Chapter 6 - Perfect Competition

Question 1

What is a price taker?

Answer 1

Is a seller (or buyer) of a commodity that is unable to affect the price at which the commodity sells by changing the amount it sells (or buys). This is a competitive seller.

Question 2

What is the opposite to a price taker?

Answer 2

A price maker - a monopolistic firm who can set price.

Question 3

Explain the demand schedule and demand curve for a competitive firm?

Answer 3

The demand schedule is the average revenue schedule for the individual firm and the demand curve is perfectly elastic.

Question 4

What is Average Revenue and Total Revenue?

Answer 4

AR is the total revenue per unit of a product sold and TR is the total number of dollars received by a firm from the sale of a product.

Question 5

Why is the demand curve perfectly elastic?

Answer 5

Due tot he assumption that each seller is a price taker.

Question 6

What is the equation for revenue under competitive conditions?

Answer 6

P=AR=MR

Question 7

What are the two complementary approaches to determining the level of output at which a competitive firm will realise maximum profits or minimum losses?

Answer 7

1. comparison of total revenue and total costs or

2. comparison of marginal revenue and marginal costs.

Question 8

What are the three questions asked in the total costs approach?

Answer 8

1. Should the firm produce - yes if TR > TC or yes if TC> TR by an amount less than TFC
2. If so, what amount - where excess of TR over TC is at a maximum, or where TC over TR is at a minimum.
3. Will production result in a profit? Yes if TR > TC and no if TC > TR.

Question 9

Where are a firms profits maximised?

Answer 9

At the point where TR exceeds TC by the greatest amount.

Question 10

What is a loss minimising case?

Answer 10

Where TC exceeds TR by the least amount.

Question 11

Where is the break even point?

Answer 11

Where TC and TR first become equal.

Question 12

What is a close-down case?

Answer 12

Where at all levels of output, losses exceed the fixed cost the firm will incur to produce.

Question 13

In the marginal revenue/cost approach what is compared?

Answer 13

The marginal revenue and the marginal cost of each successive unit of output.

Question 14

What is the profit maximisation rule and what are three characteristics of this rule?

Answer 14

MR=MC.

1) firms would rather produce than shut down
2) MR=MC is profit maximisation in all markets
3) competitive markets maximise at P=MC

Question 15

Explain loss minimising and close down?

Answer 15

Loss minimising is the same MC=MR and close down is where the marginal return (price) is less than the average variable cost. Firms should not produce at less than AVC.

Question 16

How is the short run supply curve indicated on a marginal revenue/cost graph?

Answer 16

It is represented by the MC curve at the point above where it intersects with AVC.

Question 17

In a competitive industry what determines a firm’s short run supply curve?

Answer 17

P=MC

Question 18

The industry supply and demand curves set the equilibrium point for price and production. How does the competitive firm’s curves act?

Answer 18

It yields to the industry supply and demand curves.

Question 19

What are the three assumptions we need to apply in examining long-run curves?

Answer 19

1) entry and exit of firms is the only long run adjustment
2) all firms in the industry have similar cost curves (that is they have identical costs)
3) that costs are consistent and that entry & exit of firms will not affect resource prices (it is a constant-cost industry).

Question 20

If all firms are similar, how many firms are in the industry if the industry’s equilibrium output is 100,000?

Answer 20

There must be 1000 firms, so they must produce 100 output each.

Question 21

When looking at long run curves, what will happen if demand increases?

Answer 21

The economic profits will lure new firms to enter the industry which will cause the supply to increase, and a new equilibrium is found. Price will not generally change in the long run.

Question 22

When looking at long run curves, if price is less than ATC what will occur?

Answer 22

Some firms will leave the industry, these are likely to be those that have less technology or skill.

Question 23

When looking at long run curves, what does constant-cost mean when looking at the entry of new firms?

Answer 23

It means the entry of new firms has no effect on resource prices or production costs and so graphically the entry of new firms does not change the long-run average cost curves.

Question 24

What shape is the long-run supply curve of a constant-cost industry?

Answer 24

It is perfectly elastic as after the industry has adjusted with new firms or exiting firms the price will always go back to the same price.

Question 25

If the industry is an increasing cost industry, how will supply be drawn graphically?

Answer 25

It will be upward sloping as the entry of new firms will affect resource prices, and the price and quantity would rise.

Question 26

Why would you sometimes see a decreasing cost industry?

Answer 26

Where the entry of new firms encourages or justifies new technology or service, such as new transport infrastructure.

Question 27

What does the long run equilibrium (irrespective of slope of the long run supply curve) imply?

Answer 27

That firms will end up earning normal profits, which is where MR = P = MC = Minimum ATC.

Question 28

For a purely competitive economy to lead to an efficient allocation of resources, what is required?

Answer 28

Allocative efficiency - resource allocation consistent with maximisation of consumer satisfaction.
Productive efficiency - the least costly production techniques used to produce the desired goods and services

Question 29

How is allocative efficiency expressed? and what does under-allocation and over-allocation look like?

Answer 29

P=MC, under-allocation is where Price exceeds MC and over-allocation is where Price is less than MC.

Question 30

How much will profit motivated producers produce in a pure-competiton?

Answer 30

They will produce each commodity up to that precise point at which price (marginal benefit) and marginal cost are equal. This means that resources are efficiently allocated under competition.

Question 31

What does the long-run position of minimum ATC mean?

Answer 31

That competitive firms will use the most efficient technology available.

Question 32

A competitive price system will reallocate resources in response to what?

Answer 32

A change in consumer tastes, technology or resource supplies.

Question 33

What does the invisible hand do simultaneously?

Answer 33

Maximises profits and maximises satisfaction.

Question 34

Entry barriers block all potential competitors in what ways?

Answer 34

• Economies of scale - make it hard for some to compete due to size
• Ownership of raw materials - where a firm controls or owns all the raw material required
• Legal barriers - a firm holds a copyright or patent.

Question 35

Are pure monopolies common?

Answer 35

No they are rare, however some local and geographically isolated businesses may act like monopolies.

Question 36

Analysis of the price-output behaviour of a pure monopolist needs what three assumptions?

Answer 36

1) the monopolist’s position is guaranteed (patent or ownership of raw materials)
2) No prospect of government intervention or regulation
3) The monopolist doesn’t price discriminate.

Question 37

How is the monopolist’s demand curve drawn?

Answer 37

It is drawn in the same way as the industry demand curve and is therefore down-sloping. This is because the monopolist must lower price to boost sales.

Question 38

So what happens to the price of each unit of output for a monopolist?

Answer 38

Each unit must be priced at less than the previous, but this price changes the price for all units available. For example 4 units will be purchased at $150, but 5 units could be sold at $145 etc.

Question 39

Why is the monopolist a price maker?

Answer 39

Because it can influence total supply.

Question 40

Describe how TR would be drawn on a graph for a monopolist?

Answer 40

TR increases at a decreasing rate then starts to decrease.

Question 41

What is the relationship between TR and MR?

Answer 41

TR will be at its maximum when MR will be zero. A monopolist will aim to get as close to this point without going into the negative MC range.

Question 42

When does unit elasticity occur for a monopolist firm?

Answer 42

When MR reaches zero. The production prior to unit elasticity is ‘elastic’ and after that it is ‘inelastic’.

Question 43

What does the specific price quantity combination depend upon for a monopoly?

Answer 43

The demand, the marginal revenue data and also the costs of production.

Question 44

Although the firm is a monopolist, what must we assume when considering the costs of production?

Answer 44

1) it hires resources from a competitive market

2) it has the same production technology as a competitive firm.

Question 45

Describe the supply curve of the monopolist?

Answer 45

As there is only one optimum price output combination, the monopoly seller has a supply point but not a supply curve.

Question 46

How is profit determined for a monopolist on a graph?

Answer 46

Where MR=MC, is the ideal production point, following this up intersects with the level of demand. If the ATC is less than this, a profit is made, and if it is above this then a loss is made.

Question 47

What are the misconceptions about monopoly pricing?

Answer 47

• Monopolists seek to maximise profit not necessarily price
• Monopolists seek to maximise total profit and not necessarily per unit profit
• Losses are possible because of weak or high demand costs.

Question 48

Given the same costs the pure monopolist will find it profitable to restrict output and charge a higher price than a competitive industry would. This restriction of output causes what?

Answer 48

Allocative inefficiency - because price exceeds MC and Production inefficiency - due to lack of incentive to produce at minimum average cost.

Question 49

How do business monopolies tend to contribute to the inequality in the distribution of income?

Answer 49

Because substantial economic profits of a monopolist are not widely distributed and are often concentrated in the hands of upper-income earners

Question 50

What are three cost complications that must be considered if they are not the same as other industry?

Answer 50

• Economies of scale - demand may not be sufficient to support a large number of competing firms
• X-inefficiency - the failure to produce any given output at the lowest average (and total) cost possible could increase costs
• The very long run may allow for technological progress.

Question 51

What is dynamic efficiency?

Answer 51

It is the ability to develop the most efficient production techniques over time.

Question 52

Do purely competitive firms or monopolists perform with more dynamic efficiency and introduce innovation?

Answer 52

Competitive firms generally as there is an incentive to develop new products and improve production to generate a larger profit. For a monopoly it is not as clear as barriers to entry mean drivers to innovate are less.

Question 53

What is price discrimination?

Answer 53

Where a given product is sold at more than one price and the price differences are not justified by cost differences.

Question 54

What three conditions need to exist for price discrimination to occur?

Answer 54

1) monopoly power
2) market segmentation
3) no resale of product or service

Question 55

What are the two economic consequences of price discrimination?

Answer 55

• more profits to the monopoly

* more production for the monopoly

Question 56

Why would a government use price regulation?

Answer 56

To eliminate, wholly or partially the tendency of monopolists to under-allocate resources and to earn economic profits.

Question 57

What are two forms of price regulation?

Answer 57

Socially optimum pricing - Govt sets a price ceiling equal to MC
Fair-return pricing - Govt sets a price equal to AC

Question 58

Which of the two forms results in a better profit to the monopolist?

Answer 58

Fair-retun pricing because the monopolist can create a normal profit, where as socially optimum pricing is likely to lead to losses.

Question 59

What is the dilemma of regulation?

Answer 59

That the choice of whether to subsidise the monopoly’s fixed costs from taxation revenue under marginal cost pricing or to accept a lower than socially optimal output under ‘fair return’ pricing.