Problem Set - Perfect Competition Answers

1) Suppose you are the manager of a watch making firm operating in a competitive market.
Your
cost of production is given by C = 200 + 2q 2, where q is the level of output and C is the total cost.
(The marginal cost of production is 4q and the fixed cost is Rs. 200/-)
a. If the price of watches is Rs. 100/- how many watches should you produce to maximize
profits.
Answer: MC=MR
4q=100, q=25
b. What will the profit level be?
Answer: profit=TR-TC = 1050
c. At what minimum price will the firm produce a positive output?
Answer: minimum price for a firm to produce positive output i.e. q>0 is p>= AVC as below
this price firm shuts down.
AVC= 2q, P=MR=4q, 4q>2q, for all levels of q hence as long as p>0, q>0 always.
2) A firm has short run total cost given by C = 100 + 2q + q 2
a. Find the average total cost and average variable cost function
Answer: ATC= 100/q+2+q, AVC=2+q.
b. If P = 25 how much will the firm produce in the short run?
Answer: q=11.5
c. If P = 20 how much will the firm produce in the short run?
Answer: q=9
d. Assuming that the firm has the same cost curves in the long run, for Q>0, and C(0) = 0, how
much will it produce in the long run?
Answer: Cost = 0 for q=0, but q>0 by C = 100 + 2q + q 2

For long run equilibrium of a firm AC (minimum) =MC=MR =P (refer to diagram shared
pertaining to LR equilibrium of perfectly competitive firm)
AC=100/q*+2+q* , MC=2+q*, after equating AC=MC , q*= 10
AC(at q*)= 22 (by substituting valve of q in AC function)
Hence in LR firm will produce 10 units if P=22 (since AC (minimum) =MC=MR =P)
3) A firm has marginal cost given by MC = 10 + q and average variable costs AVC = 10 + q/2. If fixed
costs are 5,000 and the market price is 100, find the firm’s maximum profit. Will the firm
continue to operate in the short run? In the long run? Explain.
Answer: In short run MC> AVC for all q>0. At P=100, setting MC=100 yields 10+q=100 or q=90.
Maximum profit = TR-TC= P. q – (AVC . q+ TFC) , here AVC .q=TVC and TC=TVC+TFC
=100(90)-(10+90/2) 90-5000= - $ 950. (Loss)
In short run, the $ 950 loss from operating is less than forgoing TFC= 5000 (and converting it to
sunk costs) hence firm will operate i.e. not shut down.
But in long run with same conditions firm will go out of business.
4) Suppose a competitive firm has long run total costs C(q) = 300 + 5q + 3q 2 for q>0 and C(0) = 0.
Marginal costs are MC = 5 + 6q. The minimum of average total cost is Rs. 65 at q = 10. Now a tax
is imposed on the firm. For each unit of output produced it must pay Rs. 15 in taxes. Derive the
new marginal cost curve. What is the minimum average total cost? At what output does this
occur? What was the firm’s original supply curve? What is the firm’s new supply curve?
Answer: After tax is imposed the new TC function is C*(q) = C(q)+15q=300+20q+3q 2 2 and
MC* =20+60q and ATC*=300/q+20+3q.
The q @ which ATC minimum is found by setting MC*=ATC* (LR- EQUBILIRIUM).
We obtain 20+60q=300/q+20+3q, or q=10.
With the tax the minimum of ATC* =30+20+3(10) =80.

The LR supply curve before tax is found by taking the MC curve above minimum ATC.
Since MC= 5+6q and minimum ATC =60, we find supply curve by setting 5+6q=p and rewriting it
as qs=(p-5)/6. If p>=65. If p<65 qs=0.
For LR supply curve after tax MC*=P 20+6q=P, LR supply curve after tax q s= (p-20)/6 if P>=80
and qs=0 if P<80.
5) The price elasticity of the demand curve faced by a perfectly competitive firm is :
a. 0
b. -1
c. – infinity (answer)
d. Price elasticity of the market demand curve
e. None of the above
6) The Smith company produces widgets. Smith’s average variable cost at it’s current output level
is Rs. 30/- per unit. It’s current average total cost per unit is Rs. 60/- per unit. If the market price
is Rs. 45/- :
a. It should produce a quantity to minimize marginal cost
b. It should shut down immediately
c. It should stay in business in the short run (answer)
d. It should produce a quantity to minimize average variable cost
e. a. and c.
7) A profit maximizing competitive firm making positive economic profits will produce in the short
run up to the point at which:
a. Total revenue is maximized

b. Marginal cost is minimized
c. Marginal revenue is maximized
d. Average revenue equals average total cost
e. Marginal revenue equals marginal cost (answer)
8) A perfectly competitive firm:
a. Chooses it’s price to maximize it’s profit

b. Sets it’s price to undercut other firms selling similar products
c. Takes it’s price as given by market conditions (answer)
d. Picks the price that yields the largest market share
9) Cold drink kiosks in Delhi are a perfectly competitive industry in long run equilibrium. One day
the city starts imposing a per month tax of Rs. 100/- on each kiosk. How does this policy affect
the number of cold drinks sold in the short run and long run:
a. Down in the short run, no change in the long run

b. Up in the short run, no change in the long run
c. No change in the short run, down in the long run (answer)
d. No change in the short run, up in the long run
10) If a profit maximizing, competitive firm is producing a quantity at which marginal cost is
between average variable cost and average total cost, it will:
a. Keep producing in the short run but exit the market in the long run(answer)
b. Shut down in the short run but return to production in the long run
c. Shut down in the short run and exit the market in the long run
d. Keep producing both in the short run and in the long run

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What factors determine the profit maximizing output level of a firm?

How does a tax on per unit output affect a competitive firm's supply curve?

1) Suppose you are the manager of a watch making firm operating in a competitive market.

2) A firm has short run total cost given by C = 100 + 2q + q 2

Answer: Cost = 0 for q=0, but q>0 by C = 100 + 2q + q 2

With the tax the minimum of ATC* =30+20+3(10) =80.

a. Total revenue is maximized

8) A perfectly competitive firm:

a. Chooses it’s price to maximize it’s profit

a. Down in the short run, no change in the long run

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