Chapter 12 - Perfect Competition

Question 1

Economic Profit (definition)

Answer 1

Defined as the difference between total revenue and total cost

Question 2

Accounting Profit (definition)

Answer 2

Total revenue less all explicit costs incurred

Question 3

Four conditions for Perfect Competition

Answer 3

1) Firms sell a standardised product
2) Firms are Price Takers
3) Free Entry and Exit, w/ perfectly mobile factors of production in the LR
4) Firms and Consumers have perfect information

Question 4

Marginal Revenue (MR) - (definition)

Answer 4

Is the change in total revenue that occurs as a result of a 1-unit change in sales

MR = ∆(PQ)/∆Q

• slope of total revenue curve
• benefit to firm of selling an additional unit of output

Question 5

Shut-down Condition

Answer 5

If price falls below the minimum of AVC, the firm should shut down in the short-run

• Being able to cover variable costs doesn’t assure the firm of a positive level of economic profit
• BUT it is sufficient to induce the firm to supply output in the SR
• the loss is less than if the firm didn’t produce at all, which would be -TFC (value of economic profit when output is zero)

Question 6

Short Run competitive industry supply:

Suppose an industry has 200 firms, each supply curve P= 100 + 1,000Q, what is the industry supply curve?

Answer 6

Steps (in general)

• Rearrange the representative firm supply curve to get Q
• Then multiply by the number of firms
• Then Rearrange to have P alone to return to slope-intercept form

Question 7

Breakeven Point for short-run competitive firm

Answer 7

The Breakeven Point is

When P = minimum of ATC
- the lowest price at which the firm will not suffer negative profits in the short-run

Question 8

Allocative Efficiency (definition)

Answer 8

A condition in which all possible gains from exchange are realised

• when P = MC
• goods and services have been distributed optimally
• MC and MU are equal

Question 9

Pareto efficient (definition)

Answer 9

An outcome where it is not possible to make some person better off without harming another person

Question 10

Producer Surplus (definition)

Answer 10

the euro amount by which a firm benefits by producing a profit-maximising level of output

• PS = sum of economic profit and FC
• In the SR PS is larger than economic profit
• PS is the same as economic profit in the LR

Question 11

Measures of Producer Surplus

Answer 11

1) Difference between total revenue and total variable cost
- difference between PQ and AVCQ
- Easier to use when calculating total producer surplus

2) OR the difference between PQ and the area under the MC curve
- easier to use for ∆ in producer surplus

Question 12

Adjustments in the LR of a competitive industry

Main steps

Answer 12

In the SR firms can earn positive economic profit and this attracts entrants of new firms, which increases supply of firms in the LR.

However, this is unstable. In the LR firms exit the market and cannot maintain capital adjustments, due to competitive environment price falls and firms exit.

In the LR:

• firms can change fixed inputs
• the firm can leave the industry or decide to enter a new industry

P* = SMC*= LMC= ATC = LAC
- economic profits of all firms are equal to 0!

Question 13

The Invisible Hand (Adam Smith)
- Main points! i.e. in what sense is the LR equilibrium in competitive markets attractive from the perspective of society as a whole

Answer 13

1) P = MC both LR and SR therefore eqm is allocatively efficient
- the last unit of output consumed is worth exactly the same to the buyer as the resource required to produce it

2) P = min point on LAC
- there is no less costly way of producing the product therefore result in Pareto Efficiency!

3) All producers earn only a normal profit, which is the OC of the resources they have invested in their firms
- the public pays not more than what it costs the firms to serve them

Question 14

Pecuniary Diseconomy (definition)

Answer 14

a rise in production cost that occurs when an expansion of industry output causes a rise in the prices of inputs.

• The LR supply curve will be upward sloping even though each individual firm’s LAC curve is U-shaped
• also produces an upward-sloping industry supply curve when each firm’s LAC curve is horizontal

Question 15

Elasticity of Supply (definition)

Answer 15

The percentage change in quantity supplied that occurs in response to a 1% change in product price

Equation = ∆Q/∆P * P/Q

∆P/∆Q is also equal to the slope of the supply curve therefore

PES is also equal to = P/Q * 1/Slope

Question 16

Constant Cost Industry (definition)

Answer 16

an industry that has a long-run supply curve horizontal at the minimum value of LRAC of production!

• increase in quantity leaves input prices unchanged

Question 17

Increasing Cost Industry (definition)

Answer 17

Increase in the output of the sector leads to an increase in input prices
- the LR supply curve will be upward sloping and the industry will be an increasing cost industry

Question 18

Decreasing Cost Industry (definition)

Answer 18

Increase in the output of the sector leads to a decrease in input prices
- the LR supply curve will be downward sloping and the industry will be a decreasing cost industry

Question 19

Why does a tax (constant) on each unit of output, in a constant cost industry, not change the amount of output sold in the LR?

Answer 19

This is because tax causes a parallel upward movement in each firm’s LAC curve.
- Min LAC curve output level remains the same

Question 20

When calculating LR equilibrium prices/quantity given TC equation…

Answer 20

Remember that in the LR, for a perfectly competitive firm P = LAC

• they produce at the minimum point of LAC so find that
• Divided TC by Q to get LAC
• Then d(LAC)/d(Q) to get the minimum point where you find equilibrium Quantity
• then find price