Chapter 10: Perfect Competition

Question 1

What is the theory of a firm

Answer 1

The theory of a firm aims to determine how much a firm will produce and at what price it sells its output on the assumption that it wishes to maximise its profits

Question 2

What is total profit

Answer 2

Total profit = TR - TC, where TC includes implicit costs
TR = Q x P and TC = AC x Q

How the price is the term mind depends on the market structure

Question 3

What are the two decisions that should be made

Answer 3

• Should we produce?
• If yes, how much should we produce?

Question 4

What are the equilibrium conditions

Answer 4

1. The shutdown rule
   Produce only if: TR >= TVC; AR >= AVC
2. Profit maximisation
   MR= MC; TR> TC

Question 5

What is perfect competition

Answer 5

Perfect competition occurs when none of the individual market participants can influence the price of the product (demand and supply determine the price)

Thus, firms in this market structure are known to be price takers

Question 6

What are the seven assumptions of a perfect competition

Answer 6

1. Very large numbers of buyers and sellers
2. Homogeneous/identical goods
3. No collusion
4. Free entry and exit from market
5. Full knowledge and information to all participants
6. No government intervention
7. Full mobility of production factors

Question 7

The demand for the product of a perfectly competitive firm

Answer 7

• The demand curve is perfectly elastic (horizontal) at the existing market price
• The producer cannot influence the market price because they are price takers but can still decide what quantity they want to sell at what given price
• The horizontal demand curve implies that if the producer asks a higher price, they won’t be able to sell products because other producers supply the same product more cheaply
• They also would not ask a lower price because consumers are willing to pay higher price which increases profit. At a lower price production cost was usually not be covered in the long run and the firm would become bankrupt

Question 8

The equilibrium of the firm under perfect competition

Answer 8

• Profit is maximised when MR=MC, provided MC is risings and lies above minimum AVC
• Positive difference between TR and TC is at a maximum

Question 9

What is the relation between MR and MC

Answer 9

MR > MC
- The firm is still making profit on the last unit produced, thus it can add to its profit
- Expanding output/production

MR = MC
- Profits are maximised

MR < MC
- The firm will make a loss and therefore profits will decrease
- Output should be reduced

Question 10

What are the three short run equilibrium positions of a perfectly competitive firm

Answer 10

Economic profit, break even or economic loss.

For as long as AR is greater than AC, the firm is earning an economic profit

Question 11

Long run equilibrium of the firm and the industry under perfect competition

Answer 11

All PFs variable
New firms can enter/exit

• Abnormal profit
  More firms enter market
  Market SUPPLY shifts right
  Price decreases, reduces profit
• Economic loss
  Firms exit market
  Market SUPPLY decrease
  Price increases, normal profit