Chapter 2: Basic Microeconomics

Question 1

Describe the conditions of a perfectly competitive market

Answer 1

1. All firms are price-takers, so no one firm’s output can affect the market price
2. All firms generate a normal profit, but not an abnormal one
3. There are many firms producing an identical or near-identical product
4. P = MC

Question 2

Define normal profit

Answer 2

A level of profit that justifies the existence of an enterprise (so when TR=TC, or when all costs both explicit and implicit are fully covered)

Question 3

Define economic profit

Answer 3

“It reflects net revenue above what is necessary to pay all of the firm’s inputs at least what they could earn in alternative employment”

Example:
I own a shop. My costs are the following: the land, labor and capital required to maintain the shop, as well as what I could have earned had I looked for employment elsewhere. When revenue = total cost, then I am making normal profit.

Question 4

What can be learnt from a market’s demand curve?

Answer 4

For an inverse demand curve:
The constant is the maximum price that consumers are willing to pay for the good. Any price beyond C results in Qd=0

The market price:
Consumer willingness to pay at the margin, that is Pm is the most any consumer would pay for the Qmth good.

Question 5

Why is the demand curve of a perfectly competitive firm horizontal?

Answer 5

Because the market price is fixed regardless of how much or how little an individual firm produces.

This only applies on an individual level. The demand curve for the entire market is still downward sloping.

Question 6

If economic profit is zero, this means that…

Answer 6

shareholders are not earning more than a normal return on their capital

Question 7

Describe the three key characteristics of consumers

Answer 7

• constrained by a budget
• optimizers of utility
• have preferences

Question 8

Define consumer surplus

Answer 8

The benefit derived from paying a price that is lower than that at which you were already willing to purchase the good.

Question 9

Define reservation price

Answer 9

Willingness to pay

Question 10

What can be said about a good if its cross price elasticity is positive?

Answer 10

It is a substitute to another good since as price increases quantity also increases

Question 11

What can be said about a good if its cross price elasticity is negative?

Answer 11

It is a complement to another good since as price increases quantity decreases