S. Klepper, Economics 73-100, Fall 2009

Solution to Mini-test 4

If wages rise by 20% and labor is the only variable cost of production, then total variable costs must rise by 20% at every level of output. This in turn implies that marginal and average variable costs rise by 20% at every level of output. Since fixed costs are not changed, average total cost rises by less than 20% at every level of output.

The (short-run) market supply curve is based on firm marginal cost curves. With marginal cost increasing by 20% at every level of output, the market supply curve must shift to the left, as pictured in the figure below, where S₀ and S₁ denote the supply curve before and after the increase in costs. The original price and output are denoted by p₀ and q₀. The new price, denoted by p₁, is equal to 1.2 times p₀. As the figure indicates, at the new price, the quantity supplied is q₀, the original output. The quantity supplied is the output where marginal cost equals price. At q₀, the marginal cost has increased by 20%. With price also rising by 20%, marginal cost equals the new price at q_0, so firms continue to supply their original output of q₀. In the short run, the break-even price at which it is profitable to supply a positive level of output equals the minimum average variable cost of production. With average variable cost rising by 20% at every level of output, the minimum value of the average variable cost must rise by 20% and thus the break-even price must rise by 20%. Since the price of milk increases by 20%, if a firm found it profitable to supply a positive level of milk before the cost and price increases then it will find it profitable to continue to supply a positive level of milk after the cost and price increase and thus will not shut down.

Based on this description, the answers to the individual questions are:

_____1. True

_____2. False

_____3. False

_____4. True

_____5. True