AP Microeconomics Production, Cost, and the Perfect Competition Model — Worked Answer Explanations

Unit 3 · 12 questions explained

Below is a complete answer key for our AP Microeconomics Production, Cost, and the Perfect Competition Model practice questions. For each question you'll find the correct choice, a full written explanation of how to get there, and — for every wrong answer — a short note on exactly why it's tempting and where it goes wrong. Reading these straight through is one of the fastest ways to find the gaps in a unit before exam day.

Prefer to test yourself first? Take the timed Production, Cost, and the Perfect Competition Model practice test and come back here to review, or head back to the Production, Cost, and the Perfect Competition Model unit overview.

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Question 1 · Easy
A firm's total fixed cost is $200 an d i t s t o t a l v a r iab l ecos t a t 10 u ni t so f o u tp u t i s$ 300. What is the average total cost (ATC) at 10 units?
- A
  $20
  Why not A: $20 = \frac{\$ 200}{10}$, which is AFC only — it excludes the variable cost component.
- B
  $30
  Why not B: $30 = \frac{\$ 300}{10}$, which is AVC only — it excludes fixed costs.
- C
  $50Correct
- D
  $500
  Why not D: $500 i s t h e t o t a l cos t ($ 200 + $300), not the average. ATC divides TC by quantity.
Explanation
$ATC = \frac{TC}{Q} = \frac{TFC + TVC}{Q} = \frac{\$ 200 + $300}{10} = \frac{\$ 500}{10} = $50$ . Equivalently, $ATC = AFC + AVC = \frac{\$ 200}{10} + \frac{ $300}{10} = \$ 20 + $30 = \$ 50$.

Key takeaway
$ATC = \frac{TC}{Q} = AFC + AVC$; always include both fixed and variable costs in the total.
Question 2 · Easy
In perfect competition, which of the following best characterizes average fixed cost (AFC) as output increases?
- A
  AFC rises as more units share the overhead cost.
  Why not A: Spreading a fixed total cost over more units makes AFC fall — not rise. More units spread the burden.
- B
  AFC is constant because fixed costs do not change with output.
  Why not B: Total fixed cost is constant, but AFC = TFC / Q. As Q rises, AFC falls. Students often confuse TFC (constant) with AFC (declining).
- C
  AFC declines continuously and approaches zero as output increases.Correct
- D
  AFC eventually rises because fixed costs become more burdensome at high output.
  Why not D: Fixed costs remain fixed regardless of output level. AFC = TFC / Q is a strictly decreasing function — it never rises.
Explanation
Average fixed cost $= \frac{T F C}{Q}$ . Since TFC is constant (does not change with output), AFC is simply a constant divided by an increasing quantity. As Q grows, AFC falls continuously and approaches — but never reaches — zero. Graphically, the AFC curve is a rectangular hyperbola that declines steeply at first and flattens as output grows. This 'spreading of overhead' is why ATC eventually falls even as AVC rises.

Key takeaway
AFC declines continuously as output rises because a fixed total cost is spread over more units.
Question 3 · Easy
A perfectly competitive firm has $P = \$ 15 $,$ ATC = $18$ , and $AVC = \$ 12$ at the profit-maximizing quantity. What is the firm's economic situation?
- A
  The firm earns a positive economic profit and will expand output.
  Why not A: Economic profit = $(P - A T C) \times Q$ . Since $P = \$ 15 < ATC = $18$ , the firm earns a loss, not a profit.
- B
  The firm incurs a loss but should continue to produce in the short run.Correct
- C
  The firm incurs a loss and should immediately shut down.
  Why not C: The firm should shut down only if $P < A V C$ . Here $P = \$ 15 > AVC = $12$ , so producing is better than shutting down.
- D
  The firm earns zero economic profit (break-even point).
  Why not D: Break-even occurs when $P = A T C$ . Here $P < A T C$ , indicating a loss.
Explanation
Since $P = \$ 15 < ATC = $18$ , the firm earns a loss of $\$ 3 $p er u ni t . H o w e v er, s in ce$ P = $15 > AVC = \$ 12 $, t h e f i r m co v er s a l l v a r iab l ecos t s pl u s$ $3$ per unit toward fixed costs. Shutting down yields a loss equal to total fixed costs ( $P = 0 < A V C$ would warrant shutdown). By producing, the firm reduces its loss below the fixed-cost baseline. In the long run, firms earning losses will exit, shifting the supply curve left until $P = A T C$ .

Key takeaway
Loss but $P \geq AVC$: produce in the short run. Shut down only if $P < AVC$.
Question 4 · Easy
In the long run, perfectly competitive industries tend toward an equilibrium at which each firm:
- A
  Earns maximum economic profit through price leadership.
  Why not A: Price-taking firms in perfect competition have no pricing power. Economic profits attract entry, eliminating them in the long run.
- B
  Earns zero economic profit, with $P = M R = M C = A T C$ .Correct
- C
  Earns zero accounting profit because all costs are variable in the long run.
  Why not C: Zero economic profit is not the same as zero accounting profit. Economic profit accounts for implicit/opportunity costs; firms can earn positive accounting profit while earning zero economic profit.
- D
  Shuts down because competition drives price below variable costs.
  Why not D: Entry and exit drive price to minimum ATC — the break-even point — not below variable costs.
Explanation
In long-run competitive equilibrium, free entry and exit drive economic profit to zero. If firms earn positive economic profit, new firms enter, increasing supply, lowering price until $P = A T C$ . If firms suffer losses, some exit, reducing supply, raising price until $P = A T C$ . At this long-run equilibrium: $P = M R = M C = A T C$ , and each firm produces at the minimum of ATC (productive efficiency) while also achieving allocative efficiency ( $P = M C$ ).

Key takeaway
Long-run competitive equilibrium: $P = MR = MC = ATC_{min}$; zero economic profit; productive + allocative efficiency.
Question 5 · Easy
The table below shows a firm's total output as labor inputs increase, with capital fixed. Which of the following describes the law of diminishing marginal returns?

Workers Total Output
0 0
1 10
2 22
3 30
4 36
5 40
- A
  Marginal product is positive for all workers listed.
  Why not A: While marginal product is positive throughout, this does not describe the law of diminishing marginal returns, which is about the rate of change in marginal product.
- B
  Marginal product begins to decline after the 2nd worker.Correct
- C
  Marginal product is constant at 8 units per worker throughout.
  Why not C: Marginal product is not constant: MP values are 10, 12, 8, 6, 4 — they rise then fall.
- D
  Total output falls after the 4th worker is hired.
  Why not D: Total output continues to rise (from 36 to 40) with the 5th worker. Diminishing marginal returns means MP falls, not that total output falls.
Explanation
Marginal product (MP) for each worker: 1st = 10, 2nd = 12, 3rd = 8, 4th = 6, 5th = 4. MP rises from worker 1 to 2 (10 → 12), then falls from worker 3 onward (12 → 8 → 6 → 4). The law of diminishing marginal returns states that as successive units of a variable input (labor) are added to a fixed input (capital), marginal product eventually declines. This occurs beginning with the 3rd worker (MP falls from 12 to 8).

Key takeaway
Diminishing marginal returns: MP eventually falls as variable input increases with fixed capital. Total output still rises — just at a slower rate.
Question 6 · Easy
A firm currently produces where $MC = \$ 8 $an d$ MR = $12$ . To maximize profit, the firm should:
- A
  Decrease output to raise price.
  Why not A: Perfectly competitive firms are price takers — they cannot change market price by adjusting output. More importantly, MR > MC means profit increases by expanding output, not contracting.
- B
  Increase output until $M R = M C$ .Correct
- C
  Keep output constant because the gap between MR and MC is already profitable.
  Why not C: As long as MR > MC, each additional unit adds more to revenue than to cost — the firm leaves profit on the table by not expanding.
- D
  Shut down because MC exceeds AVC.
  Why not D: There is no information indicating MC exceeds AVC. The profit-maximizing rule ( $M R = M C$ ) applies regardless — and here MR > MC, so the firm should produce more, not shut down.
Explanation
The profit-maximization rule for any firm is to produce where $M R = M C$ . When $M R > M C$ (here: $\$ 12 > $8$ ), each additional unit adds more revenue than cost, increasing profit. The firm should expand output until $M R = M C$ . In perfect competition, $M R = P$ , so this is also $P = M C$ . Expanding output will raise MC (due to diminishing returns) and keep MR = P constant until they meet.

Key takeaway
Profit is maximized at $MR = MC$. When $MR > MC$, increase output; when $MR < MC$, decrease output.
Question 7 · Medium
In the short run, a perfectly competitive firm should continue to produce rather than shut down as long as:
- A
  Price is greater than average total cost.
  Why not A: P > ATC is the condition for positive economic profit, but a firm can rationally continue to produce even when earning losses (P < ATC) as long as it covers variable costs.
- B
  Price is greater than or equal to average variable cost.Correct
- C
  Price is greater than or equal to average fixed cost.
  Why not C: Fixed costs are sunk in the short run — irrelevant to the shut-down decision. The relevant comparison is price vs. AVC.
- D
  Total revenue is greater than or equal to total cost.
  Why not D: TR ≥ TC means the firm is breaking even or making profit, but firms can survive short-run losses as long as TR covers TVC (i.e., P ≥ AVC).
Explanation
In the short run, fixed costs are unavoidable regardless of output. The shut-down rule compares price to average variable cost: if $P \geq A V C$ , the firm covers its variable costs and contributes something toward fixed costs, so operating is better than shutting down (which still leaves fixed costs unpaid). If $P < A V C$ , every unit sold increases losses beyond the fixed-cost loss, so the firm minimizes losses by shutting down and producing zero.

Key takeaway
Short-run shut-down rule: produce if $P \geq AVC$; shut down if $P < AVC$. Fixed costs are irrelevant to the shut-down decision.
Question 8 · Medium
As output increases, what is the relationship between marginal cost (MC) and average variable cost (AVC)?
- A
  MC is always above AVC.
  Why not A: MC is only above AVC when MC is rising and above the minimum of AVC. At low output levels, MC typically falls below AVC.
- B
  MC equals AVC at every output level.
  Why not B: MC equals AVC only at the minimum point of AVC — not at every level of output.
- C
  When MC is below AVC, AVC is falling; when MC is above AVC, AVC is rising.Correct
- D
  AVC falls whenever output increases, regardless of the level of MC.
  Why not D: AVC eventually rises as the law of diminishing returns sets in. AVC's direction depends on its relationship with MC.
Explanation
The marginal-average relationship: when MC is below AVC, each additional unit costs less than the current average, pulling the average down — AVC falls. When MC is above AVC, each additional unit costs more than the average, pulling it up — AVC rises. At the minimum of AVC, $M C = A V C$ . The same logic applies to ATC: $M C = A T C$ at the minimum of ATC.

Key takeaway
$MC < AVC$ ⟹ AVC falling; $MC > AVC$ ⟹ AVC rising; $MC = AVC$ at the minimum of AVC.
Question 9 · Medium
Which of the following correctly describes a firm's marginal cost curve in relation to its production function?
- A
  MC rises continuously from the first unit because inputs always cost more as output expands.
  Why not A: MC typically falls initially (when marginal product is rising) before rising as diminishing returns set in.
- B
  MC is the mirror image of the marginal product curve; when MP rises, MC falls.Correct
- C
  MC equals average variable cost at all output levels.
  Why not C: MC equals AVC only at the minimum of AVC, not at all levels.
- D
  MC is unrelated to the marginal product of labor because costs and production are separate decisions.
  Why not D: MC is directly derived from the production function. $M C = \frac{w}{M P _{L}}$ , so MC and MP are inversely related.
Explanation
Marginal cost and marginal product are inversely related through the wage rate: $M C = \frac{w}{M P _{L}}$ . When labor's marginal product is rising (increasing returns), each additional unit of output costs less to produce — MC falls. When diminishing returns set in and MP falls, MC rises. The U-shape of the MC curve mirrors the inverted-U shape of the MP curve. This link between the production function and cost curves is fundamental to short-run analysis.

Key takeaway
$MC = \frac{w}{MP_L}$: MC is the inverse of the marginal product curve — rising MP means falling MC.
Question 10 · Medium
A competitive firm's short-run supply curve is best represented by:
- A
  The entire MC curve above the minimum ATC.
  Why not A: Above minimum ATC is the profitability condition, not the shut-down condition. The relevant curve is above minimum AVC.
- B
  The portion of the MC curve above the minimum AVC.Correct
- C
  The ATC curve above the minimum ATC.
  Why not C: The supply curve is derived from the MC curve (where P = MC determines quantity supplied), not the ATC curve.
- D
  The MC curve below the minimum AVC, where the firm is most efficient.
  Why not D: Below minimum AVC, the firm would shut down (P < AVC). There is no production in that region of the MC curve.
Explanation
A perfectly competitive firm maximizes profit at $P = M R = M C$ . For any given price, the firm chooses the quantity where $M C = P$ , making the MC curve the firm's supply schedule. However, the firm shuts down if $P < A V C_{min}$ (loss exceeds fixed costs by producing). Therefore, the short-run supply curve is the MC curve at and above the minimum AVC — the shut-down point. Below minimum AVC, quantity supplied is zero.

Key takeaway
Short-run supply curve = MC curve above minimum AVC (the shut-down point).
Question 11 · Hard
The long-run supply curve in a constant-cost perfectly competitive industry is:
- A
  Upward sloping, because more output always requires higher costs.
  Why not A: An upward-sloping long-run supply curve characterizes an increasing-cost industry, not a constant-cost industry.
- B
  Perfectly horizontal (elastic) at the minimum long-run ATC.Correct
- C
  Perfectly vertical (inelastic) because production capacity is fixed in the long run.
  Why not C: The whole point of the long run is that all inputs, including capacity, are variable. A vertical supply curve would imply capacity cannot expand — incorrect.
- D
  Downward sloping, because economies of scale lower costs as the industry grows.
  Why not D: A downward-sloping long-run supply curve describes a decreasing-cost industry. A constant-cost industry has input costs unaffected by industry expansion — horizontal supply.
Explanation
In a constant-cost industry, input prices remain unchanged as the industry expands (because the industry is too small to affect input markets). Any positive economic profit attracts entry, supply expands, and price falls back to minimum long-run ATC. The long-run equilibrium price is always this minimum ATC, regardless of market demand. Plotting these equilibrium points across demand shifts traces a flat (perfectly horizontal) long-run supply curve at the minimum ATC price.

Key takeaway
Constant-cost industry: horizontal long-run supply at minimum ATC. Increasing-cost: upward sloping. Decreasing-cost: downward sloping.
Question 12 · Hard
Which statement accurately distinguishes explicit costs from implicit costs?
- A
  Explicit costs are variable; implicit costs are fixed.
  Why not A: Both explicit and implicit costs can be fixed or variable. The distinction is about cash payment, not variability with output.
- B
  Explicit costs involve direct money payments; implicit costs are opportunity costs of owned resources.Correct
- C
  Explicit costs are included in economic profit calculations but implicit costs are not.
  Why not C: Economic profit deducts both explicit and implicit costs from revenue. Accounting profit deducts only explicit costs.
- D
  Implicit costs are always larger than explicit costs for any firm.
  Why not D: The relative magnitudes vary by firm and industry. There is no general rule that implicit costs exceed explicit costs.
Explanation
Explicit costs are direct cash outlays — wages paid, rent, raw materials. Implicit costs are the opportunity costs of resources the firm already owns and uses in production — for example, the salary the owner forgoes by working in their own business, or the return forgone by using personal capital rather than investing it. Economic profit = Total Revenue − (Explicit + Implicit Costs). Accounting profit = Total Revenue − Explicit Costs only. A firm can show positive accounting profit while earning zero or negative economic profit if implicit costs are large.

Key takeaway
Explicit costs = cash payments; implicit costs = opportunity costs of owned resources. Economic profit deducts both.

Workers	Total Output
0	0
1	10
2	22
3	30
4	36
5	40