Homework 14: Key

1.	(Frank, Ch.11) What is the difference between economic profit and accounting profit, and how does this difference matter for actual business decisions? Economic vs. accounting profit: Economic profit includes all costs, while accounting profits looks only at cash flows. The firm should consider economic profit only.

2.	Suppose a perfectly competitive firm's short-run total cost (TC) is given by TC = 200 + 4Q + 2Q² where Q = output. Suppose the price of the firm's product is $24.
	a.	How much should the firm produce in the short run to maximize its profits? MC = 4 + 4Q MR = P = 24 Profit max => MR = MC => 24 = 4 + 4Q => Q = 5
	b.	How large will the firm's short-run profits be? Profits = TR - TC; TR = 24 x 5 = 120; TC = 200 + 4(5) + 2(5)² = 270 Profits = 120 - 270 = -150.
	c.	Should the firm operate or shut down in the short run? How can you tell? Firm should operate in short run, since it will lose more (TFC=200) if it shuts down.

3.	Suppose you own a hotel at the ski resort of Mammoth Lakes. In the lefthand diagram below, industry demand is represented by Dw for winter, Dsp for spring, Dsu for summer and Df for fall. The righthand diagram depicts the unit costs per room rented for your hotel; these costs are the same year round.

	a.	In the righthand diagrams, use the labels Q1, Q2, Q3, and Q4 to indicate the number of rooms you will choose to rent out each season if you operate. Also indicate in the diagram the size of your profits/losses for each season if you operate, and indicate which seasons, if any, you would choose to shut down instead of operating. Mammoth Lakes (///=W profits; \\\=Sp losses; Fall operating losses = box outlined between ATC&Pf at Qf) Best to shut down in Fall and just lose TFC instead of the fall operating losses. Answer key checklist: (1) Did you show the correct profits boxes: base = Q chosen; height = (P-ATC) with ATC measured at the Q chosen? (2) Did you point out that you shut down in the Fall?
	b.	What would have to be true about the size of your profits for all four seasons combined in order for you to decide to remain in this industry in the long run? Would stay in industry if profits in winter exceed losses in summer and fall. Answer key checklist: Did you focus on the long run instead of the short run?

4.	a.	Indicate which point(s) in the diagram to the right correspond to each of the following:
		(1)	The onset of diminishing marginal returns: __9____
		(2)	The onset of diminishing average returns: __7____
		(3)	The firm's shutdown point: __7____
		(4)	The firm's long-run exit point: _6____
	b.	Consider the market price of P1. Indicate which point(s) in the diagram to the right correspond to each of the following:
		(1)	Where the firm breaks even (earns zero profits): __2,4____
		(2)	Where the firm maximizes its profits: __3____
	c.	Consider the market price of P2.
		(1)	Which production point is more profitable, point 10 or point 8? _8_____
		(2)	Shade in the difference in profits between point 10 and point 8. See the area shaded in green--the excess of MR over MC from 10 to 8 is the gain from the higher level of output.