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Universidad Carlos III de Madrid – Department of Economics Principles of Economics – Course 2014-2015 - Problem Set 3
Conceptual Questions
- Explain the relationship between decreasing marginal returns and a firm’s product supply. Provide examples which show the law of diminishing marginal returns.
The supply curve is upward sloping because of the law of diminishing marginal return. In a competitive market the marginal cost curve gives us the firm's supply curve.
Marginal returns: measures the increase of total output by increasing the inputs.
Diminishing marginal returns: at some production (output) level, a firm is producing at maximum capacity and can no longer increase its output by increasing inputs.
Because of diminishing marginal returns, marginal costs are increasing. Supply function is upward-sloping because of the Law of Diminishing Marginal Returns.
Example: A factory can control its total output by increasing or decreasing its work force (employers) and amount of machinery. At some level of production, a factory maximizes its capacity and is unable to produce anymore units, incurring in losses. This occurs because of the law of diminishing marginal returns. This law impacts the addition of labor and capital to an individual firm as well as the total market's supply curve.
- Explain the relationship between total cost, marginal cost and average cost. Give examples where the average cost increases or decreases depending on whether marginal cost is above or below average cost. MC-AC: Marginal cost always passes through the lowest point of the average cost curve. Mathematically the average cost curve will be U shaped. MC-TC: MC is the increase or decrease in a firm's total cost of production as a result of changing production by one unit. AC-TC: Average cost is equal to total cost divided by the number of goods produced. Example: Initially average costs fall. But when marginal cost is above the average cost, the average cost starts to rise. Marginal costs increase in total costs if we increase output by one unit. AC=TC/Q
AC and MC intersect at the minimum of the AC. Example: look at exercise 8 in Problem Set 3
- What is the difference between a movement along the supply curve and a shift of the supply curve? Give some examples where factors that affect the supply change the quantity supplied (movements along …) or change the supply itself (shift of...).
A shift of the supply curve is a change in the quantity supplied at any given price, represented by the change of the original supply curve to a new position, denoted by a new supply curve. A movement along the supply curve is a change in the quantity supplied of a good that is the result of a change in that good’s price. For example, a change in prices produces a movement along the supply curve. A change in the price of inputs, technology, expectations or the number of sellers shifts the supply curve.
- What is the price elasticity of supply and the price elasticity of demand? Give examples of supply and demand curves which are very elastic or very inelastic.
The demand elasticity measures the sensitiveness of the demand respect to a change in the Price. It is defined as percentage change in the demand quantity respect to the
percentage change in the price, i.e.: . The supply elasticity measures the sensitiveness of the supply respect to a change in the
Price, it is defined as follows: .
, which implies that E=4*(100/380) =1.
Problems
- The cost of one additional barrel of oil for the company Skull-Oil is 10 dollars if it produces up to 1 million barrels and 50 dollars if it produces between 1 and 4 million. Its maximum production capacity is 4 million barrels.
a. What is the supply curve of Skull-Oil, if the oil market is perfectly competitive? b. If there are 20 companies like Skull-Oil in the market, what is the supply curve of the market? c. The price elasticity of supply in the long run is usually greater than that in the short run. Explain why this is true in general, and also in the particular case of Skull-Oil. d. Skull-Oil produces the first million barrels in Nigeria, and the rest in Norway. What will happen to the oil supply curve of Skull-Oil if for various reasons the cost of producing an additional barrel of oil in Nigeria is now $20 instead of $10?
a) Given that the market is competitive, the individual supply is the curve of marginal cost. The individual supply is given by the following function:
b) The aggregate supply is the horizontal summation of individual supply functions, i.e.
c) This is true because in the long time all production factors are variable whereas in the short time there is at least one constant factor. This implies that in the long time, the supply quantity can be adapted easily to a change in the price.
d) In this case the individual supply function becomes the following:
And the aggregate supply function becomes the following:
If 43<=P<49, Qs=7, If 49<=P<53, Qs=8, If 53<=P<57, Qs=9, If 57<=P, Qs=
e) Obtain the supply curve of the house market if there are 50 firms identical to José’s company.
We do a horizontal summation of supplies of the 50 identical firms, and get the aggregate supply:
Other questions
1 If a firm in a perfectly competitive market decides to increase its price above the market price, then… a) Its total revenue will increase. b) Its profit will increase. c) It will not sell anything. d) None of the previous answers is correct, as the demand curve of the firm has a positive slope.
- The marginal cost of a tennis school only depends on the wage of its instructors. The tennis instructors’ labour union negotiates a 7% increase in instructors’ wages. Then, a) The supply curve shifts towards the left. b) The supply curve shifts towards the right. c) The supply curve changes its slope from positive to negative, because of the reduction in the number of clients due to the higher cost. d) None of the above.
- The introduction of electronic books makes the demand of paper books: a) More elastic. b) More inelastic. c) It depends on the particular point of the curve considered. d) Elasticity does not change, the curve simply shifts back.
