Output will remain the same, and total economic profit will decrease.
- Output will decrease, and total economic profit will decrease.
- Output will remain the same, and total economic profit will increase.
- Output will increase, and total economic profit will decrease.
Answer: Output will remain the same, and total economic profit will decrease.
Consider a firm operating in the short run where capital is fixed and labor is the only variable input. As the firm hires more labor, how does the onset of "Diminishing Returns to an Input" affect the firm's Marginal Product of labor, and subsequently, its Marginal Cost and Average Variable Cost curves?
- Marginal Product of labor decreases, causing both Marginal Cost and Average Variable Cost to eventually rise.
- Marginal Product of labor increases, causing Marginal Cost to fall and Average Variable Cost to rise.
- Marginal Product of labor decreases, causing Marginal Cost to rise and Average Variable Cost to fall.
- Marginal Product of labor remains constant, causing Marginal Cost and Average Variable Cost to remain constant.
Answer: Marginal Product of labor decreases, causing both Marginal Cost and Average Variable Cost to eventually rise.
A small manufacturing firm is currently operating in the short run with a fixed factory size. It observes that its average total cost ($ATC$) is very high due to underutilization of its current capacity. The firm anticipates a significant and sustained increase in demand for its product. If the firm decides to expand its production capacity (a long-run decision), how might its long-run average total cost ($LRATC$) compare to its current short-run average total cost ($SRATC$) at a much higher output level, assuming the industry experiences economies of scale initially, followed by diseconomies of scale at very large scales?
- The $LRATC$ will likely be lower than the current $SRATC$ at the higher output level, as the firm can achieve economies of scale by building a larger, more efficient factory.
- The $LRATC$ will likely be higher than the current $SRATC$ at the higher output level, due to the inevitable onset of diseconomies of scale.
- The $LRATC$ will be identical to the $SRATC$ at the higher output level, as all costs become variable in the long run.
- The firm should not expand, as fixed costs will increase, leading to higher $ATC$ in both the short and long run.
Answer: The $LRATC$ will likely be lower than the current $SRATC$ at the higher output level, as the firm can achieve economies of scale by building a larger, more efficient factory.
A software company has already spent $5\text{ million}$ developing a new operating system. The project is $90\%$ complete, but a competitor just released a superior product, making the market for the new OS highly uncertain. The company estimates it will cost an additional $1\text{ million}$ to finish the project. If completed, the expected revenue is $1.2\text{ million}$. If abandoned now, the company recovers nothing from the $5\text{ million}$ already spent. Based on the "Sunk Cost" principle and "Principle of Marginal Analysis," what should the company do?
- Complete the project, as the additional revenue of $1.2\text{ million}$ exceeds the additional cost of $1\text{ million}$, ignoring the $5\text{ million}$ already spent.
- Abandon the project, as the total cost of $6\text{ million}$ ($5\text{ million}$ already spent $+ 1\text{ million}$ more) exceeds the expected revenue of $1.2\text{ million}$.
- Complete the project, but only if the competitor's product fails, otherwise abandon it.
- Abandon the project, because the initial $5\text{ million}$ investment was a mistake.
Answer: Complete the project, as the additional revenue of $1.2\text{ million}$ exceeds the additional cost of $1\text{ million}$, ignoring the $5\text{ million}$ already spent.
An industry is characterized by perfect competition. Currently, all firms in this industry are earning positive economic profits. Describe the long-run adjustment process in this industry and the resulting economic profit for individual firms.
- New firms will enter the industry, increasing market supply and driving down prices until economic profits for all firms become zero.
- Existing firms will expand their output, increasing market supply and driving down prices until accounting profits become zero.
- Firms will exit the industry, decreasing market supply and driving up prices until economic profits become negative.
- The industry will remain in its current state, as firms are already maximizing profits.
Answer: New firms will enter the industry, increasing market supply and driving down prices until economic profits for all firms become zero.
Consider a market that could either be perfectly competitive or a pure monopoly, with identical cost structures for the firms involved. How does the "Optimal Output Rule" apply differently to a monopolist compared to a perfectly competitive firm, and what is the implication for the market price and quantity?
- Both types of firms produce where $MR=MC$, but for a monopolist, $MR < P$, leading to lower output and a higher price compared to perfect competition.
- A perfectly competitive firm produces where $MR=MC$, while a monopolist produces where $P=MC$, leading to higher output and a lower price for the monopolist.
- A monopolist produces where $MR=MC$, while a perfectly competitive firm produces where $P=ATC$, leading to similar output levels but different prices.
- Both firms produce where $MR=MC$, and since their cost structures are identical, their output and price will be the same.
Answer: Both types of firms produce where $MR=MC$, but for a monopolist, $MR < P$, leading to lower output and a higher price compared to perfect competition.
A firm's "Average Total Cost" ($ATC$) curve is typically U-shaped. Explain the two primary effects that contribute to the U-shape of the $ATC$ curve as output increases.
- The "spreading effect" (Average Fixed Cost falls as output rises) dominates at low output, and the "diminishing returns effect" (Average Variable Cost rises due to diminishing returns) dominates at high output.
- The "diminishing returns effect" dominates at low output, and the "spreading effect" dominates at high output.
- Both Average Fixed Cost and Average Variable Cost continuously fall as output increases, but at different rates, creating the U-shape.
- The U-shape is primarily due to economies of scale at low output and diseconomies of scale at high output, which are long-run phenomena.
Answer: The "spreading effect" (Average Fixed Cost falls as output rises) dominates at low output, and the "diminishing returns effect" (Average Variable Cost rises due to diminishing returns) dominates at high output.
An entrepreneur owns a small bakery. Instead of renting out the space for $2,000$ per month, she uses it for her business. She also invested $50,000$ of her own money into the business, which could have earned $4\%$ interest annually in a bond. Her explicit costs are $10,000$ per month, and her total revenue is $15,000$ per month. What is the total monthly implicit cost for the entrepreneur, and what is her monthly economic profit?
- Total Implicit Cost: approximately $2,166.67$; Economic Profit: approximately $2,833.33$.
- Total Implicit Cost: $2,000$; Economic Profit: $3,000$.
- Total Implicit Cost: $0$; Economic Profit: $5,000$.
- Total Implicit Cost: $2,166.67$; Economic Profit: $5,000$.
Answer: Total Implicit Cost: approximately $2,166.67$; Economic Profit: approximately $2,833.33$.
Which market structure is characterized by significant "Barriers to Entry" that allow firms to maintain long-run economic profits, and what are common examples of such barriers?
- Monopoly and Oligopoly; examples include control of scarce resources, economies of scale (natural monopoly), and legal protections like patents.
- Perfectly Competitive Market; examples include standardized products and free entry and exit.
- Monopolistic Competition; examples include product differentiation and advertising.
- All market structures, as every firm faces some form of barrier to entry.
Answer: Monopoly and Oligopoly; examples include control of scarce resources, economies of scale (natural monopoly), and legal protections like patents.
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