Chapter 2: The Market System and the Circular Flow
Practice Problems
Problem 1: Least Cost Method
A firm can produce 100 units of good Y using three different methods, combining labor, land, capital, and entrepreneurial ability. Labor costs $3 per unit, land costs $2 per unit, capital costs $4 per unit, and entrepreneurial ability costs $10 per unit.
| Resource | Method 1 | Method 2 | Method 3 |
|---|---|---|---|
| Labor | 6 | 10 | 4 |
| Land | 5 | 2 | 8 |
| Capital | 2 | 3 | 2 |
| Entrepreneurial ability | 1 | 1 | 1 |
- Which method is the least costly way to produce 100 units of Y?
- If Y sells for 90 cents per unit, what is the firm’s economic profit using the least cost method?
- If the price of land rises from $2 to $4 per unit, does the least cost method change? What is the new economic profit?
Show Answer
Total cost of each method:
- Method 1: (6 × $3) + (5 × $2) + (2 × $4) + (1 × $10) = $18 + $10 + $8 + $10 = $46
- Method 2: (10 × $3) + (2 × $2) + (3 × $4) + (1 × $10) = $30 + $4 + $12 + $10 = $56
- Method 3: (4 × $3) + (8 × $2) + (2 × $4) + (1 × $10) = $12 + $16 + $8 + $10 = $46
- Methods 1 and 3 tie at $46, both cheaper than Method 2. Either is a valid least cost choice; assume the firm picks Method 1.
- Total revenue = 100 × $0.90 = $90. Economic profit = $90 minus $46 = $44.
- Recompute with land at $4 per unit: Method 1 = (6 × $3) + (5 × $4) + (2 × $4) + (1 × $10) = $18
- $20 + $8 + $10 = $56. Method 3 = (4 × $3) + (8 × $4) + (2 × $4) + (1 × $10) = $12 + $32 + $8 + $10 = $62. Method 2 = (10 × $3) + (2 × $4) + (3 × $4) + (1 × $10) = $30 + $8 + $12 + $10 = $60. Method 1 is now the cheapest at $56, so the least cost method does not change here, but its cost rose. New economic profit = $90 minus $56 = $34.
Problem 2: Self-Interest and Competition
A small town has exactly one hardware store. A national chain announces it is opening a second hardware store two blocks away next year.
- Before the new store arrives, what does the existing store’s self-interest push it to do about prices and service quality, given it has no local competitor?
- After the new store opens, how does competition change what self-interest pushes the existing store to do?
- Explain, in one or two sentences, why economists say it takes self-interest and competition together to benefit consumers, not self-interest alone.
Show Answer
- With no competitor, the existing store’s self-interest still points toward profit, but nothing forces that profit-seeking to benefit customers. It could charge higher prices or offer weaker service and customers would have nowhere else to go locally.
- Once a competitor opens nearby, self-interest now requires competing for the same customers. The store has an incentive to lower prices, improve service, or both, or risk losing business to the new entrant.
- Self-interest alone only guarantees a business tries to maximize its own gain. Competition is what forces that self-interest to serve customers, since a business that ignores customers loses them to a rival. Remove competition and the same self-interested motive can just as easily lead to worse outcomes for consumers.