3.4.2 - contd: diagrammatic analysis of perfect competition

Question 1

What is a an important assumption about firms in perfect competition

Answer 1

• each firm is a price taker and has to accept whatever price is set in the market as a whole
• perfectly elastic (horizontal demand curve
• D = AR = MR

Question 2

Why is demand curve a horizontal line

Answer 2

• perfectly elastic demand
• price set above will sell nothing as buyers have perfect knowledge (no quality diff between this and cheaper alternatives)
• no incentive for a firm to set a price below P1 (less profit margin)

Question 3

Why is MC = MR profit maximisation

Answer 3

Increase MR until it decreases to MC
- each extra unit is bringing in extra revenue above costs and therefore extra profit s well (albeit amount of profit earnt falls with each unit), therefore increase production closer to MC = MR will increase total profit.

• after MC = MR, costs exceed revenue causing profits to fall

Question 4

why does revenue maximisation occur at MR = 0

Answer 4

• to the right of MR = 0, MR is negative, reducing total revenue
  -to the left of MR = 0, yes marginal revenue is very high, but we can keep on increasing production till total revenue earnt is maximised up until MR = 0 where there is no additional icrease in revenue

Question 5

Why is P=MC allocative efficiency

Answer 5

• demand shows marginal benefit (measure of utlity through consumer surplus) (measure of utility) while supply shows marginal cost
• supply curve at a given price tells us the given price needed to cover supply of that unit
• to the right of MC, MC of producing are larger than MB derived so utility if falling, not allocating resources efficiently
• to the left of MC, MB is bigger than MC, but total utlity is not maximised, we should increase production to increase total utility up until MB = MC, hence total welfare is maximised (so area of BOTH consumer and producer surplus is maximised)
• p = mc is where both consumer and producer are well off and here price paid by consumers covers the exact costs of producing anothet unit

Question 6

Why do only some firms leave a loss making industry in the short run

Answer 6

• losses are made in the long run
• so if total revenue is exceeding total variable costs in the short run, its got income left over to cover those fixed costs in the long run and minimise losses
• whereas if you left immediately, you are committed to paying the full amount of fixed costs right now
• therefore only some firms may be unable to cover their variable costs, thus only they will leave

Question 7

refer to page 5 of ls8 part 2

Answer 7

this whole falshcard set is just to look at LS8 explanation of diagrams

Question 8

What happens if price falls below SVAC

Answer 8

exit market as it is better off just incurring fixed costs so firms supply curve is SMC above the point where it cuts SAVC