1) How do firms maximize profits?
Profits=Total revenue-Total cost
In order for firms to maximize profits, they must produce where the price is equal to the marginal
cost.
In a competitive industry, this is where the market price must equal the actual price.
Overall, this is where MR=MC.
2) What is the difference between fixed and variable costs? What is their relation with total
cost?
Fixed costs are those that do not change with output. They must be paid. Ex: rent, insurance,
salaries
Variable costs are those that increase when there is more output. Ex: Raw materials, hourly
labor, and utilities tied with production
*Also, if you add fixed costs to variable costs, you will get the total costs for that quantity!!!*
Ex:
Fixed=$62 (will remain 62 due to its disconnection from output)
Variable=$28 (keep in mind that this will increase as quantity increases because of its relation to
output)
TC=62+28
TC=$90
3) What does it mean to have zero economic profits? What is this difference when
compared to the breakeven point?
This occurs when total revenue covers all of a firms total costs
This signifies a stable income where there is no incentive for a firm to enter or exit the market
Additionally, this is common in long-run.
Zero economic profits (or essentially “normal profits”) suggest resources are allocated efficiently,
as firms aren’t making enough to attract new investment, nor are they being forced out.
Breakeven is the minimum sales needed to avoid a loss, but doesn’t guarantee earning more
than the next best alternative.
All in all, zero economic profits and breakeven represent differing ideas but overall are found at
the same point: when the market price equals the minimum of the average total cost curve.
Any point below this does not mean the firm should shut down right away. Despite not covering
fixed costs, the profit is still greater than shutting down right away between the actual shut down
point and the breakeven point.
CONCLUSION: The shut down point is where the average variable cost equals the price. At any
point here or below this, you aren’t even covering your day to day variable costs, so you should
shut down immediately.
EXAMPLE:
, 4) A company has $4000 in Fixed Costs (FC) and $3000 in Variable Costs (VC) for
1000 units, so Average Variable Cost (AVC) is $3. Total Costs (TC) are $7000, so
Average Total Cost (ATC) is $7.
5) Price $5 (Below ATC, Above AVC): Revenue $5000. Losses are $2000
($7000-$5000). If they shut down, they lose $4000 (all fixed costs). So, they
continue to operate, losing less money.
6) Price $2 (Below AVC): Revenue $2000. Losses are $5000 ($7000-$2000). They
are better off shutting down and only losing their $4000 fixed costs, say
7) What condition must be true for a firm to be maximizing profits, irrespective of the type of
market structure? Does this mean that the firm has “zero economic profits”?
Profit maximization occurs where marginal revenue equals marginal cost is equal to the price.
Where marginal revenue/price is greater than marginal cost, there is positive profit.
Where marginal revenue/price is less than marginal cost, there is negative profit.
On a market curve, the place where the price is greater than the average total cost is where
there is positive profit.
On a market curve, the place where the price is less than the average total cost, the firm loses
money and there is negative economic profit.
*It is especially crucial to note that where the price becomes less than the average VARIABLE
cost curve, then the firm should absolutely shut down. This is because there is no chance of
recovery, and the firm should immediately shut down in the short run.*
8) What do costs look like in the short run compared to the long run?
In the short run, at least one input is fixed (usually capital)
Therefore, firms face fixed costs here that cannot be changed.
Diminishing marginal returns eventually set in: adding more variable input (labor) to fixed input
increases marginal cost.
Cost curves:
AVC: Average variable costs
AFC: Average fixed costs
ATC: AVC + AFC (adjusted to add fixed costs; higher than AVC curve therefore)
MC: Marginal cost
In the long run, all inputs are variable. There are no fixed costs (therefore, over time, there will
be a shift from the ATC curve to the AVC curve)
Profits=Total revenue-Total cost
In order for firms to maximize profits, they must produce where the price is equal to the marginal
cost.
In a competitive industry, this is where the market price must equal the actual price.
Overall, this is where MR=MC.
2) What is the difference between fixed and variable costs? What is their relation with total
cost?
Fixed costs are those that do not change with output. They must be paid. Ex: rent, insurance,
salaries
Variable costs are those that increase when there is more output. Ex: Raw materials, hourly
labor, and utilities tied with production
*Also, if you add fixed costs to variable costs, you will get the total costs for that quantity!!!*
Ex:
Fixed=$62 (will remain 62 due to its disconnection from output)
Variable=$28 (keep in mind that this will increase as quantity increases because of its relation to
output)
TC=62+28
TC=$90
3) What does it mean to have zero economic profits? What is this difference when
compared to the breakeven point?
This occurs when total revenue covers all of a firms total costs
This signifies a stable income where there is no incentive for a firm to enter or exit the market
Additionally, this is common in long-run.
Zero economic profits (or essentially “normal profits”) suggest resources are allocated efficiently,
as firms aren’t making enough to attract new investment, nor are they being forced out.
Breakeven is the minimum sales needed to avoid a loss, but doesn’t guarantee earning more
than the next best alternative.
All in all, zero economic profits and breakeven represent differing ideas but overall are found at
the same point: when the market price equals the minimum of the average total cost curve.
Any point below this does not mean the firm should shut down right away. Despite not covering
fixed costs, the profit is still greater than shutting down right away between the actual shut down
point and the breakeven point.
CONCLUSION: The shut down point is where the average variable cost equals the price. At any
point here or below this, you aren’t even covering your day to day variable costs, so you should
shut down immediately.
EXAMPLE:
, 4) A company has $4000 in Fixed Costs (FC) and $3000 in Variable Costs (VC) for
1000 units, so Average Variable Cost (AVC) is $3. Total Costs (TC) are $7000, so
Average Total Cost (ATC) is $7.
5) Price $5 (Below ATC, Above AVC): Revenue $5000. Losses are $2000
($7000-$5000). If they shut down, they lose $4000 (all fixed costs). So, they
continue to operate, losing less money.
6) Price $2 (Below AVC): Revenue $2000. Losses are $5000 ($7000-$2000). They
are better off shutting down and only losing their $4000 fixed costs, say
7) What condition must be true for a firm to be maximizing profits, irrespective of the type of
market structure? Does this mean that the firm has “zero economic profits”?
Profit maximization occurs where marginal revenue equals marginal cost is equal to the price.
Where marginal revenue/price is greater than marginal cost, there is positive profit.
Where marginal revenue/price is less than marginal cost, there is negative profit.
On a market curve, the place where the price is greater than the average total cost is where
there is positive profit.
On a market curve, the place where the price is less than the average total cost, the firm loses
money and there is negative economic profit.
*It is especially crucial to note that where the price becomes less than the average VARIABLE
cost curve, then the firm should absolutely shut down. This is because there is no chance of
recovery, and the firm should immediately shut down in the short run.*
8) What do costs look like in the short run compared to the long run?
In the short run, at least one input is fixed (usually capital)
Therefore, firms face fixed costs here that cannot be changed.
Diminishing marginal returns eventually set in: adding more variable input (labor) to fixed input
increases marginal cost.
Cost curves:
AVC: Average variable costs
AFC: Average fixed costs
ATC: AVC + AFC (adjusted to add fixed costs; higher than AVC curve therefore)
MC: Marginal cost
In the long run, all inputs are variable. There are no fixed costs (therefore, over time, there will
be a shift from the ATC curve to the AVC curve)
