competitive market in a busy city

Directions: Answer the following questions to the best of your ability. Assignments are open-book,
open-note, and you may work in groups of up to 3 students.
Problem 1: (30 points)
Consider a gas station in a competitive market in a busy city. The gas station has total costs
T C = q
2 + 50, average total costs AT C = q + 50/q, average variable costs AV C = q and marginal
costs MC = 2q, where q is the quantity of gas, in thousands of gallons.
a.) Suppose the price in the market is $2/gallon. If this gas station was to operate (i.e. set
q > 0), what quantity should it sell? How do you know? (Hint: recall the profit maximization rule
discussed in class.) (10 points)
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b.) In the short run, would the gas station be better off producing at the quantity you found in
part a.) or shutting down (i.e. setting q = 0)? How do you know? (10 points)
c.) In the long run, ceteris paribus, would the gas station be better off staying in the industry or
exiting the industry? How do you know? (10 points)
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Problem 2: (40 points)
a.) What is the difference between a fixed and variable cost? Provide an example of each that a
typical business might face. What can we say about all costs in the long run? Explain. (10 points)
b.) What is economic profit? How does it differ from accounting profit? Explain what it means
for a business to earn positive economic profit, negative economic profit, and zero economic profit,
and how this guides firm decision-making. (10 points)
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c.) “In the long-run, in a competitive market, firms will earn zero economic profit.” Explain why
an economist might say this. Which characteristic of competitive markets guarantees this result?
(10 points)
d.) Why is perfect competition thought by neoclassical economists to be a benchmark for markets? What would Israel Kirzner say about the state of competition when the perfect competition
assumptions hold? (10 points)