Module M19 Quiz: Costs, Competitive Supply, and Industry Equilibrium
25 questions Β· Intermediate Β· Multiple choice, calculation, and short answer
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Question 1
Lesson L01 Β· Costs
The long-run cost function c(w,y) gives the:
Type: Multiple Choice
- A) Cost at a specific output using fixed inputs
- B) Minimum cost of producing output y when all inputs can be optimally chosen
- C) Fixed costs only
- D) Cost of the most expensive production method
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Answer: B) Minimum cost of producing output y when all inputs can be optimally chosen
LR cost function: c(w,y) = min{wL+rK : f(L,K)β₯y}. All inputs are variable in the long run.
Question 2
Lesson L01 Β· Costs
For f=L^0.5 Γ K^0.5 with w=4 r=1: the cost function is c(w,r,y) = 2yΓ(wr)^0.5 = 2yΓ2 = 4y. Verify that βc/βw = L* (Shephard's Lemma).
Type: Calculation
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Answer: βc/βw = β(4y)/βw = y/w^0.5 Γ r^0.5 = yΓ(r/w)^0.5. At w=4,r=1: L*=yΓ(1/4)^0.5 = y/2. Check: from optimisation K/L=w/r=4 and f=y β L^0.5Γ(4L)^0.5=2L=y β L*=y/2 β
Shephard's Lemma: βc/βw = L* = y/2 verified.
Question 3
Lesson L01 Β· Costs
Which property of cost functions ensures that a firm benefits from lower input prices?
Type: Multiple Choice
- A) Cost is increasing in y
- B) Cost is non-decreasing in w (increasing input prices cannot lower costs)
- C) Cost is concave in w (the benefit of a price fall diminishes with scale)
- D) Cost is homogeneous in y
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Answer: C) Cost is concave in w (the benefit of a price fall diminishes with scale)
Concavity in w: the firm benefits from input price falls (convex isocosts mean substitution helps) but at a diminishing rate β the cost function curves toward the origin in input price space.
Question 4
Lesson L01 Β· Costs
Why is the long-run cost function homogeneous of degree 1 in input prices?
Type: Short Answer
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Answer: If all input prices double, the minimum-cost input combination doesn't change (only relative prices affect optimal mix). With all prices doubled, the cost of the optimal bundle exactly doubles β so c(tw,ty,y) = tΓc(w,r,y).
Proportional price changes don't alter relative prices or the optimal input mix β only scale the cost.
Question 5
Lesson L01 Β· Costs
A constant-cost industry has a horizontal long-run supply curve because:
Type: Multiple Choice
- A) All firms have the same fixed costs
- B) Entry of new firms doesn't bid up input prices β input markets are perfectly elastic so LRATC stays constant as the industry expands
- C) All firms exit in the long run
- D) Government regulates the price
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Answer: B) Entry of new firms doesn't bid up input prices β input markets are perfectly elastic so LRATC stays constant as the industry expands
In a constant-cost industry, input prices are unaffected by industry expansion (inputs are not specialised). So LRATC stays at minimum and the LR supply is horizontal at min LRATC.
Question 6
Lesson L02 Β· Costs
A competitive firm's supply function y*(p,w) is derived by:
Type: Multiple Choice
- A) Setting price equal to average cost
- B) Setting price equal to marginal cost β the portion of the MC curve where Pβ₯AVC gives the supply function
- C) Minimising average cost
- D) Setting MR equal to average cost
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Answer: B) Setting price equal to marginal cost β the portion of the MC curve where Pβ₯AVC gives the supply function
Competitive supply: P=MC (profit max condition). For Pβ₯AVC the firm produces; for P<AVC it shuts down.
Question 7
Lesson L02 Β· Costs
For c(y) = yΒ² + 4 with P=$6, find profit-maximising output and profit.
Type: Calculation
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Answer: y*=3, Ο=$5
MC=2y=P=6 β y*=3. Ο=PΓy-C=6Γ3-(9+4)=18-13=$5.
Question 8
Lesson L03 Β· Costs
In an increasing-cost industry the long-run supply curve slopes upward because:
Type: Multiple Choice
- A) Firms become less efficient at larger scales
- B) Entry of firms bids up input prices (e.g. land, specialised labour) raising LRATC β the industry can only expand by offering higher prices
- C) New firms have higher costs than incumbents
- D) Government imposes supply restrictions
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Answer: B) Entry of firms bids up input prices (e.g. land, specialised labour) raising LRATC β the industry can only expand by offering higher prices
Increasing-cost industry: inputs are scarce and specialised. As the industry expands, competition for inputs raises their prices, pushing LRATC upward.
Question 9
Lesson L02 Β· Costs
Show that for a competitive firm with c(y)=yΒ²+F the supply function is y*=P/2.
Type: Calculation
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Answer: MC=2y=P β y*=P/2
Setting P=MC: P=2y β y*=P/2. This is valid for Pβ₯AVC=y (i.e. Pβ₯0 always for positive output). Shutdown if P
Question 10
Lesson L02 Β· Costs
By the envelope theorem the profit function Ο*(p,w) is convex in p. What does this imply for supply?
Type: Short Answer
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Answer: Convexity of Ο in p implies βy*/βp = βΒ²Ο/βpΒ² β₯ 0 β supply is non-decreasing in price. Higher prices induce firms to supply at least as much. This is the formal proof that supply curves slope upward (or are flat).
Convexity of profit in price β non-negative supply elasticity.
Question 11
Lesson L03 Β· Costs
Short-run industry supply is the:
Type: Multiple Choice
- A) Supply of the largest firm
- B) Horizontal sum of all individual firm supply curves (MC curves above AVC)
- C) Vertical sum of firm demand curves
- D) Average of all firm supply curves
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Answer: A) Supply of the largest firm
Industry supply = sum at each price of all firm quantities. Each firm's supply is its MC (above AVC). Horizontal sum gives the industry curve.
Question 12
Lesson L03 Β· Costs
An industry has 100 identical firms each with supply y_i = P/2 (for P>0). Find industry supply and equilibrium P if market demand is Q=500-50P.
Type: Calculation
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Answer: Y=50P; Eq: 50P=500-50P β P*=$5, Q*=250
Industry supply: Y=100ΓP/2=50P. Setting 50P=500-50P β 100P=500 β P*=$5. Q*=50Γ5=250.
Question 13
Lesson L03 Β· Costs
A decreasing-cost industry has a downward-sloping long-run supply curve. This can occur because:
Type: Multiple Choice
- A) Firms become more efficient as they grow
- B) Industry expansion creates positive external economies β e.g. a larger industry generates specialised suppliers or knowledge spillovers that reduce all firms' costs
- C) Government subsidises the industry
- D) Firms collude on price
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Answer: B) Industry expansion creates positive external economies β e.g. a larger industry generates specialised suppliers or knowledge spillovers that reduce all firms' costs
External economies of scale: as the industry grows, supporting infrastructure and specialised suppliers develop, lowering costs for all firms β LRATC falls with industry output.
Question 14
Lesson L03 Β· Costs
Explain the distinction between short-run and long-run industry supply responses to a demand shock.
Type: Short Answer
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Answer: Short run: existing firms move along their MC curves β output rises, price rises, firms may earn economic profit. Long run: entry attracts new firms (or exit occurs if losses), expanding (contracting) industry supply until economic profit returns to zero. LR supply is more elastic than SR supply.
In SR, only intensive margin adjusts (existing firms). In LR, extensive margin also adjusts (entry/exit).
Question 15
Lesson L03 Β· Costs
Australia's mining sector experienced a resources boom 2003-2012. Using industry supply analysis explain the long-run supply response.
Type: Multiple Choice
- A) Supply stayed flat β mines can't expand
- B) In the SR prices rose and existing mines expanded output (movement along SR supply). In the LR new mines entered attracted by profits, shifting supply right and moderating price rises β an increasing-cost industry response
- C) All mines shut down during the boom
- D) The AUD fell during the boom
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Answer: B) In the SR prices rose and existing mines expanded output (movement along SR supply). In the LR new mines entered attracted by profits, shifting supply right and moderating price rises β an increasing-cost industry response
Resources boom: SR price rise β entry β LR supply shifts right. Australia's increasing-cost resources industry: land/labour bids pushed LRATC up as industry expanded.
Question 16
Lesson L04 Β· Costs
Producer surplus in a competitive market equals:
Type: Multiple Choice
- A) Total revenue
- B) Revenue minus variable costs β the area above the supply curve below price
- C) Total profit including fixed cost recovery
- D) Fixed costs only
Show Answer
Answer: B) Revenue minus variable costs β the area above the supply curve below price
PS = TR - TVC = area above supply curve below price. Differs from profit by fixed costs: Ο = PS - FC.
Question 17
Lesson L04 Β· Costs
With supply P=2Q and demand P=20-2Q find equilibrium and calculate producer surplus.
Type: Calculation
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Answer: P*=\(10, Q*=5; PS=\)25
Eq: 2Q=20-2Q β 4Q=20 β Q*=5, P*=10. PS = 0.5ΓbaseΓheight = 0.5Γ5Γ10=$25 (triangle above supply curve).
Question 18
Lesson L04 Β· Intermediate
Why does producer surplus overstate profit when fixed costs are large?
Type: Short Answer
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Answer: PS = TR - TVC. Profit = TR - TC = TR - TVC - TFC = PS - TFC. When fixed costs are large, PS can be positive while profit is negative β the firm covers variable costs but not fixed costs. PS only equals profit when FC=0.
costs
Question 19
Lesson L04 Β· Costs
A competitive equilibrium maximises total surplus (CS+PS). This is because:
Type: Multiple Choice
- A) Prices are always low
- B) All mutually beneficial trades occur: every unit where WTP β₯ MC is produced. Any restriction (e.g. monopoly, tax) creates deadweight loss by leaving beneficial trades unmade
- C) Consumers always win in competitive markets
- D) Producers earn maximum profit
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Answer: B) All mutually beneficial trades occur: every unit where WTP β₯ MC is produced. Any restriction (e.g. monopoly, tax) creates deadweight loss by leaving beneficial trades unmade
At P*=MC every unit where value (WTP) exceeds cost (MC) is traded. No beneficial trade is foregone β total surplus is maximised.
Question 20
Lesson L04 Β· Costs
Australian iron ore producers earn significant producer surplus (quasi-rents) during price booms. In the long run this surplus tends to:
Type: Multiple Choice
- A) Persist permanently
- B) Attract entry and investment eroding the surplus as supply expands and costs rise (increasing-cost industry)
- C) Disappear immediately
- D) Be captured entirely by workers
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Answer: B) Attract entry and investment eroding the surplus as supply expands and costs rise (increasing-cost industry)
In LR competitive equilibrium entry eliminates economic profit. For a natural resource (fixed land) true rents persist; for a reproducible input, quasi-rents are competed away.
Question 21
Lesson L05 Β· Costs
In long-run competitive equilibrium economic profit equals zero because:
Type: Multiple Choice
- A) Firms are inefficient
- B) Free entry attracts firms when profit is positive; free exit occurs when profit is negative β the process continues until P = min LRATC and Ο = 0
- C) Government taxes all profit
- D) Firms collude to share markets
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Answer: B) Free entry attracts firms when profit is positive; free exit occurs when profit is negative β the process continues until P = min LRATC and Ο = 0
Zero profit is the long-run equilibrium condition under free entry/exit. It reflects competitive pressure, not firm incompetence.
Question 22
Lesson L05 Β· Costs
P = min LRATC in long-run competitive equilibrium. If min LRATC = $30 and demand is Q=1000-10P, find long-run equilibrium quantity.
Type: Calculation
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Answer: Q*=700
LR: P*=min LRATC=$30. Q*=1000-10Γ30=1000-300=700.
Question 23
Lesson L05 Β· Costs
'Zero economic profit does not mean the firm earns nothing.' Explain.
Type: Short Answer
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Answer: Economic profit subtracts the opportunity cost of all inputs including the owner's invested capital and time. Zero economic profit means the firm earns exactly its opportunity cost β a normal return on investment. The firm may earn positive accounting profit.
Normal profit = opportunity cost of capital. Zero economic profit = exactly this normal return.
Question 24
Lesson L05 Β· Costs
An industry has 50 firms each at min LRATC=$25 producing y*=100 units. Demand rises shifting equilibrium. In the LR what happens to P, number of firms, and profit?
Type: Multiple Choice
- A) P rises permanently; existing firms earn profit
- B) P returns to $25 (min LRATC); more firms enter; each earns zero economic profit in the new LR equilibrium
- C) Existing firms expand permanently
- D) P falls below $25
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Answer: B) P returns to $25 (min LRATC); more firms enter; each earns zero economic profit in the new LR equilibrium
With a constant-cost industry: demand increase β SR price rise β entry β LR supply expands until P = min LRATC = $25 again. More firms, same price, zero profit.
Question 25
Lesson L05 Β· Costs
Rents vs quasi-rents: Australian farmland near Sydney earns high rents. These are:
Type: Multiple Choice
- A) Temporary quasi-rents that will be competed away
- B) True economic rents β the land is in fixed supply so its value reflects location scarcity. These rents persist in long-run equilibrium unlike quasi-rents in reproducible industries
- C) Normal profits
- D) Accounting profits only
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Answer: B) True economic rents β the land is in fixed supply so its value reflects location scarcity. These rents persist in long-run equilibrium unlike quasi-rents in reproducible industries
Fixed-supply inputs earn true rents that persist even in LR equilibrium. Quasi-rents (returns above variable cost) in industries with reproducible capital are competed away by entry.