Chapter 9: Perfect Competition

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1 Chapter 9: Perfect Competition Perfect Competition Law of One Price Short-Run Equilibrium Long-Run Equilibrium Maximize Profit Market Equilibrium Constant- Cost Industry Increasing- Cost Industry Decreasing- Cost Industry Firm s Supply Curve Market Supply Curve Comparative Statics Pu re Profit Normal Profit Loss Market Demand Shifters Market Supply Shifters Shutting Down Outline and Conceptual Inquiries Establishing the Law of One Price Why will all firms charge the same price without knowingly doing so? Market Period Tedium Understanding the Short Run Deriving the Market Supply Curve The Profit Potential How to Determine Short-Run Price and Output Establishing Market Equilibrium Drawing the Individual Firm s Supply Curve What does the SMC curve tell us? What does the SATC curve tell us? Why would a firm ever operate at a loss? What does the SAVC curve tell us? What does the AFC curve tell us? Shifting Market Demand Shifting Market Supply A Market Demand and Supply Shifters Model Application: Food before Fuel Application: Beer Tax Application: Agricultural Pesticide Cancellation Long Run: Removing Short-Run Fixations Why, in the long run, will revenue never exceed cost? Long-Run Cost Adjustment

2 What are the Equilibrium Conditions? If the price falls, would a firm ever supply more? Application: Output Tax: Who Pays the Tax? Application: Should a Firm Adopt a New Technology? Summary 1. A perfectly competitive market is based on assuming small size and large number of firms, homogeneous products, free mobility of resources, perfect knowledge, and zero transaction costs. These assumptions result in the Law of One Price. 2. The market supply curve is the horizontal summation of individual firms supply curves. In a market period, the market supply curve is perfectly inelastic, implying no supply response to a change in price. In the short and long run, market supply is responsive to a price change. 3. A profit-maximizing firm will equate marginal revenue to marginal cost for determining its optimal level of output. In a perfectly competitive market, a firm has no influence on output price, so marginal revenue is equal to average revenue (the output price). 4. The short-run marginal cost curve above short-run average variable cost is a perfectly competitive firm s supply curve. It represents how much a firm is willing and able to supply at the current market price. 5. The short-run average total cost curve indicates if a firm is earning a pure profit, normal profit, or operating at a loss. If p > SATC, the firm is earning a pure profit, if p = SATC, it is earning a normal profit, and if p < SATC, it is operating at a loss. 6. The short-run average variable cost curve indicates if a firm should operate or not. If SATC > p > SAVC, the firm is able to cover all of its variable costs and has some revenue to apply toward its fixed costs. Thus, the firm can minimize its losses by staying in business. In contrast, if price falls below SAVC, then the firm is not able cover all of its variable cost, and thus, will incur greater losses by operating. It will minimize its losses by shutting down. 7. Without any governmental agencies, the free market will respond to an increase in market demand by both rationing quantity supplied and increasing the production of the commodity. In general, markets response to shifts in demand or supply may be investigated by considering the responsiveness of demand and supply to changes in the market price. 8. In the long run, all inputs can vary, so firms are free to enter and exit an industry. If an industry is experiencing short-run pure profits, in the long run firms will enter this industry. This will result in expanded market output. In contrast, if the industry is experiencing shortrun losses, in the long run firms will exit this industry. 9. For a constant-cost industry, the entry or exit of firms does not change the average cost of production, so the long-run market supply curve is perfectly elastic (horizontal). In contrast,

3 for an increasing- (decreasing-) cost industry, the average cost of production rises (declines) with the entry of new firms, so the long-run market supply curve has a positive (negative) slope. Key Concepts average revenue consumers constant-cost industry decreasing-cost industry elasticity of supply firm s short-run supply curve increasing-cost industry industry industry supply curve invisible hand Law of One Price marginal revenue market-clearing price market supply curve perfectly-competitive market Key Equations MR = SMC Profit-maximizing condition. p > SAVC Condition for operating. p > SATC A firm is earning a pure profit. p = SATC A firms is earning a normal profit. p = SMC = SATC = LMC = LAC Long-run equilibrium condition.

4 TEST YOURSELF Multiple Choice 1. Which of the following is not a characteristic of perfect competition? a. Homogeneous products b. Large number of firms c. Imperfect knowledge d. Free mobility of resources. 2. The concept that all firms in a perfectly competitive market will charge the same price is known as the a. Law of Demand b. Law of One Price c. Law of Supply d. Law of Competitive Forces. 3. When the price of a product rises, quantity supplied does not change. This statement likely describes a firm s production in the a. Short run b. Market period c. Long run d. None of the above, a firm will always increase quantity supplied when prices rise. 4. The price elasticity of supply measures how responsive is to changes in. a. Supply; an input price b. A buyer; an input price c. Supply; output price d. A buyer; the cost of production. 5. Suppose the market supply for batteries can be represented by Q = p. If the price of batteries is $4.00, what is the price elasticity of supply? a. 8/7 b. 7/8 c. 7/8 d. 8/7.

5 6. Consider the following graph: p SMC SATC p = AR = MR 0 q 1 q 2 q 3 q 4 q For maximizing profits (or minimizing losses), a firm should choose an output level of a. q 1 b. q 2 c. q 3 d. q Consider the graph in Question 6. In the short run, this firm a. Is operating at a loss b. Should shut down c. Is earning normal profits d. Is earning a pure profit. 8. Under perfect competition, the demand curve facing a firm is a. Downward-sloping b. Perfectly elastic c. Perfectly inelastic d. The market demand curve. 9. Suppose the market demand and supply for pizza can be represented by Q D = 150 8p and Q S = p. The market equilibrium price is and the market equilibrium quantity. a. $5; 110 b. $7; 64 c. $8; 86 d. $7; 74.

6 10. A perfectly competitive firm will earn a pure profit if a. p > SATC b. p > SMC c. MR > SMC d. SATC > SMC. 11. A perfectly competitive firm will earn a normal profit if a. MR = SMC b. p = SMC c. p = SATC d. SATC = SMC. 12. Young s Market sells its output in a perfectly competitive market at a price of $4. At its current output level, its short-run marginal cost is $4, average total cost is $4.25 and average variable cost is $3.90. To maximize profits (or minimize losses), the company should a. Increase its output b. Continue at its current output level c. Shutdown d. Decrease its output. 13. A perfectly competitive firm s short-run supply curve is its short-run a. Average total cost curve b. Marginal cost curve above SATC c. Average variable cost curve d. Marginal cost curve above SAVC. 14. Suppose the supply of potato chips is relatively elastic, while the supply of French fries is relatively inelastic. An equal increase in the demand for potato chips and the demand for French fries will cause a(n) a. Equal change in the prices of potato chips and French fries b. Larger increase in the price of potato chips than in the price of French fries c. Smaller increase in the price of potato chips than in the price of French fries d. None of the above. 15. Suppose the demand for flat-screen TVs is relatively elastic and the demand for play stations is inelastic. Technological breakthroughs in these two industries will a. Likely benefit buyers of play stations more than buyers of flat screens b. Lead to increased profits for firms in these two industries c. Lead to higher play-station and flat-screen prices d. Likely benefit buyers of flat screens more than buyers of play stations.

7 16. Suppose the market for firewood is perfectly competitive and firms are earning pure profits. What do you expect will occur in the long-run? a. Some firms will exit the industry b. The price of firewood will fall c. The demand for firewood will rise d. The supply of firewood will shift left. 17. Which of the following is a condition for long-run equilibrium in a perfectly competitive industry? a. SMC = p = SATC b. p = SAVC = SMC c. LMC = LAC d. Both a and c. 18. For a constant-cost industry, the long-run supply curve is a. Upward-sloping b. U-shaped c. Horizontal d. Downward-sloping. 19. If the long-run industry supply curve is upward-sloping, this implies that the industry is a(n) a. Increasing-cost industry b. Constant-cost industry c. Decreasing-cost industry d. Increasing returns to scale industry. 20. An increasing-cost industry is one where a. Firms face significant decreasing returns to scale b. The entry of firms leads to higher input prices c. Firms will operate at a loss d. Firms face diminishing marginal returns in the short run.

8 Short Answer 1. List the characteristics of a perfectly competitive market. 2. Explain how the characteristics of a perfectly competitive industry lead to the Law of One Price. 3. What does the price elasticity of supply measure? How is it calculated? Describe how supply can be categorized as elastic, inelastic or unitary. 4. Draw a graph illustrating a firm in a perfectly competitive market that is earning a short-run pure profit. Indicate the firm s profit-maximizing level of output and show the area of profit. What is the necessary condition for a firm to be earning a pure profit? 5. Graphically describe a perfectly competitive firm s decision to shut down. Explain the role of fixed and variable costs in this decision. 6. Graph two supply and demand diagrams: one with a relatively elastic supply curve and one with a relatively inelastic supply curve. Suppose demand rises in both markets. Describe the role that the elasticity of supply plays in the determination of the new equilibrium price and quantity. 7. Explain what is meant by a long-run market equilibrium. What conditions exist? Graphically illustrate a perfectly competitive market in long-run equilibrium. 8. Graph a perfectly competitive firm operating at a loss. Illustrate how the market will adjust to long-run equilibrium. 9. Comment on the following statement: The long-run goal of a profit-maximizing competitive firm is to equate price to long-run average cost. 10. Graph a competitive market in long-run equilibrium. Suppose the demand for the product falls. Describe what will occur to firms in this industry in the short run. Describe the long-run adjustment that will occur in this industry, assuming that it is an increasing-costs industry. Illustrate the long-run market supply curve.

9 Problems 1. Assume that an industry is made up of three firms with the following supply curves: Solve for the market supply curve. 2. Suppose the market supply of a commodity can be represented by Q S = 5p 3. What is the price elasticity of supply? 3. Suppose the market demand and supply for a good can be represented by Q D = 50 15p and Q S = p. Find the market equilibrium price and quantity sold. 4. Marich Inc., sells its output in a perfectly competitive market at a price of $30. Its short-run total cost function is STC = 2q 2 + 2q a. What is the firm s STVC and TFC? b. What is the firm s short-run supply curve? c. What is the firm s profit-maximizing level of output? Will it earn a pure profit or loss? How much? d. At what price would this firm earn a normal profit? 5. A firm sells its output in a perfectly competitive market at a price of $13. Its short-run total cost function is STC = 3q 2 + q a. What is the firm s profit-maximizing level of output? Will it earn a pure profit or operate at a loss? How much? b. What recommendation would you make with regard to it continuing to operate? Explain. 6. Suppose the market demand and supply for a good can be represented by Q D = 6p 1 and Q S = 5p 2. If demand increases by 20 percent at the same time the supply decreases by 5 percent, what will be the final effect on the equilibrium price in the market? 7. Suppose all firms in a constant-cost, perfectly competitive industry face the same cost SATC = ½q 2 q + 10 and a market demand of Q D = 150 4p. a. Find the long-run equilibrium price and quantity sold by each firm. How many firms will there be in this industry? b. Suppose the market demand falls to Q D = 110 4p. What will happen to the number of firms in the industry? 8. Refer to Problem 7. Suppose this industry is not a constant-costs, but instead a decreasingcosts industry. After the decline in market demand to Q D = 110 4p, each firm s cost can be represented by SATC = ½q 2 q + 8. Find the new long-run equilibrium price and the number of firms in the industry

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