Question

1. The firm’s long run demand for an input is determined by the interaction of three effects, the substitution effect, the output effect, and the profit maximizing effect. Show graphically and explain the role of the profit maximizing effect.

2. Suppose that you have only two investment alternatives. One is an interest bearing asset such as a GIC, earning an annual rate of return r. The other is a gold bullion, the unit price of which is pt in year t. Write down the equilibrium condition which must hold if you are to keep some of both assets in your portfolio.

Answer 1

1) Graphical illustration of long‐run profit maximization. The long‐run equilibrium for an individual firm in a perfectly competitive market is illustrated in Figure.

The profit-maximizing level of output, where marginal cost equals marginal revenue, results in an equilibrium quantity of Q units of output. Because of the firm's average total costs per unit equal to the firm's marginal revenue per unit, the firm is earning zero economic profits. Furthermore, the firm is shown to be producing at the minimum point of its long‐run average total cost curve, at the minimum efficient scale level of output.