UNIVERSITY OF WASHINGTON Department of Economics

Economics 200 Scott

Problem Set 4. Competitive Firm Behavior

Economic Profit:

1. Undeterred by the statistics on the mortality rates of small businesses (more than half go out of business in 18 months), a young chef opens his own restaurant. To do so, he quit his own job at $8,000 per year, cashed in $20,000 worth of savings bonds yielding 5% to provide capital for the business, and took over a store building owned by his wife which had previously been rented out at $500 per month. His expenses during the first year amounted to $50,000 for food, $15,000 for extra help, and $2,000 for gas, electricity, etc. His total receipts for the first year are $78,000. Assume he is a profit maximizer and derives no particular satisfaction from being his own boss, etc. Would you advise the young chef to stay in business?

Suggested Answer:

Competition:

2. See notes from lecture on Tuesday, February 9.

3. Cost Minimization. The diagram below, with intercepts 250 and 100 for the straightline, uses the standard notation and depicts the cost-minimizing use of factors of production for a profit-maximizing firm. The price of labor is $5.

Economics 200 2 Scott Problem Set 4

K

L

K*

L* 100

250

a. What is the numerical value of the firms total cost? $500 Explain.

b. What is the numerical value of the price of capital? $2 Explain.

Economics 200 3 Scott Problem Set 4

4. Factor Substitution. Use isoquants and isocost curves to show:

Economics 200 4 Scott Problem Set 4

5. Analysis of a Lump-Sum Tax in Competitive Markets. See notes from lecture on Wednesday, February 10.

Economics 200 5 Scott Problem Set 4

6. LR and SR Costs, Isoquants and Isocosts. Draw the long-run average cost of a firm as the envelope of a few short-run average cost schedules (see p. 143 of your text and your notes from lecture). Talk through the intuition, using isoquant-isocost diagrams to illustrate your reasoning.

See notes from Thursday, February 4.

7. Marginal Product of Labor, Marginal Revenue Product of Labor, and Labor Demand. Using diagrams, explain the equivalence between the condition price equals marginal cost and the condition wage equals marginal revenue product of labor in the short run. Refer to your notes and to pages 182-183 in the text. Note that your text calls marginal revenue produce the value of marginal product. How will an increase in the price of a good affect the demand for labor used in the production of that good in the short-run?

See notes from Friday, February 5.