- Which of the following pairs most accurately captures the two assumptions economists make about resources and wants that together create the central economic problem?
- Resources are unlimited and human wants are limited
- Both resources and human wants are unlimited
- Both resources and human wants are limited
- Resources are limited and human wants are unlimited
Correct answer: Resources are limited and human wants are unlimited
The central economic problem rests on resources being limited while human wants are unlimited. This combination is what economists call scarcity, and it forces every society to make choices about how to use its finite resources. If resources were unlimited or wants were satisfiable, there would be no scarcity and no need for economizing.
- Because scarcity forces every society to make choices, every economic system must answer which three fundamental questions?
- When to produce, where to store, and how to advertise
- What to produce, how to produce it, and for whom to produce
- How to tax, how to borrow, and how to print money
- Who to hire, who to fire, and who to promote
Correct answer: What to produce, how to produce it, and for whom to produce
Every economy must answer what to produce, how to produce it, and for whom to produce, because scarcity prevents producing everything for everyone. These three questions arise directly from limited resources confronting unlimited wants. The other options describe narrow business or financial decisions rather than the basic allocation questions all societies face.
- Which scenario best demonstrates that opportunity cost can include a nonmonetary sacrifice?
- A shopper pays $40 for a jacket at a store
- A firm records $10,000 of rent as an expense
- A bank charges a $25 fee to wire money
- A retiree spends an afternoon napping instead of volunteering at a charity
Correct answer: A retiree spends an afternoon napping instead of volunteering at a charity
The retiree napping instead of volunteering best shows a nonmonetary opportunity cost, because the sacrifice is the forgone value of volunteering rather than any money paid. Opportunity cost is the value of the next-best alternative given up, and that alternative need not involve cash. The other options describe explicit monetary payments, not forgone alternatives.
- A city can use a vacant lot to build either a library or a parking garage, but not both. If it builds the library, the opportunity cost of that decision is best described as which of the following?
- The dollar amount spent constructing the library
- The combined value of the library and the garage
- The value of the parking garage that was not built
- Zero, because the lot was already owned by the city
Correct answer: The value of the parking garage that was not built
The opportunity cost is the value of the parking garage that was not built, since the garage was the next-best alternative use of the lot. Opportunity cost measures the single best forgone option, not the construction spending or the value of the chosen option. The fact that the city already owned the lot does not make the cost zero, because the land still had an alternative use.
- Along a downward-sloping production possibilities curve between two goods, why must producing more of one good require producing less of the other?
- Because resources are fully and efficiently employed, leaving none idle to expand both
- Because the prices of both goods are fixed by the government
- Because consumer demand for one good is always falling
- Because technology improves continuously over time
Correct answer: Because resources are fully and efficiently employed, leaving none idle to expand both
On a curve, resources are already fully and efficiently employed, so the only way to make more of one good is to shift resources away from the other. This trade-off is what gives the curve its downward slope and reflects opportunity cost. Prices, demand trends, and technology changes do not explain movement along an existing curve at full employment.
- An economy is currently producing inside its production possibilities curve. Which single change would allow it to reach a point that lies beyond the current curve rather than merely on it?
- Reallocating existing resources between the two goods
- Putting currently unemployed resources back to work
- An advance in technology that expands productive capacity
- Producing the exact combination consumers most prefer
Correct answer: An advance in technology that expands productive capacity
Only an advance in technology that expands productive capacity can push the economy beyond the current curve, because points beyond it require an outward shift of the curve itself. Putting idle resources to work or reallocating production only moves the economy to a point on the existing curve. Reaching previously unattainable points demands genuine economic growth.
- Two points on the same production possibilities curve both represent which of the following?
- Inefficient use of the economy's resources
- Combinations that are currently unattainable
- Identical opportunity costs for every additional unit
- Efficient, full employment of the economy's resources
Correct answer: Efficient, full employment of the economy's resources
Any two points on the curve represent efficient, full employment of resources, because all points on the curve use resources fully and produce the maximum attainable output. Points inside the curve are inefficient, and points beyond it are unattainable. The opportunity cost of moving between the two points need not be identical, especially on a bowed-out curve.
- Suppose in one day Factory X can produce 100 chairs or 50 tables, while Factory Y can produce 60 chairs or 60 tables. Which factory has the absolute advantage in producing chairs?
- Factory X, because it can produce more chairs per day
- Factory Y, because it can produce more tables per day
- Both factories, because each can produce chairs
- Neither, because absolute advantage requires equal output
Correct answer: Factory X, because it can produce more chairs per day
Factory X has the absolute advantage in chairs because it can produce 100 chairs per day compared with Factory Y's 60, and absolute advantage is based on producing more output. Absolute advantage compares physical productivity, not opportunity cost. Factory Y's higher table output is irrelevant to who is more productive at making chairs.
- Using the same data, in which Factory X makes 100 chairs or 50 tables and Factory Y makes 60 chairs or 60 tables per day, which factory has the comparative advantage in producing tables?
- Factory X, because its opportunity cost per table is lower
- Factory Y, because its opportunity cost per table is lower
- Both factories, because their opportunity costs are equal
- Neither, because Factory X is more productive overall
Correct answer: Factory Y, because its opportunity cost per table is lower
Factory Y has the comparative advantage in tables because its opportunity cost is 1 chair per table, lower than Factory X's 2 chairs per table. Comparative advantage belongs to the producer that gives up the least of the other good, regardless of overall productivity. This is why each factory specializes where its opportunity cost is lowest.
- Why is it impossible for a single producer to hold a comparative advantage in both of two goods at the same time?
- Because absolute advantage prevents any comparative advantage
- Because opportunity costs are always equal across producers
- Because comparative advantage depends only on total output
- Because giving up less of one good necessarily means giving up more of the other
Correct answer: Because giving up less of one good necessarily means giving up more of the other
A producer cannot have a comparative advantage in both goods because having a lower opportunity cost in one good necessarily means having a higher opportunity cost in the other. Opportunity costs are reciprocals, so an advantage in one direction implies a disadvantage in the other. This is precisely why specialization and trade can benefit both parties.
- An entrepreneur is deciding whether to open her store for a fourth hour. The fourth hour is expected to add $75 in sales and $75 in additional costs. According to marginal analysis, the fourth hour is best described as which of the following?
- Clearly profitable and should definitely be added
- Clearly unprofitable and should definitely be avoided
- The breakeven margin, where added benefit just equals added cost
- Irrelevant, because only total profit should guide the decision
Correct answer: The breakeven margin, where added benefit just equals added cost
The fourth hour is the breakeven margin, where marginal benefit of $75 just equals marginal cost of $75. At this point the activity neither adds to nor subtracts from net gain, which is exactly the optimal stopping point that marginal analysis identifies. Decisions are made by comparing marginal benefit and marginal cost, not total profit alone.
- A firm that has already spent $5,000 on nonrefundable research is deciding whether to continue a project. A correct application of marginal analysis would tell the firm to base its decision on which of the following?
- The $5,000 already spent, since it must be recovered
- The average cost of all spending across the project
- The additional benefits and additional costs of continuing from this point forward
- The total amount budgeted at the start of the project
Correct answer: The additional benefits and additional costs of continuing from this point forward
The firm should base its decision on the additional benefits and additional costs of continuing from this point forward, because rational decisions are made at the margin. The $5,000 already spent is a sunk cost that cannot be recovered and should not influence the decision. Average and total figures are not the relevant comparison for whether to take the next step.
- When the income earned by the owners of the factors of production is described, labor, capital, land, and entrepreneurship are most commonly paid in which respective forms?
- Profit, rent, interest, and wages
- Wages, interest, rent, and profit
- Interest, wages, profit, and rent
- Rent, profit, wages, and interest
Correct answer: Wages, interest, rent, and profit
Labor earns wages, capital earns interest, land earns rent, and entrepreneurship earns profit. These factor payments are the income side of the four factors of production. Matching each factor to the wrong payment, as the other options do, misidentifies how resource owners are compensated in the circular flow.
- A deposit of iron ore beneath the ground that has not yet been extracted is best classified as which factor of production?
- Capital, because it can be used to make goods
- Labor, because workers will mine it
- Land, because it is a natural resource
- Entrepreneurship, because someone must decide to extract it
Correct answer: Land, because it is a natural resource
The iron ore deposit is classified as land, because land includes all natural resources drawn from the environment, such as minerals, water, and soil. Capital refers to manufactured tools and equipment, not raw natural inputs. Although labor and entrepreneurship are involved in extracting and organizing the ore, the unextracted deposit itself is a gift of nature.
- A perfectly competitive market is producing a quantity at which marginal cost exceeds marginal benefit. With respect to allocative efficiency, this outcome means the market is doing which of the following?
- Overproducing the good relative to the allocatively efficient quantity
- Underproducing the good relative to the allocatively efficient quantity
- Producing exactly the allocatively efficient quantity
- Producing at the lowest possible average total cost
Correct answer: Overproducing the good relative to the allocatively efficient quantity
When marginal cost exceeds marginal benefit, the market is overproducing relative to the allocatively efficient quantity, because the last units cost society more than they are worth. Allocative efficiency requires output where marginal benefit equals marginal cost, so cutting back output would raise society's net benefit. This concerns the right quantity, not minimum average total cost.
- How does allocative efficiency differ from productive efficiency?
- Allocative efficiency means producing at lowest cost; productive efficiency means producing what consumers value most
- The two terms describe exactly the same condition in a market
- Allocative efficiency applies only to monopolies; productive efficiency applies only to competition
- Allocative efficiency means producing the mix society values most; productive efficiency means producing at lowest cost
Correct answer: Allocative efficiency means producing the mix society values most; productive efficiency means producing at lowest cost
Allocative efficiency means producing the mix of goods society values most highly, where marginal benefit equals marginal cost, while productive efficiency means producing at the lowest possible cost. The two are distinct conditions, and a market can achieve one without the other. They are not identical, nor are they restricted to particular market structures.
- A drought permanently destroys a large share of a nation's arable farmland while its labor force, capital stock, and technology remain unchanged. What is the most likely effect on the nation's production possibilities curve?
- It shifts outward because the remaining resources work harder
- It rotates to become perfectly straight
- It shifts inward because the economy has fewer natural resources
- It stays in place but the economy moves to a point beyond it
Correct answer: It shifts inward because the economy has fewer natural resources
The curve shifts inward because the loss of arable farmland reduces the nation's available natural resources, lowering its maximum attainable output. The production possibilities curve depends on the quantity and quality of resources, so destroying land contracts productive capacity. Points beyond a curve are unattainable, so the economy cannot simply move outside it.
- An economy chooses to devote a large share of current resources to building factories, machinery, and infrastructure rather than to producing consumer goods today. Analyzing this choice with the production possibilities model, what trade-off is the economy making?
- It sacrifices future growth in exchange for higher present consumption
- It sacrifices present consumption in exchange for faster future growth
- It eliminates opportunity cost by investing in capital
- It guarantees an immediate outward shift with no cost
Correct answer: It sacrifices present consumption in exchange for faster future growth
The economy is sacrificing present consumption in exchange for faster future growth, because building capital expands future productive capacity and shifts the curve outward over time. The trade-off is fewer consumer goods now for more output later. Investing in capital does not eliminate opportunity cost, and the outward shift comes only in the future, not instantly and without cost.
- A college student receives two free concert tickets for the same night: one to Artist A, which she values at $50, and one to Artist B, which she values at $30. She can attend only one. If she chooses Artist A, what is the opportunity cost of attending?
- $30, the value of the Artist B concert she gives up
- $50, the value she places on the Artist A concert
- $80, the combined value of both concerts
- Zero, because both tickets were received for free
Correct answer: $30, the value of the Artist B concert she gives up
The opportunity cost is $30, the value of the Artist B concert she gives up, because that is her next-best forgone alternative. Opportunity cost is the value of what is sacrificed, even when the chosen option was free, so the zero-cost answer is wrong. It is neither the value of the chosen concert nor the sum of both, but only the single best alternative given up.
- The law of demand states which of the following relationships, holding all else constant?
- As the price of a good rises, the quantity demanded of it falls
- As the price of a good rises, the quantity demanded of it rises
- As consumer income rises, the quantity demanded always falls
- As the price of a good rises, the quantity supplied of it falls
Correct answer: As the price of a good rises, the quantity demanded of it falls
The law of demand states that as the price of a good rises, the quantity demanded falls, holding all else constant, producing an inverse price-quantity relationship. This inverse relationship is why demand curves slope downward. It describes buyer behavior in response to price, not the effect of income or the behavior of suppliers.
- Which factor, when it changes, causes a movement along a fixed demand curve rather than a shift of the entire curve?
- A change in consumer tastes for the good
- A change in the price of the good itself
- A change in the price of a related good
- A change in the number of buyers in the market
Correct answer: A change in the price of the good itself
A change in the price of the good itself causes a movement along the demand curve, a change in quantity demanded. Shifts of the entire demand curve are caused by changes in determinants such as tastes, related-good prices, income, or the number of buyers. Distinguishing a movement along the curve from a shift is central to the supply and demand model.
- The law of supply states that, holding all else constant, producers will do which of the following?
- Offer less quantity for sale as the price rises
- Offer the same quantity regardless of price
- Offer more quantity only when input costs rise
- Offer more quantity for sale as the price rises
Correct answer: Offer more quantity for sale as the price rises
The law of supply states that producers offer more quantity for sale as the price rises, holding all else constant, creating a direct relationship between price and quantity supplied. Higher prices make production more profitable, encouraging firms to expand output. This direct relationship is why supply curves slope upward.
- An increase in the price of fertilizer, an input used to grow corn, will most directly cause which of the following in the corn market?
- An increase in the quantity of corn demanded
- A movement up along the corn supply curve
- A rightward shift of the corn demand curve
- A leftward shift (decrease) of the corn supply curve
Correct answer: A leftward shift (decrease) of the corn supply curve
A rise in the price of fertilizer, an input, decreases supply, shifting the corn supply curve leftward because production becomes more costly at every price. A change in input prices is a supply determinant, so it shifts the curve rather than causing a movement along it. It affects sellers' willingness to produce, not the demand curve.
- Price elasticity of demand measures which of the following?
- The responsiveness of quantity demanded to a change in price
- The responsiveness of quantity supplied to a change in price
- The change in total revenue when output doubles
- The slope of the demand curve at the equilibrium point
Correct answer: The responsiveness of quantity demanded to a change in price
Price elasticity of demand measures the responsiveness of quantity demanded to a change in price, calculated as the percentage change in quantity demanded divided by the percentage change in price. It captures how sensitive buyers are to price changes. It is distinct from elasticity of supply and is not the same as the curve's slope.
- When the price of a good rises by 10 percent and the quantity demanded falls by 25 percent, demand for that good over this range is best described as which of the following?
- Perfectly inelastic
- Unit elastic
- Inelastic
- Elastic
Correct answer: Elastic
Demand is elastic here because the 25 percent drop in quantity demanded exceeds the 10 percent rise in price, giving an elasticity coefficient greater than 1 in absolute value. When the percentage change in quantity is larger than the percentage change in price, buyers are highly responsive. Unit elastic would require equal percentage changes, and inelastic would require a smaller quantity response.
- Which of the following goods is most likely to have a relatively inelastic demand?
- A brand of soda with many close substitutes
- A life-saving prescription medication with no substitute
- A luxury vacation package
- Tickets to one particular concert among many entertainment options
Correct answer: A life-saving prescription medication with no substitute
A life-saving prescription medication with no substitute has relatively inelastic demand because buyers will purchase it almost regardless of price, so quantity demanded changes little when price changes. The availability of substitutes is the most important determinant of elasticity. Goods with many substitutes, luxuries, and discretionary purchases tend to have more elastic demand.
- Price elasticity of supply measures which of the following?
- How much consumer income changes when prices change
- The burden of a tax borne by producers
- The total surplus generated in a competitive market
- The percentage change in quantity supplied divided by the percentage change in price
Correct answer: The percentage change in quantity supplied divided by the percentage change in price
Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price, measuring how responsive producers are to price changes. A larger coefficient means output adjusts greatly when price changes. It concerns sellers' responsiveness, not consumer income, tax burdens, or total surplus.
- Supply tends to be more elastic in the long run than in the short run primarily because, given more time, producers can do which of the following?
- Ignore changes in the market price
- Eliminate all of their fixed costs
- Adjust plant size and other resources to change output
- Force consumers to buy a fixed quantity
Correct answer: Adjust plant size and other resources to change output
Supply is more elastic in the long run because producers have time to adjust plant size, hire more workers, and reallocate resources, allowing output to respond more fully to price changes. In the short run, at least one input is fixed, limiting how much firms can expand or contract. Greater flexibility over time makes quantity supplied more responsive to price.
- Income elasticity of demand is used to classify a good as which of the following?
- A substitute or a complement
- Elastic or inelastic with respect to its own price
- A normal good or an inferior good
- A public good or a private good
Correct answer: A normal good or an inferior good
Income elasticity of demand classifies a good as normal or inferior based on the sign of the response. A positive income elasticity means demand rises with income, identifying a normal good, while a negative income elasticity identifies an inferior good. It measures the relationship between income and demand, not own-price responsiveness or the relationship between two goods.
- When consumer income rises by 5 percent and the quantity demanded of a particular good falls by 3 percent, the good is best classified as which of the following?
- A normal good, because demand responds to income
- A complement, because two goods are involved
- A Giffen good, because demand rose with price
- An inferior good, because the income elasticity is negative
Correct answer: An inferior good, because the income elasticity is negative
The good is inferior because its income elasticity is negative: quantity demanded fell when income rose, giving a negative ratio. Inferior goods are those consumers buy less of as their income increases, often substituting toward higher-quality alternatives. A normal good would show demand rising with income, and complements are identified by cross-price elasticity, not income elasticity.
- Cross-price elasticity of demand is used to determine whether two goods are which of the following?
- Substitutes or complements
- Normal or inferior
- Elastic or inelastic in supply
- Efficient or inefficient to produce
Correct answer: Substitutes or complements
Cross-price elasticity of demand determines whether two goods are substitutes or complements based on the sign of the response. A positive value means the goods are substitutes, since a higher price for one raises demand for the other, while a negative value means they are complements. It measures how the price of one good affects demand for another.
- When the price of coffee rises and the quantity of tea demanded increases, the positive cross-price elasticity indicates that coffee and tea are which of the following?
- Complements
- Inferior goods
- Substitutes
- Unrelated goods
Correct answer: Substitutes
Coffee and tea are substitutes because the cross-price elasticity is positive: a higher price for coffee increased the quantity of tea demanded as buyers switched between them. A positive sign signals goods that can replace one another in consumption. Complements would show a negative cross-price elasticity, and unrelated goods would show a value near zero.
- According to the total revenue test, if demand for a good is elastic, a decrease in the good's price will cause total revenue to do which of the following?
- Fall, because quantity barely changes
- Rise, because the percentage increase in quantity exceeds the percentage decrease in price
- Remain unchanged, regardless of the price change
- Fall to zero immediately
Correct answer: Rise, because the percentage increase in quantity exceeds the percentage decrease in price
When demand is elastic, lowering the price raises total revenue because the percentage increase in quantity demanded exceeds the percentage decrease in price. The gain from selling more units outweighs the loss from the lower price per unit. With elastic demand, price and total revenue move in opposite directions.
- A firm raises its price and finds that its total revenue increases. Using the total revenue test, the demand for the firm's product over this range must be which of the following?
- Unit elastic
- Perfectly elastic
- Inelastic
- Perfectly elastic and inelastic at once
Correct answer: Inelastic
Demand must be inelastic because a price increase raised total revenue, meaning quantity demanded fell by a smaller percentage than the price rose. With inelastic demand, price and total revenue move in the same direction. Unit elastic demand would leave total revenue unchanged, and perfectly elastic demand would cause revenue to collapse when price rose.
- Consumer surplus in a market is best described as which of the following?
- The difference between the amount buyers are willing to pay and the price they actually pay
- The difference between the price sellers receive and their marginal cost
- The total amount of money spent by all consumers
- The quantity of a good left unsold at the market price
Correct answer: The difference between the amount buyers are willing to pay and the price they actually pay
Consumer surplus is the difference between what buyers are willing to pay and the price they actually pay, representing the net benefit consumers receive. On a graph it is the area below the demand curve and above the market price. It is distinct from producer surplus, which compares price received to marginal cost.
- A consumer is willing to pay up to $30 for a concert ticket but buys it for $18. The consumer surplus from this purchase is which of the following?
Correct answer: $12
The consumer surplus is $12, the difference between the $30 the buyer was willing to pay and the $18 actually paid. Consumer surplus measures the extra value a buyer receives beyond the price. Adding the two figures or using either one alone would not represent the net benefit gained.
- Producer surplus in a competitive market is represented graphically by which of the following?
- The area below the demand curve and above the price
- The area above the supply curve and below the price
- The entire area under the demand curve
- The area where shortage occurs below a price ceiling
Correct answer: The area above the supply curve and below the price
Producer surplus is the area above the supply curve and below the market price, capturing the difference between the price sellers receive and their marginal cost of production. It measures the benefit producers gain from selling at the market price. Consumer surplus, by contrast, is the area below the demand curve and above the price.
- Market equilibrium in a competitive market occurs at the price and quantity where which of the following is true?
- Consumer surplus is zero
- Total revenue is at its maximum
- The quantity demanded equals the quantity supplied
- The government sets a binding price control
Correct answer: The quantity demanded equals the quantity supplied
Market equilibrium occurs where the quantity demanded equals the quantity supplied, determining the equilibrium price and quantity. At this point there is no shortage or surplus, so there is no pressure for the price to change. Equilibrium is reached by market forces, not by maximizing revenue or by government price controls.
- In a market, both a decrease in supply and an increase in demand occur at the same time. What is the definite effect on equilibrium price?
- Equilibrium price definitely rises
- Equilibrium price definitely falls
- Equilibrium price stays exactly the same
- Equilibrium price becomes impossible to determine in any direction
Correct answer: Equilibrium price definitely rises
Equilibrium price definitely rises because a decrease in supply pushes price up and an increase in demand also pushes price up, so both forces work in the same direction. The effect on equilibrium quantity, however, is ambiguous and depends on the relative sizes of the shifts. When both shifts push price the same way, the price change is determinate.
- A binding price ceiling is set below the equilibrium price in a market. The most direct result is which of the following?
- A persistent surplus of the good
- A persistent shortage of the good
- An increase in the equilibrium price
- An outward shift of the supply curve
Correct answer: A persistent shortage of the good
A binding price ceiling set below equilibrium creates a persistent shortage because at the artificially low price the quantity demanded exceeds the quantity supplied. Buyers want more than sellers are willing to provide at that price. A surplus instead results from a binding price floor set above equilibrium.
- Which of the following is the most commonly cited real-world example of a binding price floor?
- Rent control on apartments
- A minimum wage set above the equilibrium wage
- Gasoline price caps during a shortage
- A subsidy paid to farmers
Correct answer: A minimum wage set above the equilibrium wage
A minimum wage set above the equilibrium wage is the classic example of a binding price floor, since it holds the wage above the market-clearing level. A binding floor causes the quantity supplied to exceed the quantity demanded, producing a surplus, which in labor markets appears as unemployment. Rent control and gasoline caps are price ceilings, not floors.
- When the government imposes an excise tax on a good, the burden of the tax falls more heavily on consumers when which of the following is true?
- Demand is more inelastic than supply
- Demand is more elastic than supply
- Both demand and supply are perfectly elastic
- The tax is collected from sellers rather than buyers
Correct answer: Demand is more inelastic than supply
Consumers bear more of a tax when demand is more inelastic than supply, because buyers who are less responsive to price absorb a larger share of the increase. Tax incidence falls on whichever side of the market is less elastic. The legal point of collection does not change the economic burden, which is determined by relative elasticities.
- Deadweight loss in a market is best described as which of the following?
- The total tax revenue collected by the government
- The loss of total surplus from producing a quantity other than the efficient one
- The profit earned by firms at equilibrium
- The amount consumers spend above the market price
Correct answer: The loss of total surplus from producing a quantity other than the efficient one
Deadweight loss is the loss of total surplus that results when the quantity traded differs from the efficient equilibrium quantity, such as under a tax or binding price control. It represents mutually beneficial transactions that no longer occur. It is not tax revenue, which is a transfer, nor is it firm profit.
- A per-unit tax is placed on a good in a competitive market, reducing the quantity traded below the equilibrium level. The deadweight loss from this tax represents which of the following?
- The revenue transferred to the government
- The increase in consumer surplus from the tax
- The gains from trade lost on units no longer produced and sold
- The portion of the tax paid by sellers
Correct answer: The gains from trade lost on units no longer produced and sold
The deadweight loss represents the gains from trade lost on units that are no longer produced and sold because the tax reduced quantity below the efficient level. These are transactions that would have benefited both buyers and sellers but no longer occur. Tax revenue is a transfer to the government, not part of the deadweight loss.
- An increase in consumer income causes the demand for a normal good to shift rightward. This change reflects which of the following?
- A movement along the demand curve caused by a price change
- A change in a demand determinant other than the good's own price
- A change in the law of supply
- An increase in producer surplus only
Correct answer: A change in a demand determinant other than the good's own price
The rightward shift reflects a change in a demand determinant other than the good's own price, in this case consumer income. Because income is a non-price factor, it shifts the entire demand curve rather than causing a movement along it. For a normal good, higher income raises demand, shifting the curve to the right.
- A binding price ceiling on rental housing is expected to create a shortage. Which additional consequence is most consistent with the supply and demand model?
- Landlords supply more apartments at the controlled price
- Total surplus in the market increases above the competitive level
- A deadweight loss arises because some mutually beneficial rentals no longer occur
- The equilibrium price rises above the ceiling automatically
Correct answer: A deadweight loss arises because some mutually beneficial rentals no longer occur
A binding rent ceiling creates a deadweight loss because the reduced quantity of housing supplied means some mutually beneficial rentals no longer take place. The shortage and lost transactions lower total surplus rather than raising it. Landlords actually supply fewer units at the controlled price, and a legal ceiling prevents the price from rising to equilibrium.
- A per-unit tax is imposed in a market where supply is highly inelastic and demand is highly elastic. Which side of the market will bear the larger share of the tax burden?
- Producers, because supply is more inelastic than demand
- Consumers, because demand is more inelastic than supply
- The government, because it collects the tax
- Neither side, because the burden is always shared equally
Correct answer: Producers, because supply is more inelastic than demand
Producers bear the larger share because supply is more inelastic than demand, so the less responsive side absorbs more of the tax. When sellers cannot easily reduce output and buyers can easily reduce purchases, the burden shifts toward producers. Tax incidence depends on relative elasticities, not on who legally remits the tax.
- In a competitive market at equilibrium with no taxes or price controls, total surplus is which of the following?
- Equal to consumer surplus minus producer surplus
- Equal to government tax revenue
- Maximized, with no deadweight loss
- Zero, because buyers and sellers cancel out
Correct answer: Maximized, with no deadweight loss
At a competitive equilibrium with no taxes or controls, total surplus is maximized and there is no deadweight loss, because the efficient quantity is produced and all mutually beneficial trades occur. Total surplus equals consumer surplus plus producer surplus, not the difference between them. Interventions that move the market away from equilibrium reduce total surplus.
- The law of diminishing returns states that, in the short run, as more units of a variable input are added to a fixed input, what eventually happens?
- The marginal product of the variable input eventually declines
- Total product immediately falls to zero
- The fixed input must also be increased proportionally
- Average fixed cost begins to rise with each unit
Correct answer: The marginal product of the variable input eventually declines
The marginal product of the variable input eventually declines once the law of diminishing returns sets in, because additional workers must share a fixed amount of capital. This causes each additional unit of input to add less to output than the previous one. Total product can still rise during this stage, and the fixed input remains fixed in the short run.
- Marginal product is best defined as which of the following?
- The total output produced by all units of input combined
- The additional output produced by adding one more unit of a variable input
- The output produced per dollar of total cost
- The average output produced per worker employed
Correct answer: The additional output produced by adding one more unit of a variable input
Marginal product is the additional output produced by adding one more unit of a variable input, holding other inputs fixed. It is the change in total product divided by the change in the variable input. It is distinct from total product, which sums all output, and from average product, which divides total output by the number of input units.
- A factory's total product rises from 40 units to 52 units when it hires its sixth worker. The marginal product of the sixth worker is which of the following?
- 52 units
- 40 units
- 12 units
- Approximately 8.7 units
Correct answer: 12 units
The marginal product of the sixth worker is 12 units, the change in total product (52 minus 40) attributable to that one additional worker. Marginal product isolates the extra output from the last input added, not the total output or the average per worker. Dividing total output by the number of workers would instead give average product.
- Total product in the short run refers to which of the following?
- The extra output from the last unit of input added
- The total quantity of output produced at each level of the variable input
- The total cost of producing a given level of output
- The output level at which average cost is minimized
Correct answer: The total quantity of output produced at each level of the variable input
Total product is the total quantity of output a firm produces at each level of the variable input. It is the foundation from which marginal product and average product are derived. It measures output, not cost, and it is not defined by the point where average cost is lowest.
- When marginal product is positive but falling, total product is doing which of the following?
- Falling at an increasing rate
- Remaining constant
- Rising but at a decreasing rate
- Equal to zero
Correct answer: Rising but at a decreasing rate
When marginal product is positive but falling, total product is still rising but at a decreasing rate, because each additional input adds less output than the one before. Total product reaches its maximum only when marginal product equals zero, and total product falls only when marginal product turns negative. Positive marginal product always means total product is increasing.
- Fixed cost in the short run is best described as a cost that does which of the following?
- Increases with each additional unit of output produced
- Falls to zero whenever the firm stops producing
- Does not change as the level of output changes
- Equals total cost divided by the quantity produced
Correct answer: Does not change as the level of output changes
Fixed cost does not change as the level of output changes, so the firm pays it even when output is zero. Examples include rent on a factory and insurance premiums committed in advance. It contrasts with variable cost, which rises with output, and it must be paid in the short run regardless of production.
- Which of the following is the clearest example of a fixed cost for a manufacturing firm in the short run?
- Wages paid to hourly production workers
- The cost of raw materials used in each unit
- Electricity consumed by running machines
- Monthly rent on the factory building
Correct answer: Monthly rent on the factory building
Monthly rent on the factory building is a fixed cost because it stays the same regardless of how many units the firm produces. Wages for hourly workers, raw materials, and machine electricity all rise and fall with output, making them variable costs. Fixed costs are obligations that do not depend on the production level in the short run.
- Variable cost is the portion of a firm's costs that does which of the following?
- Changes directly with the level of output produced
- Remains constant regardless of how much is produced
- Must be paid even when the firm produces nothing
- Always equals the firm's total fixed cost
Correct answer: Changes directly with the level of output produced
Variable cost changes directly with the level of output, rising as the firm produces more and falling as it produces less. Costs such as raw materials and hourly labor are variable because they depend on output. This distinguishes them from fixed costs, which remain constant and must be paid even at zero output.
- A firm's total cost is $900 when it produces 30 units and $960 when it produces 31 units. The marginal cost of the 31st unit is which of the following?
- $960
- $60
- About $31
- About $30
Correct answer: $60
The marginal cost of the 31st unit is $60, the change in total cost (960 minus 900) from producing one more unit. Marginal cost captures only the added cost of the last unit, not the total or the average cost. Dividing total cost by quantity would instead give average total cost.
- Marginal cost is best defined as which of the following?
- The total cost of producing all units of output
- The cost of the fixed inputs used in production
- The additional cost of producing one more unit of output
- Total cost divided by the quantity of output
Correct answer: The additional cost of producing one more unit of output
Marginal cost is the additional cost of producing one more unit of output, calculated as the change in total cost divided by the change in quantity. It is central to the profit-maximizing rule of producing where marginal revenue equals marginal cost. It differs from average total cost, which divides total cost by quantity.
- The marginal cost curve is typically U-shaped, eventually rising at higher output levels. This upward slope is most directly explained by which concept?
- Economies of scale in the long run
- The law of diminishing returns
- A binding price floor in the output market
- The presence of fixed costs
Correct answer: The law of diminishing returns
The rising portion of the marginal cost curve is explained by the law of diminishing returns, because as marginal product falls, each additional unit of output requires more variable input and therefore costs more to produce. Diminishing marginal returns and rising marginal cost are two sides of the same relationship. Fixed costs and economies of scale do not drive the short-run shape of marginal cost.
- Average total cost is calculated by which of the following methods?
- Dividing total cost by the quantity of output produced
- Subtracting fixed cost from variable cost
- Dividing the change in total cost by the change in output
- Multiplying marginal cost by total output
Correct answer: Dividing total cost by the quantity of output produced
Average total cost is total cost divided by the quantity of output, giving the per-unit cost of production. It equals the sum of average fixed cost and average variable cost. It is distinct from marginal cost, which is the change in total cost from one more unit, not a per-unit average.
- The average total cost curve is typically U-shaped. The rising portion of the curve occurs primarily because of which of the following?
- Average fixed cost spreading over more units
- Diminishing returns eventually pushing average variable cost up faster than average fixed cost falls
- The complete elimination of fixed costs
- A leftward shift of the firm's demand curve
Correct answer: Diminishing returns eventually pushing average variable cost up faster than average fixed cost falls
The rising portion of the average total cost curve occurs because diminishing returns eventually push average variable cost up faster than average fixed cost continues to fall. At low output, spreading fixed cost dominates and average total cost falls, but at high output rising average variable cost dominates. The interaction of these two components produces the U shape.
- Average variable cost is calculated as which of the following?
- Total fixed cost divided by quantity
- Total cost divided by quantity
- The change in total cost from one more unit
- Total variable cost divided by quantity
Correct answer: Total variable cost divided by quantity
Average variable cost is total variable cost divided by the quantity of output, giving the per-unit variable cost. It is important because the shutdown decision compares price to average variable cost. It is distinct from average fixed cost and from average total cost, which includes both fixed and variable components.
- The marginal cost curve intersects the average variable cost curve at which point?
- At the minimum point of average variable cost
- At the maximum point of average variable cost
- Where average variable cost equals average fixed cost
- At the firm's break-even point only
Correct answer: At the minimum point of average variable cost
The marginal cost curve intersects the average variable cost curve at the minimum point of average variable cost. When marginal cost is below average variable cost it pulls the average down, and when it is above it pulls the average up, so the two curves meet at the lowest point of average variable cost. The same logic explains why marginal cost crosses average total cost at its minimum.
- Economies of scale exist when, in the long run, a firm's long-run average total cost does which of the following as output increases?
- Rises as output increases
- Falls as output increases
- Stays constant at every output level
- Becomes equal to marginal revenue
Correct answer: Falls as output increases
Economies of scale exist when long-run average total cost falls as output increases, often because larger operations allow specialization, bulk purchasing, and more efficient use of capital. This contrasts with diseconomies of scale, where average cost rises with output, and constant returns to scale, where it stays flat. Economies of scale are a long-run concept where all inputs are variable.
- When a firm's long-run average total cost rises as it expands output, the firm is experiencing which of the following?
- Economies of scale
- Constant returns to scale
- The law of demand
- Diseconomies of scale
Correct answer: Diseconomies of scale
Rising long-run average total cost as output expands indicates diseconomies of scale, often caused by coordination and management difficulties in very large firms. This is the opposite of economies of scale, where average cost falls. Constant returns to scale would leave long-run average total cost unchanged as output grows.
- Which of the following is a defining characteristic of a perfectly competitive market?
- A small number of interdependent firms
- Significant barriers preventing new firms from entering
- Many firms selling an identical (homogeneous) product
- A single firm controlling the entire market
Correct answer: Many firms selling an identical (homogeneous) product
A perfectly competitive market has many firms selling an identical, or homogeneous, product, which is why no single firm can influence the market price. Other defining features include free entry and exit and perfect information. This contrasts with oligopoly, which has few interdependent firms, and monopoly, which has a single seller.
- A perfectly competitive firm is described as a price taker because it does which of the following?
- Sets its own price above the market price to earn profit
- Must accept the market price determined by industry supply and demand
- Can raise the market price by reducing its own output
- Faces a downward-sloping demand curve for its product
Correct answer: Must accept the market price determined by industry supply and demand
A perfectly competitive firm is a price taker because it must accept the market price set by overall industry supply and demand. Since its output is a tiny share of the market and its product is identical to rivals', it cannot raise price without losing all customers. As a result, the individual firm faces a perfectly elastic, horizontal demand curve at the market price.
- To maximize profit, a firm in any market structure should produce the quantity at which which of the following is true?
- Marginal revenue equals marginal cost
- Total revenue equals total cost
- Average total cost is at its minimum
- Price equals average fixed cost
Correct answer: Marginal revenue equals marginal cost
A firm maximizes profit by producing where marginal revenue equals marginal cost, because up to that point each additional unit adds more to revenue than to cost. Producing beyond it would add more cost than revenue, reducing profit. This rule applies across all market structures, not just perfect competition.
- A perfectly competitive firm is currently producing at a quantity where its marginal revenue exceeds its marginal cost. To increase profit, the firm should do which of the following?
- Decrease output to lower its marginal cost
- Keep output exactly the same
- Shut down immediately
- Increase output until marginal revenue equals marginal cost
Correct answer: Increase output until marginal revenue equals marginal cost
The firm should increase output until marginal revenue equals marginal cost, because every additional unit where marginal revenue exceeds marginal cost adds to profit. Stopping short of that point leaves profitable units unproduced. The profit-maximizing quantity is reached precisely where marginal revenue and marginal cost are equal.
- Marginal revenue is best defined as which of the following?
- The total revenue earned from selling all units of output
- The additional revenue from selling one more unit of output
- The price multiplied by the firm's fixed cost
- Total revenue divided by marginal cost
Correct answer: The additional revenue from selling one more unit of output
Marginal revenue is the additional revenue a firm earns from selling one more unit of output, calculated as the change in total revenue divided by the change in quantity. It is compared with marginal cost to find the profit-maximizing quantity. It is distinct from total revenue, which sums revenue across all units.
- For a perfectly competitive firm, marginal revenue is equal to which of the following?
- The market price of the good
- The firm's average total cost
- The firm's total fixed cost
- Half of the market price
Correct answer: The market price of the good
For a perfectly competitive firm, marginal revenue equals the market price, because the firm can sell every additional unit at that same constant price. This makes the firm's demand, marginal revenue, and price all equal and horizontal. The relationship marginal revenue equals price is unique to price-taking firms and does not hold for firms with market power.
- In the short run, a perfectly competitive firm should shut down production when which of the following is true?
- Price is below average total cost
- Price is above marginal cost
- Price is below average variable cost
- Total revenue is greater than total variable cost
Correct answer: Price is below average variable cost
A firm should shut down in the short run when price falls below average variable cost, because at that point it cannot even cover its variable costs and loses less by producing nothing. If price is above average variable cost but below average total cost, the firm still operates to cover part of its fixed costs. The shutdown rule compares price to average variable cost, not average total cost.
- The shutdown point for a perfectly competitive firm occurs at the minimum of which curve?
- The average total cost curve
- The average fixed cost curve
- The marginal revenue curve
- The average variable cost curve
Correct answer: The average variable cost curve
The shutdown point occurs at the minimum of the average variable cost curve, where the marginal cost curve intersects it. Below this price the firm cannot cover its variable costs and should cease producing in the short run. The minimum of average total cost instead defines the break-even point.
- The break-even point for a perfectly competitive firm occurs at the price where which of the following is true?
- Price equals minimum average total cost, yielding zero economic profit
- Price equals minimum average variable cost
- Price equals average fixed cost
- Marginal revenue equals total cost
Correct answer: Price equals minimum average total cost, yielding zero economic profit
The break-even point occurs where price equals the minimum of average total cost, giving the firm zero economic profit. At this price the firm covers all of its costs, including the opportunity cost of resources, but earns no economic profit. The shutdown point, by contrast, occurs at the minimum of average variable cost.
- A perfectly competitive firm faces a market price of $12, produces 100 units, and has an average total cost of $9 at that output. What is the firm's short-run economic profit?
- $1,200
- $900
- $300
- Zero, because firms always break even
Correct answer: $300
The firm's short-run economic profit is $300, found by multiplying the per-unit profit of $3 (price of 12 minus average total cost of 9) by the 100 units produced. Economic profit equals quantity times the difference between price and average total cost. The firm earns positive profit here because price exceeds average total cost in the short run.
- A perfectly competitive firm produces where price is greater than average total cost. In the short run, this firm is earning which of the following?
- Positive economic profit
- Zero economic profit
- An economic loss
- Negative marginal revenue
Correct answer: Positive economic profit
When price exceeds average total cost, the firm earns positive economic profit in the short run, because revenue per unit is greater than the cost per unit. A perfectly competitive firm can earn short-run profits, losses, or break even depending on where price sits relative to its cost curves. Such profits attract entry, which erodes them over the long run.
- In the long run, a perfectly competitive industry reaches equilibrium when economic profit is driven to which level, and through what mechanism?
- Maximized, through barriers that block new firms
- Negative, through forced government regulation
- Zero, through the entry and exit of firms
- Unchanged, because firms ignore profit signals
Correct answer: Zero, through the entry and exit of firms
Long-run equilibrium in perfect competition occurs when economic profit is driven to zero through the entry and exit of firms. Positive economic profits attract new entrants, increasing supply and lowering price, while losses cause firms to exit until price returns to minimum average total cost. Free entry and exit are what enforce zero long-run economic profit.
- A perfectly competitive firm in long-run equilibrium produces at the minimum point of its average total cost curve. This outcome is the definition of which efficiency concept?
- Allocative efficiency
- Productive efficiency
- Dynamic efficiency
- Distributive efficiency
Correct answer: Productive efficiency
Producing at the minimum point of average total cost defines productive efficiency, because the firm is making output at the lowest possible per-unit cost. Perfect competition achieves this in long-run equilibrium. It is distinct from allocative efficiency, which is achieved when price equals marginal cost.
- Allocative efficiency is achieved in a market when output is produced at the level where which of the following is true?
- Average total cost equals average variable cost
- Marginal revenue is at its maximum
- Total revenue equals total fixed cost
- Price equals marginal cost
Correct answer: Price equals marginal cost
Allocative efficiency is achieved when price equals marginal cost, because at that output the value buyers place on the last unit equals the cost of producing it, so society's resources are allocated to their most valued use. Perfect competition reaches this point in equilibrium. This differs from productive efficiency, which concerns producing at minimum average total cost.
- A perfectly competitive firm faces a market price of $7. Its average variable cost is $8 and its average total cost is $11 at the profit-maximizing output. In the short run, the firm should do which of the following?
- Continue operating because it covers part of its fixed costs
- Shut down because the price is below average variable cost
- Raise its price to $11 to break even
- Expand output to lower average total cost
Correct answer: Shut down because the price is below average variable cost
The firm should shut down because the price of $7 is below its average variable cost of $8, so it cannot even cover its variable costs and would lose less by halting production. Operating to cover part of fixed costs makes sense only when price is above average variable cost. As a price taker, the firm cannot raise its price to break even.
- A perfectly competitive industry is initially in long-run equilibrium when a sudden permanent increase in market demand raises the price. What sequence best describes the industry's adjustment back to long-run equilibrium?
- Existing firms exit, supply falls, and price rises further
- Firms collude to keep the higher price permanently
- Short-run profits attract entry, supply rises, price falls, and profit returns to zero
- Average total cost shifts upward until losses appear
Correct answer: Short-run profits attract entry, supply rises, price falls, and profit returns to zero
The higher price creates short-run economic profits that attract new firms, increasing industry supply, which pushes price back down until economic profit returns to zero. This entry-driven adjustment restores long-run equilibrium at minimum average total cost. Firms in perfect competition cannot collude, and it is entry rather than exit that responds to profits.
- A monopoly is best defined as a market structure characterized by which of the following?
- Many small firms selling slightly differentiated products
- A few large firms whose decisions are interdependent
- Many firms selling an identical, homogeneous product
- A single seller of a product that has no close substitutes
Correct answer: A single seller of a product that has no close substitutes
A monopoly is a market with a single seller of a product that has no close substitutes, giving the firm substantial control over price. Because there is only one producer, the firm is a price maker rather than a price taker. This contrasts with monopolistic competition, which has many differentiated firms, and oligopoly, which has a few interdependent firms.
- For a single-price monopolist, marginal revenue is always less than the price charged because of which of the following?
- To sell an additional unit, the firm must lower the price on all units sold
- The monopolist faces a perfectly elastic demand curve
- The monopolist must pay a per-unit tax on every sale
- Marginal cost rises faster than marginal revenue at every output
Correct answer: To sell an additional unit, the firm must lower the price on all units sold
Marginal revenue is less than price for a single-price monopolist because, to sell one more unit, the firm must lower the price on all units it sells, not just the last one. The lost revenue on earlier units pulls marginal revenue below the new price. This is why the monopolist's marginal revenue curve lies below its downward-sloping demand curve.
- Compared with a perfectly competitive market producing the same good, an unregulated single-price monopoly typically results in which of the following?
- A lower price and a larger quantity
- The same price and quantity as perfect competition
- A higher price and a smaller quantity, creating deadweight loss
- Zero economic profit in both the short run and long run
Correct answer: A higher price and a smaller quantity, creating deadweight loss
An unregulated monopoly produces a higher price and a smaller quantity than perfect competition, creating deadweight loss. Because the monopolist restricts output to the point where marginal revenue equals marginal cost rather than where price equals marginal cost, some mutually beneficial transactions never occur. This underproduction is the source of the monopoly's allocative inefficiency.
- A natural monopoly arises in an industry where which of the following conditions is present?
- A single firm can supply the entire market at a lower average cost than multiple firms could
- Many firms can each produce at the lowest possible average cost
- The government legally prohibits any single firm from dominating
- Products are highly differentiated among competing sellers
Correct answer: A single firm can supply the entire market at a lower average cost than multiple firms could
A natural monopoly arises when a single firm can supply the entire market at a lower average cost than several smaller firms could, owing to extensive economies of scale. High fixed costs spread over large output keep long-run average cost falling across the relevant range. This cost structure makes it efficient for one firm rather than many to serve the market.
- Which of the following industries is most commonly cited as an example of a natural monopoly?
- A local water distribution utility
- A fast-food restaurant chain
- A wheat-farming operation
- A clothing retailer in a shopping mall
Correct answer: A local water distribution utility
A local water distribution utility is the clearest example of a natural monopoly because the enormous fixed cost of building a pipe network makes it wasteful to have competing systems. One provider can serve the whole area at far lower average cost than several duplicate networks. Fast food, farming, and clothing retail involve many competing firms and do not share this cost structure.
- When a regulator sets a fair-return price for a natural monopoly, the price is set equal to which of the following?
- Marginal cost, eliminating all deadweight loss
- Marginal revenue at the profit-maximizing output
- Average total cost, allowing a normal profit
- The lowest point on the marginal cost curve
Correct answer: Average total cost, allowing a normal profit
A fair-return price for a natural monopoly is set equal to average total cost, which lets the firm earn a normal profit and avoid losses. Setting price at marginal cost, the socially optimal point, would force the firm to operate at a loss because its average cost lies above marginal cost. Regulators therefore often choose the average-cost price as a workable compromise.
- Price discrimination is best described as the practice of which of the following?
- Charging all customers an identical price for a good
- Selling a good below marginal cost to drive out rivals
- Refusing to sell to customers who cannot pay full price
- Charging different customers different prices for the same good for reasons unrelated to cost
Correct answer: Charging different customers different prices for the same good for reasons unrelated to cost
Price discrimination is charging different customers different prices for the same good for reasons unrelated to cost differences, in order to capture more consumer surplus. The seller sorts buyers by their willingness to pay. It requires market power and the ability to prevent resale, distinguishing it from simply charging one uniform price.
- Which of the following is a necessary condition for a firm to engage in successful price discrimination?
- The firm must operate in a perfectly competitive market
- All customers must have identical willingness to pay
- The firm must charge a price below its marginal cost
- The firm must be able to prevent resale between customer groups
Correct answer: The firm must be able to prevent resale between customer groups
A firm must be able to prevent resale between customer groups to price discriminate successfully, otherwise low-price buyers would resell to high-price buyers and undercut the scheme. The firm must also have market power and be able to separate buyers by willingness to pay. Perfectly competitive firms, which are price takers with identical buyers, cannot price discriminate.
- Which of the following is the clearest real-world example of price discrimination?
- A grocery store charging every shopper the same posted price
- A movie theater offering discounted tickets to students and seniors
- A gas station raising its price for all customers at once
- A factory paying different wages based on worker productivity
Correct answer: A movie theater offering discounted tickets to students and seniors
A movie theater offering discounted tickets to students and seniors is a clear example of price discrimination, since identical seats are sold at different prices based on buyers' willingness to pay. The theater can separate groups by ID and prevent resale of tickets. A single posted price or a uniform price increase applies the same price to everyone and is not discrimination.
- Monopolistic competition is a market structure characterized by which of the following?
- A single seller protected by high barriers to entry
- A few large firms producing an identical product
- Many firms selling a perfectly homogeneous product
- Many firms selling differentiated products with easy entry and exit
Correct answer: Many firms selling differentiated products with easy entry and exit
Monopolistic competition features many firms selling differentiated products with easy entry and exit. Product differentiation gives each firm some pricing power and a downward-sloping demand curve, while free entry drives long-run economic profit to zero. This combination distinguishes it from monopoly, oligopoly, and perfect competition.
- In long-run equilibrium, a monopolistically competitive firm earns which level of economic profit, and why?
- Positive economic profit, because barriers block entry
- Negative economic profit, because all firms eventually fail
- Zero economic profit, because free entry and exit erode profits
- Maximum economic profit, because products are differentiated
Correct answer: Zero economic profit, because free entry and exit erode profits
A monopolistically competitive firm earns zero economic profit in long-run equilibrium because free entry and exit erode any profits. When firms earn short-run profits, new entrants attracted by differentiation shrink each firm's demand until economic profit disappears. The absence of strong entry barriers is what drives this outcome, similar to perfect competition.
- A restaurant in a city with dozens of competing eateries spends heavily on a distinctive menu and atmosphere yet still earns only normal profit over time. This situation best illustrates which market structure?
- Monopolistic competition
- Pure monopoly
- Perfect competition
- Natural monopoly
Correct answer: Monopolistic competition
This situation illustrates monopolistic competition, in which many firms differentiate their products yet earn only normal profit in the long run because entry is easy. The distinctive menu and atmosphere give the restaurant some pricing power, but rivals' entry competes away economic profit. Perfect competition would feature identical products, and a monopoly would have a single protected seller.
- An oligopoly is a market structure defined by which of the following?
- A single seller controlling the entire market
- Many firms with no influence over price
- A few large interdependent firms that must consider rivals' reactions
- Many firms selling identical products with free entry
Correct answer: A few large interdependent firms that must consider rivals' reactions
An oligopoly consists of a few large interdependent firms, each of which must consider how rivals will react to its decisions. This mutual interdependence is the defining feature and is the reason oligopoly behavior is analyzed using game theory. It contrasts with monopoly's single seller and with the many independent firms of competitive markets.
- The behavior of firms in an oligopoly is most commonly analyzed using which of the following tools?
- The production possibilities curve
- The Lorenz curve
- The total revenue test
- Game theory and payoff matrices
Correct answer: Game theory and payoff matrices
Oligopoly behavior is most commonly analyzed using game theory and payoff matrices, because firms are interdependent and each one's best choice depends on what rivals do. Payoff matrices map out the outcomes of strategic interaction between firms. The production possibilities curve, Lorenz curve, and total revenue test address unrelated topics.
- In a simultaneous one-time game, a payoff matrix is primarily used to represent which of the following?
- The long-run average cost of each firm
- The income distribution among households
- The outcomes each player receives for every combination of strategies
- The elasticity of demand facing each firm
Correct answer: The outcomes each player receives for every combination of strategies
A payoff matrix represents the outcomes each player receives for every combination of the players' strategies. By laying out the payoffs, it allows analysts to identify dominant strategies and equilibria in strategic situations. It depicts strategic interaction, not cost curves, income distribution, or demand elasticity.
- A Nash equilibrium in a game occurs when which of the following is true?
- No player can improve their payoff by unilaterally changing strategy
- Every player earns the highest possible payoff in the matrix
- All players choose to cooperate with one another
- One player has eliminated all of their rivals from the market
Correct answer: No player can improve their payoff by unilaterally changing strategy
A Nash equilibrium occurs when no player can improve their payoff by unilaterally changing strategy, given what the other players are doing. At this outcome each player's choice is a best response to the others' choices, so no one has an incentive to deviate alone. It does not require that players reach the jointly best outcome or that they cooperate.
- A dominant strategy for a player is best defined as a strategy that does which of the following?
- Yields the best outcome only when the rival cooperates
- Gives the highest payoff regardless of what the other player chooses
- Always leads both players to the cooperative outcome
- Maximizes the combined payoffs of all players
Correct answer: Gives the highest payoff regardless of what the other player chooses
A dominant strategy gives a player the highest payoff regardless of what the other player chooses. Because it is the best response no matter the rival's decision, a rational player will always select it when one exists. It is defined by an individual player's best choice, not by joint outcomes or by the rival's cooperation.
- Two competing firms, A and B, each choose whether to set a high or low price. If charging a low price yields a higher payoff for Firm A whether Firm B chooses high or low, then for Firm A charging a low price is which of the following?
- A dominated strategy
- A collusive agreement
- A dominant strategy
- A natural monopoly outcome
Correct answer: A dominant strategy
Charging a low price is a dominant strategy for Firm A, because it produces the higher payoff regardless of whether Firm B prices high or low. A dominant strategy is the best choice no matter what the rival does. It is the opposite of a dominated strategy, which would be worse in every case, and it is an independent choice rather than a collusive agreement.
- Collusion among oligopoly firms refers to which of the following?
- Firms independently lowering prices to win market share
- Firms cooperating to restrict output and raise prices like a monopoly
- A single firm acquiring all of its competitors
- Firms entering the market to compete away economic profit
Correct answer: Firms cooperating to restrict output and raise prices like a monopoly
Collusion is when oligopoly firms cooperate to restrict output and raise prices, behaving collectively like a monopoly to increase joint profits. A formal collusive arrangement among firms is called a cartel. This is distinct from independent price competition and from one firm simply buying out its rivals.
- Collusive agreements among oligopolists are often unstable primarily because of which of the following?
- Each individual firm has an incentive to cheat by secretly lowering its price
- Customers refuse to buy from firms that cooperate
- Collusion always reduces the firms' combined profits
- Government subsidies make cheating unprofitable
Correct answer: Each individual firm has an incentive to cheat by secretly lowering its price
Collusive agreements are unstable because each individual firm has an incentive to cheat by secretly lowering its price or expanding output to capture extra sales at the others' expense. Since every member faces this temptation, the cartel tends to break down. The instability stems from individual profit incentives, not from reduced joint profits or government subsidies.
- In long-run equilibrium, a monopolistically competitive firm produces at a level of output that exhibits excess capacity. This means the firm does which of the following?
- Produces at the minimum point of its average total cost curve
- Produces the allocatively efficient quantity where price equals marginal cost
- Produces more output than a perfectly competitive firm would
- Produces less than the output that would minimize average total cost
Correct answer: Produces less than the output that would minimize average total cost
Excess capacity means the monopolistically competitive firm produces less than the output that would minimize average total cost. Because it faces a downward-sloping demand curve, its long-run equilibrium occurs on the falling portion of the average total cost curve rather than at the minimum. The gap between this output and the minimum-cost output is the excess capacity.
- The presence of excess capacity in monopolistic competition is most directly a consequence of which of the following?
- The firm facing a perfectly elastic demand curve
- The firm facing a downward-sloping demand curve due to product differentiation
- The complete absence of fixed costs in the long run
- Government regulation setting price equal to average total cost
Correct answer: The firm facing a downward-sloping demand curve due to product differentiation
Excess capacity results most directly from the firm facing a downward-sloping demand curve due to product differentiation. That slope causes the long-run zero-profit output to fall short of the minimum-average-cost quantity. A perfectly elastic demand curve, as in perfect competition, would instead lead the firm to produce at minimum average total cost with no excess capacity.
- Barriers to entry are best defined as which of the following?
- Factors that make it difficult for new firms to enter a market
- Costs that all firms must pay each time they produce a unit
- Government taxes imposed on consumers of a good
- The minimum price a firm must charge to break even
Correct answer: Factors that make it difficult for new firms to enter a market
Barriers to entry are factors that make it difficult for new firms to enter a market, such as patents, large startup costs, control of resources, or government licensing. By limiting competition, they allow existing monopolies and oligopolies to sustain economic profit in the long run. They concern entry difficulty, not per-unit production costs or taxes on consumers.
- Why can a monopoly sustain positive economic profit in the long run while a monopolistically competitive firm cannot?
- The monopoly faces a horizontal demand curve
- The monopoly is protected by significant barriers to entry that block new competitors
- The monopoly always produces at minimum average total cost
- The monopoly charges a price equal to marginal cost
Correct answer: The monopoly is protected by significant barriers to entry that block new competitors
A monopoly can sustain long-run economic profit because it is protected by significant barriers to entry that block new competitors from eroding its profits. In monopolistic competition, by contrast, easy entry attracts rivals whenever profits appear, driving long-run profit to zero. The difference in long-run outcomes traces directly to the presence or absence of entry barriers.
- A monopoly produces at the output where marginal revenue equals marginal cost, then sets price using which curve?
- The marginal cost curve at that output
- The marginal revenue curve at that output
- The demand curve at that output
- The average variable cost curve at that output
Correct answer: The demand curve at that output
A monopoly sets its price using the demand curve at the profit-maximizing output, charging the highest price consumers are willing to pay for that quantity. It finds the quantity where marginal revenue equals marginal cost, then reads the price off the demand curve directly above that quantity. Because demand lies above marginal revenue, the price exceeds marginal revenue and marginal cost.
- Consider a single-time pricing game between two firms in which both would earn higher profits if they jointly charged high prices, yet each has a dominant strategy to charge a low price. What outcome does game theory predict?
- Both firms charge high prices and reach the cooperative outcome
- Both firms charge low prices, ending in an outcome worse for both than cooperation
- One firm exits the market entirely
- The firms achieve allocative efficiency by setting price equal to marginal cost
Correct answer: Both firms charge low prices, ending in an outcome worse for both than cooperation
Game theory predicts both firms charge low prices, reaching a Nash equilibrium that is worse for both than cooperation would have been. Since charging low is each firm's dominant strategy, both choose it even though joint high pricing would yield greater combined profit. This prisoner's-dilemma logic explains why collusion is hard to sustain without enforcement.
- A factor market is best described as a market in which which of the following is bought and sold?
- Finished consumer goods purchased by households
- Resources such as labor, land, and capital used to produce goods and services
- Government bonds issued to finance public spending
- Imported products traded between two nations
Correct answer: Resources such as labor, land, and capital used to produce goods and services
A factor market is one where resources such as labor, land, and capital are bought and sold. Factor markets are distinct from product markets, in which finished consumer goods are exchanged; in factor markets, firms are the buyers and households are the sellers of the productive inputs used to make output.
- In a factor market for labor, which of the following parties is typically the buyer and which is the seller?
- Households are the buyers of labor and firms are the sellers of labor
- The government is the buyer of labor and firms are the sellers of labor
- Firms are the buyers of labor and households are the sellers of labor
- Firms are both the buyers and the sellers of labor
Correct answer: Firms are the buyers of labor and households are the sellers of labor
In a factor market, firms are the buyers of labor and households are the sellers of labor. This reverses the roles found in product markets, where firms sell goods and households buy them. Households supply their labor to firms, which demand that labor as an input to production.
- The demand for labor is described as a derived demand because it depends primarily on which of the following?
- The number of workers willing to accept a given wage
- The wages paid in unrelated industries
- The personal preferences of individual workers
- The demand for the goods and services that the labor helps to produce
Correct answer: The demand for the goods and services that the labor helps to produce
Labor demand is a derived demand because it depends on the demand for the goods and services the labor helps produce. Firms hire workers not for the workers' sake but to make products that consumers want, so when product demand rises or falls, the demand for the labor used to make that product moves in the same direction.
- Consumer demand for electric vehicles increases sharply, raising the price automakers can charge for them. Holding other factors constant, what is the most likely effect on the labor market for autoworkers who build electric vehicles?
- The demand for these autoworkers increases because labor demand is derived from product demand
- The demand for these autoworkers decreases because higher prices reduce hiring
- The supply of these autoworkers increases immediately
- There is no effect, since labor markets are independent of product markets
Correct answer: The demand for these autoworkers increases because labor demand is derived from product demand
The demand for the autoworkers increases because labor demand is derived from product demand. When consumers demand more electric vehicles and the product price rises, each worker becomes more valuable to the firm, raising the marginal revenue product of labor and shifting the demand for that labor to the right.
- The marginal revenue product (MRP) of a resource is calculated as which of the following?
- The total output divided by the number of resource units employed
- The marginal product of the resource multiplied by the marginal revenue (or product price) of the output
- The marginal product of the resource divided by its price
- The change in total cost divided by the change in output
Correct answer: The marginal product of the resource multiplied by the marginal revenue (or product price) of the output
Marginal revenue product equals the marginal product of the resource multiplied by the marginal revenue (which equals price in a perfectly competitive product market). MRP measures the additional revenue a firm earns from employing one more unit of a resource, and it represents the firm's demand curve for that resource.
- A worker's marginal product is 6 units of output, and each unit sells for $5 in a perfectly competitive product market. What is the marginal revenue product of that worker?
Correct answer: $30
The marginal revenue product is $30, found by multiplying the marginal product of 6 units by the 5-dollar product price. In a perfectly competitive product market, marginal revenue equals price, so 6×5=30, or $30, the maximum the firm would pay to hire that worker.
- A profit-maximizing firm hiring in a competitive labor market should continue hiring additional workers until which of the following condition is reached?
- The marginal revenue product of labor equals the marginal product of labor
- The marginal product of labor is maximized
- Total revenue equals total cost
- The marginal revenue product of labor equals the marginal factor cost (the wage)
Correct answer: The marginal revenue product of labor equals the marginal factor cost (the wage)
The firm hires until the marginal revenue product of labor equals the marginal factor cost. As long as an additional worker adds more to revenue (MRP) than to cost (MFC, the wage in a competitive labor market), hiring that worker raises profit; the firm stops where the two are equal.
- Marginal factor cost (MFC) is best defined as which of the following?
- The additional revenue a firm earns by selling one more unit of output
- The additional cost a firm incurs by hiring one more unit of a resource
- The total cost of all resources divided by output
- The cost of the fixed resources a firm uses in the short run
Correct answer: The additional cost a firm incurs by hiring one more unit of a resource
Marginal factor cost is the additional cost of hiring one more unit of a resource. It is the resource-market counterpart to marginal cost in the product market; firms compare MFC to the marginal revenue product when deciding how many units of a resource to employ.
- In a perfectly competitive labor market, why is a firm's marginal factor cost equal to the market wage rate?
- The firm must raise the wage for every worker each time it hires one more
- The firm sets the wage to maximize the surplus of its workers
- The firm is a wage taker and can hire any quantity of labor at the going wage without raising it
- The marginal product of labor is constant across all workers
Correct answer: The firm is a wage taker and can hire any quantity of labor at the going wage without raising it
In a perfectly competitive labor market the firm is a wage taker, so it can hire any quantity at the market wage without bidding the wage up. Because each additional worker costs exactly the going wage, the marginal factor cost equals that wage and the labor supply curve facing the firm is horizontal.
- A monopsony is best described as a market structure in which there is which of the following?
- A single seller of a particular product
- Many buyers and many sellers of a resource
- Two dominant firms that collude on resource prices
- A single buyer of a particular resource
Correct answer: A single buyer of a particular resource
A monopsony is a market with a single buyer of a resource. It is the buyer-side counterpart to a monopoly, which has a single seller. A classic example is a single large employer that is the only major purchaser of labor in an isolated town.
- Compared with a perfectly competitive labor market, an unregulated monopsonist employing labor will typically do which of the following?
- Pay a lower wage and hire fewer workers
- Pay a higher wage and hire more workers
- Pay the competitive wage but hire more workers
- Pay a lower wage but hire the same number of workers
Correct answer: Pay a lower wage and hire fewer workers
An unregulated monopsonist pays a lower wage and hires fewer workers than a competitive market. Because the monopsonist must raise the wage for all workers to attract one more, its marginal factor cost exceeds the wage; it hires where MRP equals that higher MFC, restricting employment and pushing the wage below the competitive level.
- For a monopsonist hiring labor, why does the marginal factor cost of labor exceed the wage paid to each worker?
- Because it can hire all workers it wants at the going market wage
- To attract one more worker it must raise the wage paid to all workers it already employs
- Because the marginal product of labor is rising
- Because the product it sells faces perfectly elastic demand
Correct answer: To attract one more worker it must raise the wage paid to all workers it already employs
The monopsonist's marginal factor cost exceeds the wage because to hire one more worker it must raise the wage paid to every worker. The cost of an additional worker therefore includes both that worker's wage and the higher wages now paid to all previously hired workers, making MFC greater than the wage at every employment level.
- According to the least-cost rule, a firm minimizes the cost of producing a given level of output when its input mix satisfies which of the following conditions?
- The total cost of labor equals the total cost of capital
- The marginal product of each input is equal to its price
- The same number of units of each input is employed
- The marginal product per dollar spent is equal across all inputs
Correct answer: The marginal product per dollar spent is equal across all inputs
The least-cost rule is satisfied when the marginal product per dollar is equal across all inputs, meaning MP of labor divided by the price of labor equals MP of capital divided by the price of capital. If one input yields more output per dollar, the firm can lower cost by shifting spending toward it until the ratios are equal.
- A firm finds that the marginal product per dollar spent on labor is greater than the marginal product per dollar spent on capital. To lower the cost of producing its current output, the firm should do which of the following?
- Use more capital and less labor until the marginal products per dollar are equal
- Use more labor and less capital until the marginal products per dollar are equal
- Use equal amounts of labor and capital
- Keep the input mix unchanged because cost is already minimized
Correct answer: Use more labor and less capital until the marginal products per dollar are equal
The firm should use more labor and less capital. When labor delivers more output per dollar than capital, reallocating spending toward labor increases output per dollar spent and lowers the cost of the given output; the firm keeps substituting until the marginal product per dollar is equalized across the two inputs, satisfying the least-cost rule.
- A perfectly competitive firm's marginal revenue product curve for labor slopes downward primarily because of which of the following?
- The product price falls as the firm hires more workers
- The wage rate rises as the firm hires more workers
- The law of diminishing marginal returns lowers each additional worker's marginal product
- Workers become less willing to supply labor at higher employment
Correct answer: The law of diminishing marginal returns lowers each additional worker's marginal product
The MRP curve slopes downward because of diminishing marginal returns, which reduce each additional worker's marginal product. For a competitive firm the product price is constant, so the only reason additional workers add less revenue is that they add less output; MRP equals marginal product times price, and the falling marginal product drives MRP down.
- A government imposes a minimum wage set above the wage a monopsonist would otherwise pay but below the competitive wage. Which outcome does the factor-market model predict?
- Employment must fall sharply as it would in a competitive labor market
- The wage rises but employment necessarily falls below the monopsony level
- Neither the wage nor employment changes
- Both the wage and the level of employment can rise toward the competitive outcome
Correct answer: Both the wage and the level of employment can rise toward the competitive outcome
Both the wage and employment can rise toward the competitive outcome. Unlike a competitive market, where a binding minimum wage reduces employment, a well-set minimum wage in a monopsony fixes the marginal factor cost at the legal wage over a range, allowing the firm to hire more workers while paying more, moving the market closer to the competitive result.
- In economics, the term market failure refers to which of the following situations?
- A market in which a single firm earns short-run economic losses and exits
- A situation in which the free market, left on its own, allocates resources inefficiently
- Any market in which the equilibrium price rises faster than consumer incomes
- A market that temporarily experiences a shortage before adjusting to equilibrium
Correct answer: A situation in which the free market, left on its own, allocates resources inefficiently
Market failure is best described as a situation in which the free market, on its own, allocates resources inefficiently. It occurs when an unregulated market does not produce the socially optimal quantity, as with externalities or public goods, creating a role for government to improve the outcome. Short-run losses, rising prices, or temporary shortages are normal market adjustments, not failures of allocation.
- A factory dumps waste into a river, imposing cleanup costs on downstream residents who are not part of the transaction. This spillover effect is an example of which of the following?
- A negative externality, because a cost is imposed on third parties
- A positive externality, because production benefits society overall
- A public good, because the river is shared by everyone
- The free-rider problem, because residents do not pay the factory
Correct answer: A negative externality, because a cost is imposed on third parties
This scenario illustrates a negative externality, because a cost of production is imposed on third parties who are not part of the market transaction. The factory considers only its private costs, so it overproduces relative to the socially optimal quantity. It is not a positive externality (that involves spillover benefits), nor a public good or free-rider problem, which concern non-excludable shared goods.
- When a good generates a negative externality in production, how does the market outcome compare to the socially optimal outcome?
- The market produces too little, and the price is too high
- The market produces the efficient quantity but at the wrong price
- The market produces too much, because marginal social cost exceeds marginal private cost
- The market produces too much, because marginal social benefit exceeds marginal social cost
Correct answer: The market produces too much, because marginal social cost exceeds marginal private cost
With a negative production externality the market produces too much, because marginal social cost exceeds marginal private cost. Producers ignore the spillover costs borne by others, so they expand output past the point where marginal social cost equals marginal social benefit, creating deadweight loss. The correction is to reduce output toward the socially optimal level, not to expand it.
- A homeowner pays to renovate the exterior of her house, which raises the property values of neighboring homes whose owners pay nothing. This situation is an example of which of the following?
- A negative externality requiring a corrective tax
- A positive externality, in which a spillover benefit reaches third parties
- A public good, because the neighborhood appearance is non-rival
- Allocative efficiency, because everyone benefits from the renovation
Correct answer: A positive externality, in which a spillover benefit reaches third parties
This is a positive externality, in which a spillover benefit reaches third parties who did not pay for it. Because the homeowner captures only her private benefit and ignores the gains to neighbors, the activity is underprovided relative to the socially optimal level. A subsidy, not a corrective tax, would encourage more of this beneficial activity.
- To move a market with a positive externality toward the socially optimal quantity, a government would most appropriately use which of the following policies?
- Impose a per-unit tax equal to the external benefit
- Set a binding price ceiling below equilibrium
- Provide a per-unit subsidy equal to the marginal external benefit
- Ban production until the externality is eliminated
Correct answer: Provide a per-unit subsidy equal to the marginal external benefit
The appropriate policy is a per-unit subsidy equal to the marginal external benefit. Because a positive externality causes underproduction, a subsidy lowers the effective cost to producers or consumers and increases output toward the level where marginal social benefit equals marginal social cost. A tax would worsen the shortfall, and a ceiling or ban does not address underprovision.
- A pure public good is defined by which two key characteristics?
- It is rival in consumption and excludable
- It is non-rival in consumption and non-excludable
- It is produced only by private firms seeking profit
- It is always provided free of charge by the government
Correct answer: It is non-rival in consumption and non-excludable
A pure public good is non-rival in consumption and non-excludable. Non-rival means one person's use does not reduce the amount available to others, and non-excludable means people cannot be prevented from consuming it even if they do not pay, as with national defense. These traits, not who produces it or whether it is free, are what define a public good.
- Why do private markets tend to underprovide public goods such as national defense?
- Because public goods are too cheap for firms to bother producing
- Because consumers value public goods less than private goods
- Because non-excludability allows people to consume the good without paying for it
- Because public goods generate negative externalities that deter producers
Correct answer: Because non-excludability allows people to consume the good without paying for it
Private markets underprovide public goods because non-excludability allows people to consume the good without paying for it. Since producers cannot withhold the good from non-payers, they cannot capture enough revenue to cover costs, so too little is produced. This stems from the goods' defining traits, not from low consumer valuation or any negative externality.
- The free-rider problem arises primarily because a public good has which characteristic?
- Rivalry, so consumption by one person depletes the supply for others
- High marginal cost, so each additional unit is expensive to produce
- Inelastic demand, so consumers keep buying as the price rises
- Non-excludability, so individuals can benefit without contributing
Correct answer: Non-excludability, so individuals can benefit without contributing
The free-rider problem arises chiefly from non-excludability, which lets individuals benefit from a good without contributing to its cost. Because people cannot be excluded for not paying, each person has an incentive to let others fund the good, leading to underfunding. Rivalry, marginal cost, and demand elasticity are not the source of free riding.
- A government imposes a per-unit tax on a polluting firm set equal to the marginal external cost of its production. This corrective tax is best known as which of the following?
- A lump-sum tax
- A Pigouvian tax
- A regressive excise tax
- A tariff on the good
Correct answer: A Pigouvian tax
A tax set equal to the marginal external cost of a polluting activity is a Pigouvian tax. By forcing the firm to internalize the spillover cost, it raises private marginal cost up to marginal social cost and reduces output toward the socially optimal level. It differs from a lump-sum tax, a general excise tax, or a tariff, none of which is designed to match the external cost.
- A Pigouvian tax improves efficiency in a market with a negative externality mainly by accomplishing which of the following?
- Eliminating all production of the good
- Internalizing the externality so private cost reflects social cost
- Redistributing income from producers to consumers
- Guaranteeing producers a minimum price for their output
Correct answer: Internalizing the externality so private cost reflects social cost
A Pigouvian tax improves efficiency by internalizing the externality, so that the firm's private marginal cost reflects the full marginal social cost. Once decision-makers face the true cost of the spillover, they cut output back to the socially optimal quantity, shrinking the deadweight loss. The goal is efficient output, not zero production or income redistribution.
- According to the Coase theorem, an externality can be resolved efficiently through private bargaining when which conditions are met?
- Property rights are clearly defined and transaction costs are low
- The government imposes a corrective tax on the polluter
- The good is non-rival and non-excludable
- The number of affected parties is extremely large
Correct answer: Property rights are clearly defined and transaction costs are low
The Coase theorem holds that private bargaining can resolve an externality efficiently when property rights are clearly defined and transaction costs are low. Under those conditions, the affected parties can negotiate to the efficient outcome regardless of who initially holds the rights, without government intervention. High transaction costs or large numbers of parties, by contrast, tend to block such bargaining.
- On a Lorenz curve diagram, what does the straight 45-degree diagonal line of perfect equality represent?
- A situation in which the richest household owns all of the income
- A situation in which each percentage of the population earns the same percentage of total income
- The point at which the Gini coefficient equals one
- The total revenue collected from a progressive income tax
Correct answer: A situation in which each percentage of the population earns the same percentage of total income
The 45-degree line on a Lorenz curve represents perfect equality, a situation in which each percentage of the population earns exactly that same percentage of total income. The farther the actual Lorenz curve bows away from this diagonal, the greater the income inequality. The line is not about a single household owning everything, nor does it depict tax revenue.
- A country's income distribution becomes more unequal over a decade. How would this change be reflected by its Lorenz curve and Gini coefficient?
- The Lorenz curve moves closer to the diagonal and the Gini coefficient falls
- The Lorenz curve bows farther from the diagonal and the Gini coefficient rises
- Both the Lorenz curve and the Gini coefficient remain unchanged
- The Lorenz curve shifts upward and the Gini coefficient becomes negative
Correct answer: The Lorenz curve bows farther from the diagonal and the Gini coefficient rises
Greater inequality is shown by a Lorenz curve that bows farther from the diagonal and a Gini coefficient that rises. The larger gap between the curve and the line of perfect equality means a larger area between them, which increases the Gini coefficient toward one. Movement toward the diagonal or a falling coefficient would instead signal reduced inequality.
- The Gini coefficient is a numerical measure of income inequality whose value ranges between which of the following?
- 0 and 1, where 0 indicates perfect equality and 1 indicates perfect inequality
- 0 and 100, where higher numbers always indicate higher average income
- Negative 1 and positive 1, where 0 indicates a balanced budget
- 1 and 10, where 1 indicates the highest possible inequality
Correct answer: 0 and 1, where 0 indicates perfect equality and 1 indicates perfect inequality
The Gini coefficient ranges between 0 and 1, where 0 indicates perfect equality and 1 indicates perfect inequality. It is derived from the Lorenz curve as the ratio of the area between the curve and the line of equality to the total area beneath that line. The measure tracks distribution, not average income or budget balance, and it is never negative.
- A firm's production function shows the relationship between which two of the following?
- The quantity of inputs used and the maximum output that can be produced
- The price of output and the total revenue the firm earns
- The market demand curve and the firm's marginal revenue
- The level of fixed cost and the level of variable cost
Correct answer: The quantity of inputs used and the maximum output that can be produced
The production function relates the quantity of inputs used and the maximum output that can be produced from those inputs. It is a technological relationship, not a cost or revenue relationship. Prices, revenue, and cost concepts are layered on top of the production function later in the analysis.
- In which range of output is a variable input said to exhibit increasing marginal returns?
- When each additional unit of the variable input adds less to total product than the previous unit
- When each additional unit of the variable input adds more to total product than the previous unit
- When total product is falling as more input is added
- When average fixed cost equals average variable cost
Correct answer: When each additional unit of the variable input adds more to total product than the previous unit
Increasing marginal returns occur when each additional unit of the variable input adds more to total product than the previous unit, so marginal product is rising. Diminishing returns describe falling marginal product, and negative returns describe falling total product. Increasing returns typically appear at low output levels before diminishing returns set in.
- Average product of labor is calculated by which of the following methods?
- The change in total product divided by the change in labor
- Total cost divided by total product
- Total product divided by the number of units of labor
- Total revenue divided by the quantity of output sold
Correct answer: Total product divided by the number of units of labor
Average product of labor equals total product divided by the number of units of labor employed. The change in total product divided by the change in labor defines marginal product, not average product. The other options describe average total cost and average revenue rather than a productivity measure.
- When marginal product of labor is greater than average product of labor, the average product is doing which of the following?
- Falling
- Remaining constant at its minimum
- Equal to zero
- Rising
Correct answer: Rising
Average product is rising whenever marginal product is greater than average product, because each additional worker contributes more than the existing average and pulls that average up. When marginal product is below average product, the average falls. The marginal product curve crosses the average product curve at the maximum of average product.
- A firm hires labor and capital. In the short run, which statement about its inputs is correct?
- At least one input is fixed and cannot be varied
- All inputs can be freely varied in quantity
- Output cannot change at all
- Marginal cost is always constant
Correct answer: At least one input is fixed and cannot be varied
In the short run at least one input is fixed and cannot be varied, which is the defining feature that distinguishes the short run from the long run. In the long run all inputs become variable. Output can still change in the short run by adjusting the variable input, and marginal cost generally varies with output.
- Which of the following best describes the long run in production theory?
- Any period longer than one calendar year
- A planning period long enough that all inputs are variable
- A period in which only labor can be adjusted
- A period in which fixed costs are zero
Correct answer: A planning period long enough that all inputs are variable
The long run is a planning period long enough that all inputs are variable, so the firm can adjust its plant size and every factor of production. It is defined by flexibility of inputs, not by a fixed amount of calendar time. In the long run there are no fixed costs because every input can be changed.
- Total fixed cost as output increases in the short run behaves in which of the following ways?
- It rises in direct proportion to output
- It falls as more units are produced
- It remains constant regardless of the quantity produced
- It first rises and then falls
Correct answer: It remains constant regardless of the quantity produced
Total fixed cost remains constant regardless of the quantity produced because, by definition, fixed costs do not change with output in the short run. It is average fixed cost, not total fixed cost, that falls as output rises. Total variable cost is the component that increases with output.
- Average fixed cost as a firm increases its output does which of the following?
- Stays constant at all output levels
- Increases steadily with each additional unit
- First falls and then rises in a U-shape
- Continuously declines, approaching but never reaching zero
Correct answer: Continuously declines, approaching but never reaching zero
Average fixed cost continuously declines, approaching but never reaching zero, because a constant total fixed cost is spread over an ever larger number of units. This spreading effect is why average fixed cost never turns upward. The U-shape applies to average total cost and average variable cost, not average fixed cost.
- Total cost in the short run is equal to which of the following?
- Total fixed cost plus total variable cost
- Total revenue minus total profit
- Marginal cost multiplied by average total cost
- Average variable cost divided by output
Correct answer: Total fixed cost plus total variable cost
Total cost equals total fixed cost plus total variable cost, the two components into which short-run costs are divided. Total revenue minus profit equals total cost only as an accounting identity but is not the standard definition. The remaining options combine cost concepts incorrectly.
- A firm produces 50 units at a total cost of $800, of which $300 is fixed cost. Its average variable cost at this output is which of the following?
Correct answer: $10
The average variable cost is $10. Total variable cost equals total cost of 800 minus fixed cost of 300, which is $500, and dividing 500 by the 50 units produced gives $10 per unit. The figure of $16 would be average total cost, and $6 would be average fixed cost.
- The vertical distance between the average total cost curve and the average variable cost curve at any output represents which of the following?
- Marginal cost
- Total variable cost
- Average fixed cost
- Economic profit per unit
Correct answer: Average fixed cost
The vertical distance between average total cost and average variable cost equals average fixed cost, because average total cost is the sum of average fixed cost and average variable cost. Since average fixed cost shrinks as output grows, the two curves converge at higher output. Marginal cost and profit are unrelated to this particular gap.
- When marginal cost is below average total cost, average total cost is doing which of the following?
- Rising
- At its maximum point
- Equal to average fixed cost
- Falling
Correct answer: Falling
Average total cost is falling whenever marginal cost is below average total cost, because producing an additional unit at a cost lower than the current average pulls the average down. When marginal cost exceeds average total cost, the average rises. The marginal cost curve crosses average total cost at the latter's minimum.
- The marginal cost curve intersects the average total cost curve at which point?
- The minimum point of the average total cost curve
- The maximum point of the average total cost curve
- The point where average fixed cost is highest
- The point where total fixed cost equals total variable cost
Correct answer: The minimum point of the average total cost curve
The marginal cost curve intersects the average total cost curve at the minimum point of average total cost. To the left of that point marginal cost lies below the average and the average falls, and to the right marginal cost lies above the average and it rises. This same logic explains why marginal cost crosses average variable cost at its minimum.
- Diseconomies of scale in the long run are most commonly attributed to which of the following?
- The law of diminishing marginal returns to a fixed input
- Difficulties in managing and coordinating a very large firm
- A constant total fixed cost being spread over more units
- Marginal revenue exceeding marginal cost
Correct answer: Difficulties in managing and coordinating a very large firm
Diseconomies of scale are most commonly attributed to difficulties in managing and coordinating a very large firm, such as communication breakdowns and bureaucracy that raise long-run average total cost. The law of diminishing returns is a short-run concept tied to a fixed input, not a long-run scale issue. Spreading fixed cost and revenue comparisons are unrelated.
- Constant returns to scale exist in the long run when which of the following is true?
- Long-run average total cost falls as output increases
- Long-run average total cost rises as output increases
- Long-run average total cost stays the same as output increases
- Total fixed cost equals total variable cost
Correct answer: Long-run average total cost stays the same as output increases
Constant returns to scale exist when long-run average total cost stays the same as output increases, meaning the firm gains no cost advantage or disadvantage from expanding. Falling long-run average cost reflects economies of scale, and rising long-run average cost reflects diseconomies of scale. The cost-component comparison is not relevant to returns to scale.
- The long-run average total cost curve is best described as which of the following?
- The sum of all short-run marginal cost curves
- A horizontal line at the level of fixed cost
- The portion of the marginal cost curve above average variable cost
- An envelope curve tracing the lowest cost of producing each output across all possible plant sizes
Correct answer: An envelope curve tracing the lowest cost of producing each output across all possible plant sizes
The long-run average total cost curve is an envelope curve tracing the lowest cost of producing each output across all possible plant sizes. Because plant size is variable in the long run, the firm can always choose the most efficient scale for each output level. It is not a simple sum of marginal cost curves nor a flat fixed-cost line.
- In a perfectly competitive market, the demand curve facing an individual firm is which of the following?
- Horizontal at the market price
- Downward sloping like the market demand curve
- Upward sloping at higher quantities
- Vertical at the firm's capacity
Correct answer: Horizontal at the market price
The demand curve facing an individual perfectly competitive firm is horizontal at the market price, reflecting that the firm can sell any quantity at that price but nothing above it. The downward-sloping curve describes the market as a whole, not the single price-taking firm. The firm's horizontal demand is also its marginal revenue curve.
- The total revenue of a perfectly competitive firm increases in which way as it sells more output?
- At an increasing rate as quantity rises
- At a constant rate equal to the market price per unit
- At a decreasing rate because price must be cut
- It eventually declines as more is sold
Correct answer: At a constant rate equal to the market price per unit
Total revenue for a perfectly competitive firm increases at a constant rate equal to the market price per unit, because the firm sells every unit at the same fixed price. Revenue does not slow or fall, since the firm faces no need to lower price to sell more. This constant slope is why marginal revenue equals price for such a firm.
- A perfectly competitive firm produces where price exceeds average variable cost but is below average total cost. In the short run, this firm should do which of the following?
- Shut down immediately to avoid any loss
- Raise its price above the market price
- Continue producing because it covers all variable cost and part of fixed cost
- Increase output until price equals average fixed cost
Correct answer: Continue producing because it covers all variable cost and part of fixed cost
The firm should continue producing because price covers all variable cost and part of fixed cost, which makes its loss smaller than the loss from shutting down and paying full fixed cost. Shutting down is justified only when price falls below average variable cost. A price taker cannot set its own price, ruling out raising it.
- When a perfectly competitive firm is producing at a quantity where marginal cost exceeds marginal revenue, it can increase profit by doing which of the following?
- Increasing output until total cost equals total revenue
- Raising the market price
- Holding output exactly where it is
- Decreasing output until marginal revenue equals marginal cost
Correct answer: Decreasing output until marginal revenue equals marginal cost
The firm can increase profit by decreasing output until marginal revenue equals marginal cost, because the last units cost more to produce than they add in revenue. Cutting those loss-adding units reduces total cost more than revenue. Profit is maximized at the quantity where marginal revenue equals marginal cost.
- A perfectly competitive firm's short-run supply curve is which of the following?
- The portion of its marginal cost curve at or above the minimum of average variable cost
- Its entire average total cost curve
- The horizontal demand curve it faces
- The portion of its marginal cost curve below average variable cost
Correct answer: The portion of its marginal cost curve at or above the minimum of average variable cost
The firm's short-run supply curve is the portion of its marginal cost curve at or above the minimum of average variable cost, since the firm produces along marginal cost only when price covers variable cost. Below that point the firm shuts down and supplies zero. The average total cost curve and the demand curve are not supply curves.
- In the long run, if firms in a perfectly competitive industry are earning positive economic profit, what is expected to happen?
- Existing firms exit, reducing market supply and raising price
- New firms enter, market supply rises, and price falls toward minimum average total cost
- Price remains permanently above average total cost
- The market demand curve shifts rightward
Correct answer: New firms enter, market supply rises, and price falls toward minimum average total cost
New firms enter, market supply rises, and price falls toward minimum average total cost, eliminating the positive economic profit. Entry is possible because perfectly competitive industries have no barriers. Exit occurs only when firms suffer losses, and positive profit cannot persist in long-run equilibrium.
- If firms in a perfectly competitive industry are suffering economic losses, the long-run adjustment process involves which of the following?
- Firms enter the industry, increasing market supply
- The market price falls further below average total cost
- Firms exit the industry, market supply falls, and price rises until losses are eliminated
- Each firm raises its individual price to cover costs
Correct answer: Firms exit the industry, market supply falls, and price rises until losses are eliminated
Firms exit the industry, market supply falls, and price rises until losses are eliminated and remaining firms earn zero economic profit. Exit shrinks supply and pushes the market price upward. Price takers cannot individually raise price, and entry would only deepen the losses.
- A perfectly competitive firm in long-run equilibrium produces where price equals which of the following?
- Average fixed cost only
- Marginal revenue, which lies above average total cost
- The maximum of average variable cost
- Marginal cost, which also equals the minimum of average total cost
Correct answer: Marginal cost, which also equals the minimum of average total cost
In long-run equilibrium the firm produces where price equals marginal cost, which also equals the minimum of average total cost, so it earns zero economic profit and operates at productive efficiency. Because price equals marginal cost, the market is also allocatively efficient. Profit-maximizing price cannot stay above average total cost in the long run.
- Productive efficiency in a perfectly competitive market is achieved because firms produce at which of the following?
- The lowest possible average total cost per unit
- The output where marginal revenue is greatest
- The point where average fixed cost is highest
- An output where price exceeds marginal cost
Correct answer: The lowest possible average total cost per unit
Productive efficiency is achieved because firms produce at the lowest possible average total cost per unit, which occurs at the minimum of the average total cost curve in long-run equilibrium. This means society's resources produce goods at the least cost. Allocative efficiency, by contrast, is the condition that price equals marginal cost.
- A single-price monopolist maximizes profit by producing the quantity where which of the following conditions holds, and then setting price according to which curve?
- Produce where price equals marginal cost, then set price along the marginal cost curve
- Produce where marginal revenue equals marginal cost, then set price along the demand curve
- Produce where marginal revenue equals average total cost, then set price along the marginal revenue curve
- Produce where price equals average total cost, then set price along the average total cost curve
Correct answer: Produce where marginal revenue equals marginal cost, then set price along the demand curve
The profit-maximizing rule is to produce where marginal revenue equals marginal cost and then read the price up to the demand curve. A monopolist sets quantity at the MR = MC intersection because beyond that point each unit adds more to cost than to revenue. The price is found by going up from that quantity to the demand curve, which is always above marginal revenue for a monopolist.
- For a monopolist facing a downward-sloping demand curve, marginal revenue is positive over which portion of the demand curve?
- The elastic portion, where demand is price elastic
- The inelastic portion, where demand is price inelastic
- Only at the unit-elastic midpoint of the demand curve
- Over the entire length of the demand curve
Correct answer: The elastic portion, where demand is price elastic
Marginal revenue is positive over the elastic portion of the demand curve. When demand is elastic, lowering price increases total revenue, so the extra unit sold adds to revenue and MR is positive. On the inelastic portion MR is negative, and a profit-maximizing monopolist never produces there.
- The deadweight loss created by a single-price monopoly arises primarily because the monopoly does which of the following?
- Charges a price below marginal cost, causing overproduction
- Produces a quantity at which price exceeds marginal cost, leaving mutually beneficial trades unmade
- Earns positive economic profit in the long run
- Sets marginal revenue equal to marginal cost rather than to average total cost
Correct answer: Produces a quantity at which price exceeds marginal cost, leaving mutually beneficial trades unmade
Deadweight loss occurs because the monopoly produces a quantity where price exceeds marginal cost, so some units that consumers value above the cost of producing them are never made. Those forgone mutually beneficial trades represent lost total surplus. A perfectly competitive market would expand output until price equals marginal cost, eliminating that loss.
- Compared with a single-price monopoly, a perfectly price-discriminating monopolist that captures all consumer surplus will produce a level of output that is which of the following?
- Lower, because it restricts output to raise price
- The same, because it still maximizes profit at marginal revenue equals marginal cost
- Higher, equal to the allocatively efficient quantity where price equals marginal cost
- Indeterminate without knowing the exact demand curve
Correct answer: Higher, equal to the allocatively efficient quantity where price equals marginal cost
A perfectly price-discriminating monopolist produces the allocatively efficient quantity where price equals marginal cost, which is higher than the single-price monopoly output. Because it charges each buyer their maximum willingness to pay, its marginal revenue curve becomes the demand curve, so it expands output until demand meets marginal cost. There is no deadweight loss, though all surplus is captured by the firm.
- When a perfectly price-discriminating monopolist charges each consumer the maximum they are willing to pay, what happens to consumer surplus?
- Consumer surplus is entirely converted into producer surplus
- Consumer surplus increases relative to perfect competition
- Consumer surplus equals the deadweight loss of a single-price monopoly
- Consumer surplus remains unchanged from the single-price case
Correct answer: Consumer surplus is entirely converted into producer surplus
Under perfect price discrimination consumer surplus is entirely converted into producer surplus because each buyer pays exactly their willingness to pay. There is no gap between value and price for any consumer, so no surplus is left for buyers. The firm captures the entire area between the demand curve and the marginal cost curve.
- Senior-citizen and student discounts at a movie theater are an example of price discrimination that works because these groups typically have which characteristic?
- More inelastic demand, so they pay a higher price
- More elastic demand, so they are charged a lower price
- Identical demand elasticities, so the firm charges them the same price
- Higher incomes, so they can afford to pay more
Correct answer: More elastic demand, so they are charged a lower price
Discounts target groups with more elastic demand, so they are charged a lower price. Students and seniors are generally more price-sensitive, meaning a high price would cause many of them to skip the movie. By segmenting buyers and charging the more elastic group less, the firm sells more tickets and raises total profit.
- For a natural monopoly, requiring the firm to set price equal to marginal cost (the socially optimal price) would most likely cause which problem?
- The firm would earn excessive economic profit
- The firm would incur an economic loss because price would be below average total cost
- The firm would produce far less than the competitive quantity
- Marginal cost would exceed marginal revenue at every output level
Correct answer: The firm would incur an economic loss because price would be below average total cost
Marginal-cost pricing causes a natural monopoly to incur an economic loss because its average total cost is still falling and lies above marginal cost at the relevant output. Setting price at marginal cost therefore puts price below average total cost, so each unit is sold at a loss. This is why regulators often use fair-return (average-cost) pricing instead or provide a subsidy.
- A natural monopoly is characterized by which feature of its long-run average total cost curve over the relevant range of market demand?
- Average total cost is rising due to diseconomies of scale
- Average total cost is constant at all output levels
- Average total cost is declining due to large economies of scale
- Average total cost equals marginal cost at every quantity
Correct answer: Average total cost is declining due to large economies of scale
A natural monopoly has a declining average total cost curve over the relevant range because of large economies of scale, often from high fixed costs. This means one large firm can supply the entire market at a lower cost per unit than two or more firms could. The falling-cost condition is what makes a single producer the most efficient outcome.
- In short-run equilibrium, a monopolistically competitive firm earning positive economic profit produces where marginal revenue equals marginal cost and sets a price that is in which relationship to average total cost?
- Price equals average total cost
- Price is below average total cost
- Price is above average total cost
- Price equals marginal cost
Correct answer: Price is above average total cost
When earning short-run economic profit, the firm's price lies above average total cost at the profit-maximizing quantity. The gap between price and average total cost multiplied by quantity equals the economic profit. Like a monopolist, the firm faces a downward-sloping demand curve and sets price above marginal revenue.
- What drives a monopolistically competitive market from short-run economic profits toward zero economic profit in the long run?
- Government regulation forcing price equal to marginal cost
- Entry of new firms, which shifts each existing firm's demand curve leftward
- Exit of firms, which shifts each remaining firm's demand curve rightward
- A binding price ceiling imposed by competitors
Correct answer: Entry of new firms, which shifts each existing firm's demand curve leftward
Entry of new firms drives long-run profits to zero by shifting each existing firm's demand curve leftward. Because there are no significant barriers to entry, positive profits attract new competitors who take away some demand from incumbents. Entry continues until the demand curve is just tangent to average total cost and economic profit is zero.
- In long-run equilibrium, a monopolistically competitive firm is productively inefficient because it produces at an output where which of the following is true?
- Price is below marginal cost
- Output is below the minimum point of average total cost
- Marginal revenue exceeds marginal cost
- Average total cost equals marginal cost
Correct answer: Output is below the minimum point of average total cost
The firm is productively inefficient because it produces below the minimum point of average total cost, which is the excess-capacity result. The downward-sloping demand curve is tangent to ATC on its falling portion, not at the lowest point. As a result the firm could lower its average cost by producing more, but doing so would reduce profit.
- Monopolistic competition fails to achieve allocative efficiency in long-run equilibrium because the firm sets a price that is in what relationship to marginal cost?
- Price equals marginal cost
- Price is below marginal cost
- Price is above marginal cost
- Price equals average revenue and marginal cost simultaneously
Correct answer: Price is above marginal cost
Allocative efficiency fails because price is above marginal cost at the firm's chosen output. Since the firm faces a downward-sloping demand curve, it sets price above marginal revenue, which equals marginal cost at the optimum. The gap between price and marginal cost means some valued units go unproduced, creating a small deadweight loss.
- A defining feature that distinguishes oligopoly from monopolistic competition is which of the following?
- Firms in oligopoly sell completely identical products only
- Oligopoly has a small number of interdependent firms whose decisions affect one another
- Oligopoly firms always earn zero economic profit in the long run
- Oligopoly markets have no barriers to entry
Correct answer: Oligopoly has a small number of interdependent firms whose decisions affect one another
Oligopoly is defined by a small number of interdependent firms whose decisions affect one another, unlike the many independent firms in monopolistic competition. Because each firm is large relative to the market, one firm's pricing or output choice influences its rivals' profits. This mutual interdependence is what makes strategic behavior and game theory central to analyzing oligopoly.
- In a payoff matrix for two firms, an outcome is a Nash equilibrium when which of the following holds?
- Both firms could increase their payoff by switching strategies together
- Neither firm can improve its own payoff by unilaterally changing its strategy
- The combined payoff of both firms is at its maximum possible value
- Each firm chooses the strategy with the lowest possible payoff for its rival
Correct answer: Neither firm can improve its own payoff by unilaterally changing its strategy
A Nash equilibrium occurs when neither firm can improve its own payoff by unilaterally changing its strategy, given the other's choice. Each player's strategy is a best response to the other's, so no one has an incentive to deviate alone. Notably, a Nash equilibrium need not maximize the firms' combined payoff, as the prisoner's dilemma illustrates.
- In the prisoner's dilemma applied to two colluding firms, why do both firms tend to cheat on a price-fixing agreement and end up with lower joint profit?
- Cheating is a dominant strategy for each firm regardless of what the other does
- Cooperating yields a higher individual payoff than cheating in every case
- Government subsidies reward firms that cut prices
- Both firms have inelastic demand, so price cuts always lower revenue
Correct answer: Cheating is a dominant strategy for each firm regardless of what the other does
Both firms cheat because cutting price (cheating) is a dominant strategy for each firm regardless of what the other does. Each firm reasons that undercutting the agreed price raises its own profit whether the rival cooperates or cheats. When both follow this logic they reach the non-cooperative outcome with lower joint profit, which is the Nash equilibrium of the game.
- A player in a simultaneous game has a dominant strategy when one strategy yields a higher payoff than the alternatives under which condition?
- Only when the other player chooses to cooperate
- No matter which strategy the other player chooses
- Only when both players coordinate in advance
- Only in a repeated game played many times
Correct answer: No matter which strategy the other player chooses
A dominant strategy yields a higher payoff no matter which strategy the other player chooses. Because it is always the best choice, a rational player will select it regardless of the rival's action. When both players have dominant strategies, the resulting cell is the game's Nash equilibrium.
- Two firms, X and Y, simultaneously choose Advertise or Don't advertise. If Advertise gives each firm a higher payoff than Don't advertise no matter what the rival does, the predicted outcome is which of the following?
- Both firms choose Don't advertise to save costs
- Both firms choose Advertise, the dominant-strategy equilibrium
- One firm advertises while the other does not, in alternating fashion
- The firms collude to avoid advertising entirely
Correct answer: Both firms choose Advertise, the dominant-strategy equilibrium
Both firms choose Advertise, the dominant-strategy equilibrium, because Advertise yields a higher payoff for each no matter what the rival does. Since neither can gain by unilaterally switching to Don't advertise, this is also the Nash equilibrium. Even if both would jointly prefer to avoid advertising costs, individual incentives push them to advertise.
- Collusion among oligopolists, such as forming a cartel to set a common price, is intended to allow the firms to do which of the following?
- Behave collectively like a single monopolist and raise joint profits
- Achieve allocative efficiency by setting price equal to marginal cost
- Eliminate all barriers to entry in the industry
- Guarantee that each firm earns zero economic profit
Correct answer: Behave collectively like a single monopolist and raise joint profits
Collusion lets oligopolists behave collectively like a single monopolist and raise joint profits. By agreeing to restrict output and charge the monopoly price, the cartel earns the higher profit a monopolist would. The arrangement is often unstable, however, because each member has an incentive to cheat by secretly expanding output.
- Barriers to entry such as patents, control of a key resource, or large economies of scale are important to monopoly because they allow the firm to do which of the following?
- Set price equal to marginal cost in the long run
- Sustain positive economic profit in the long run by blocking new competitors
- Eliminate the deadweight loss associated with monopoly
- Force marginal revenue to equal price at every output
Correct answer: Sustain positive economic profit in the long run by blocking new competitors
Barriers to entry allow a monopoly to sustain positive economic profit in the long run by blocking new competitors. Without entry, profits are not competed away as they are in monopolistic competition. Patents, exclusive resource control, and economies of scale are common sources of these barriers.
