UNIVERSITY OF WASHINGTON

Department of Economics
Economics 200

Scott
Problem Set 4. Competitive Firm Behavior

Economic Profit:
1.

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

Suggested Answer:

Competition:
2.

See notes from lecture on Tuesday, February 9.

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

Economics 200
Problem Set 4

Scott

250

K*

L*

100

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

Explain.

b. What is the numerical value of the price of capital?

Explain.

$2

Economics 200
Problem Set 4

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

Scott

Economics 200
Problem Set 4

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

Wednesday, February 10.

Scott

Economics 200
Problem Set 4

Scott

6. LR and SR Costs, Isoquants and Isocosts. Draw the long-run average cost of a firm as the
envelope of a few short-run average cost schedules (see p. 143 of your text and your notes from
lecture). Talk through the intuition, using isoquant-isocost diagrams to illustrate your
reasoning.
See notes from Thursday, February 4.
7. Marginal Product of Labor, Marginal Revenue Product of Labor, and Labor Demand.
Using diagrams, explain the equivalence between the condition price equals marginal cost and
the condition wage equals marginal revenue product of labor in the short run. Refer to your
notes and to pages 182-183 in the text. Note that your text calls marginal revenue produce the
value of marginal product. How will an increase in the price of a good affect the demand for
labor used in the production of that good in the short-run?
See notes from Friday, February 5.