3. Profit maximization and competitive supply

Question 1

What is profit maximization in a perfectly competitive market?

Answer 1

Profit maximization occurs when a firm chooses the output level where marginal revenue (MR) equals marginal cost (MC).

Question 2

What is the atomicity of actors in a perfectly competitive market?

Answer 2

Atomicity means that there are many small firms and buyers, none of which can influence the market price individually.

Question 3

What is product homogeneity in a perfectly competitive market?

Answer 3

Product homogeneity means that all firms sell identical products, making them perfect substitutes.

Question 4

What does free entry and exit mean in a competitive market?

Answer 4

Free entry and exit mean that firms can enter or leave the market without barriers, adjusting supply and profits over time.

Question 5

What is marginal revenue (MR)?

Answer 5

Marginal revenue is the additional revenue a firm earns from selling one more unit of output.

Question 6

What is marginal cost (MC)?

Answer 6

Marginal cost is the additional cost incurred from producing one more unit of output.

Question 7

What is the output rule in a competitive market?

Answer 7

The output rule states that a firm maximizes profit when marginal cost (MC) equals the price (P) of the good.

Question 8

What is the shut-down rule in the short run?

Answer 8

The shut-down rule states that a firm should cease production if the price falls below average variable cost (AVC).

Question 9

What is the supply curve for a competitive firm in the short run?

Answer 9

In the short run, the supply curve is the portion of the marginal cost (MC) curve that lies above the average variable cost (AVC) curve.

Question 10

What is the short-run market supply curve?

Answer 10

The short-run market supply curve is the horizontal summation of the supply curves of all firms in the market.

Question 11

What is producer surplus in the short run?

Answer 11

Producer surplus is the difference between a firm’s total revenue and its variable costs, representing profit before fixed costs are subtracted.

Question 12

What is producer surplus in the long run?

Answer 12

In the long run, producer surplus is the difference between total revenue and total cost, including both variable and fixed costs.

Question 13

What is long-run profit maximization?

Answer 13

Long-run profit maximization occurs when a firm produces at the output level where price (P) equals both marginal cost (MC) and average cost (AC).

Question 14

What is long-run competitive equilibrium?

Answer 14

Long-run competitive equilibrium is when all firms earn zero economic profit because price equals marginal cost (MC) and average cost (AC).

Question 15

What is economic rent?

Answer 15

Economic rent is the payment to a factor of production in excess of what is needed to keep it in its current use.

Question 16

What is a constant-cost industry?

Answer 16

A constant-cost industry is an industry where input costs do not change as output increases, resulting in a horizontal long-run supply curve.

Question 17

What is an increasing-cost industry?

Answer 17

An increasing-cost industry is one where input costs rise as output increases, leading to an upward-sloping long-run supply curve.

Question 18

What is a decreasing-cost industry?

Answer 18

A decreasing-cost industry is one where input costs fall as output increases, leading to a downward-sloping long-run supply curve.

Question 19

What is the price elasticity of market supply?

Answer 19

The price elasticity of market supply measures how responsive the quantity supplied is to a change in price, calculated as (ΔQ / ΔP) * (P / Q).

Question 20

What is the effect of an output tax on a firm’s costs?

Answer 20

An output tax increases a firm’s marginal cost (MC), shifting the MC curve upward by the amount of the tax.

Question 21

How does the atomicity of actors affect price setting in a perfectly competitive market?

Answer 21

Because there are many small firms and buyers, no single firm or buyer can influence the market price, meaning prices are determined by overall supply and demand.

Question 22

How does free entry and exit in the market affect long-run equilibrium?

Answer 22

Free entry and exit ensure that firms enter when there are profits and exit when there are losses, leading to zero economic profit in the long-run competitive equilibrium.

Question 23

What happens to a firm’s supply curve when marginal cost increases due to a tax?

Answer 23

When a tax increases marginal cost, the firm’s supply curve shifts upward, meaning the firm will supply less at each price level.

Question 24

How does a constant-cost industry maintain a horizontal long-run supply curve?

Answer 24

In a constant-cost industry, input prices do not change as industry output expands, so the long-run supply curve remains horizontal at the minimum average cost.

Question 25

How does the shut-down rule help firms decide whether to operate in the short run?

Answer 25

The shut-down rule advises that if the price falls below average variable cost (AVC), the firm should shut down because it cannot cover its variable costs, let alone fixed costs.

Question 26

How would an increase in demand affect a perfectly competitive firm’s long-run equilibrium?

Answer 26

An increase in demand raises the market price in the short run, leading to short-term profits for firms. In the long run, new firms enter the market, driving prices down until profits return to zero.

Question 27

How can the concept of producer surplus help explain long-run adjustments in a competitive market?

Answer 27

In the short run, producer surplus includes profits above fixed costs, but in the long run, competitive pressures eliminate excess profits, leading to zero producer surplus beyond covering total costs.

Question 28

How do increasing-cost industries affect the long-run supply curve?

Answer 28

In an increasing-cost industry, as firms expand output, input costs rise, leading to an upward-sloping long-run supply curve because higher prices are needed to cover increasing costs.

Question 29

How does economic rent influence the allocation of resources in a competitive market?

Answer 29

Economic rent reflects the earnings of a factor above its opportunity cost. Firms will allocate resources to markets or uses where they can earn the highest rent, leading to efficient resource distribution.

Question 30

How does the output rule guide profit maximization in both the short run and the long run?

Answer 30

The output rule, where price equals marginal cost (P = MC), ensures that firms maximize profit in both the short and long run by producing the quantity where the additional revenue equals the additional cost of production.

Question 31

How would you analyze the effects of a tax on long-run equilibrium in a perfectly competitive market?

Answer 31

A tax increases firms’ marginal costs, leading to higher prices and lower quantities in the short run. In the long run, some firms exit the market, reducing supply until prices rise enough to restore zero economic profit at the new equilibrium.

Question 32

How does the concept of economic rent relate to firm behavior in an increasing-cost industry?

Answer 32

In an increasing-cost industry, firms earning economic rent on scarce inputs face rising costs as output expands. This limits the number of firms entering the market, helping to sustain higher long-run prices and preserving rent on these inputs.

Question 33

How would you assess the impact of free entry and exit on long-run supply elasticity?

Answer 33

Free entry and exit increase long-run supply elasticity, as new firms enter when prices rise above costs, expanding supply, and firms exit when prices fall, keeping the long-run supply curve relatively more responsive to price changes.

Question 34

How would you evaluate the role of producer surplus in long-run market adjustments?

Answer 34

In the long run, producer surplus disappears as firms enter or exit the market until prices equal average costs. Any surplus gained from temporary price increases is eroded, leading to zero economic profit and no long-term producer surplus.

Question 35

How does the shut-down rule interact with fixed and variable costs in short-run production decisions?

Answer 35

The shut-down rule helps firms decide whether to produce in the short run by comparing price with average variable cost (AVC). If price is above AVC, the firm covers variable costs and part of fixed costs; if below, it should shut down to minimize losses.

Question 36

What is the formula for profit maximization in a perfectly competitive market?

Answer 36

π(q) = R(q) - C(q), where π is profit, R(q) is total revenue, and C(q) is total cost.

Question 37

What is the formula for marginal revenue (MR)?

Answer 37

MR(q) = ΔR / Δq, where MR is the additional revenue from selling one more unit and q is the quantity produced.

Question 38

What is the formula for marginal cost (MC)?

Answer 38

MC(q) = ΔTC / Δq, where MC is the additional cost of producing one more unit and TC is total cost.

Question 39

What is the output rule in a competitive market?

Answer 39

MC(q) = P, meaning profit maximization occurs when marginal cost equals the price of the good.

Question 40

What is the formula for price elasticity of market supply (Ep)?

Answer 40

Ep = (ΔQ / ΔP) * (P / Q), where Ep is the price elasticity of supply, Q is quantity supplied, and P is price.

Question 41

What is the formula for producer surplus (PS)?

Answer 41

PS = R - VC, where R is total revenue and VC is variable cost.

Question 42

What is the formula for profit (π)?

Answer 42

π = R - VC - FC, where π is profit, R is total revenue, VC is variable cost, and FC is fixed cost.

Question 43

What is the long-run competitive equilibrium condition?

Answer 43

P = MC = AC, meaning price equals both marginal cost and average cost in the long-run equilibrium.

Question 44

What is the formula for economies of scale in a constant-cost industry?

Answer 44

The long-run supply curve is horizontal at the minimum average cost, meaning cost remains constant as output expands.

Question 45

What is the effect of an output tax on marginal cost (MC)?

Answer 45

MC + Tax = P, meaning the marginal cost of production increases by the amount of the tax.