CHAPTER 8 (midterm 2) Flashcards
What is market structure and what are the 3 major characteristics that define market structure?
Market Structure: the competitive environment in which firms operate
- Number of firms: more firms = more competitive market
- Whether the consumer cares which company made the good: more identical products = more competitive market
- Barriers to entry: new firms easily entering market = more competitive market
Explain Perfect Competition using the 3 main characteristics of market structure
- Many firms
- Identical products sold
- No barriers to entry
Explain the nature of price under perfect competition
- example of a type of firm like this?
Firms in perfect competition are price takers
- each firm has a relatively small share of the market, and are therefore unable to influence market price by altering quantity produced
ex. small farmer producing a commodity crop (corn, tomatoes, etc.)
Since Perfect Competition is really just a theoretical construct, why do we learn about it?
- PC markets are very rare (only a few) but there are many that are ALMOST PC
- PC is a benchmark scenario/equilibrium that we can use to measure the efficiency of other markets
What are some other characteristics of a perfectly competitive market? (brands, advertising, choices)
- there is no brand preference and no need for advertising
- bc identical product (perfect substitutes) and no preferences, consumers only care about price
- therefore, firms have to take the market price and the only choice they have to make is how much output to produce (to get lowest cost per output)
Explain the characteristics of an individual firm’s demand curve in a perfectly competitive market (price taking)
It is HORIZONTAL and is PERFECTLY ELASTIC at the market equilibrium price
**remember this is just talking about the individual firm’s demand curve, not the market demand and supply
Most of the goods we buy are in what kind of market structure?
monopolistic competition
What is profit? In perfect competition, when is profit maximized?
Profit is the difference between a firm’s total revenue and total cost
Profit is maximized when MC = P,
and MR = P, SOO
profit maximization: MC = P = MR
What is MR? Explain its nature in perfect competition
MR is the additional revenue by selling 1 more unit of product
Because price is given in PC, the MR is just going to be the price of an additional unit sold
*****(also we can say the firm’s horizontal demand curve = market price = marginal revenue)
In perfect competition, what happens if MC < P, or if MC > P?
MC < P
- profit could be increased by producing additional units
MC > P
- profit could be increased by reducing production
- additional units are costing you more to produce than you’re selling them for
In PC, the marginal cost curve approaches the marginal revenue curve from _______
below
What are the equations for profit? How can you compute profit from a graph?
profit = TR - TC
profit = (P - ATC) x Q
Graph:
area of a rectangle: length (Q) x height (difference between P and ATC)
(therefore if P > ATC you have positive profit and if ATC > P you have a negative profit)
What is the equation for profit if a firm shuts down? What is it if they continue operating? What can these equations tell us about our decision to stay open or shut down?
Shuts down: profit = - FC
Continues operating: profit = TR - (FC+VC)
comparing these and finding the difference:
ProfitOperatue - ProfitShutdown = TR - VC
**therefore, firms should remain open and operating in the short run as long as total revenue is greater than or equal to variable costs, EVEN if net profit is negative
State the rules for knowing when to shut down your firm or continue operating (whether you have positive or negative profits)
Continue operating if…
TR > or equal to VC
OR
P > or equal to AVC
Shut down if…
TR < VC
OR
P < AVC
*basically continue operating as long as you can cover your variable costs
In perfect competition in the short run, describe the characteristics of the firm’s short-run supply curve
The short-run supply curve is equal to the short-run marginal cost curve
*only the portion of the short-run marginal cost curve ABOVE the average variable cost (AVC) curve will be on the firm’s supply curve - because the firm will shutdown and supply will be 0 if P < AVC
in PC short-run, where MC = AVC, what is this point called?
Called the shut-down point > at any price point below this point, the quantity supplied is 0
How is market price determined in a perfectly competitive industry?
It is determined by the interaction between market supply and market demand
What is market supply?
It is the horizontal sum of all individual firms’ supply curves
What is producer surplus for a perfectly competitive firm?
Producer surplus is the sum of the differences between marginal cost and the price of output at every level of output
AKA
It is the difference between total revenue and total variable cost
PS = TR - VC
OR (P - AVC) x Q
What is the easiest way to find producer surplus on a graph? What’s the other way to look at it?
You should think of the Total Revenue - Total Variable Cost idea
which also is shown as…
Producer surplus = (P - AVC) x Q
*this will give you the producer surplus rectangle
Producer surplus is also shown as the area between Price and the MC curve, but you can’t calculate this because it’s not a rectangle
Show how producer surplus and profit relate - and what does this say about a firm’s decision to stay open or shut down?
*While profit includes ALL costs (including FC), producer surplus only considers VC
PS = TR - VC
Profit = PS - FC
*This means that firms will operate without making a profit, but they will shut down if they are not making any producer surplus
In perfect competition, how does the long run system differ from the short run?
- In the short run, some costs are fixed; in the long run, all inputs (and therefore costs) may be adjusted
- In the long run, free entry and exit is guaranteed - they can freely enter and exit in response to market conditions (in the short run we assume the # of firms is somewhat fixed)
- The short-run supply curve is the portion of the short-run marginal cost curve above the short-run average VARIABLE cost curve
> in the long run, firms will not stay in business unless all costs can be covered by revenue
*therefore, the long-run supply curve is the portion of the marginal cost curve above the long-run average TOTAL cost curve
What does free entry mean?
It is the ability of a firm to enter an industry without encountering legal or technical barriers
In PC, when will firms want to enter the market? and what effect does this entry have?
*Firms will enter the market if they see profit being made
> in the long-run, ATC includes ALL costs including opportunity costs
> So, if there are positive economic “profits”, new firms will enter
*When firms enter a market, the supply curve shifts outwards, price will go down for all firms, profits will go down until they are 0 (earning just enough to cover costs) > in the long run, there are 0 economic profits (account profits could still be positive)
In PC in the long run, how would a graph show positive long-run profit?
The positive profit would be the difference between P and LATC
> rectangle (P-LATC) x Q
Of course if profits are positive in the long run, firms will enter the market, supply curve will shift outward, and the price will go down, reducing profits
In the long-run, ATC = ____
AVC
What does free exit mean? In PC long-run, what effect will free exit have?
Free exit is the ability of a firm to exit an industry without encountering legal or technical barriers
Firms exiting the market will cause the industry supply curve to shift inward > ** market price will rise until market price equals the minimum of the LATC curve
In PC in the long-run, what will the price equal to?
The price will equal min LATC > 0 economic profit > price is stabilized here in the long-run
What is the important characteristic to note about the INDUSTRY supply curve in long-run PC (with firms entering and exiting)
The long run industry supply curve will be HORIZONTAL
(long-run industry demand is downward sloping)
Describe the process of adjustment to a new market equilibrium in response to an increase in demand (PC long-run)
- existing firms enjoy positive economic profits in the short run because P > LATC
- new firms eventually enter the market, supply shifts out, and price falls to minimum LATC
Describe the process of adjustment to a new market equilibrium in response to an increase in production costs (temporary and permanent) (PC long-run)
what happens to the state of the supply curve in each case
Some firms will experience negative economic profits in the short run > eventually these firms will exit the industry and supply will shift inward, driving up the market price until it is equal to LATC
Temporary increase:
- eventually will go back to original price and a horizontal supply curve
Permanent increase:
- shift up in the LATC curve
- new long-run equilibrium where new P = lowest point on LATC
- will have an UPWARD sloping supply curve
What is the implication of a constant-cost industry
- LATC is constant no matter the output level - doesn’t change with expansions or contractions in the industry
- this implies a horizontal long-run supply curve
**BUT, not all industries follow this constant-cost model
What are the implications of an increasing-cost industry?
- LATC increase with industry output
- possibly due to competition over a scarce input
- results in an upward-sloped long-run supply curve
What are the implications of a decreasing-cost industry?
- LATC fall with industry output
- results in a downward-sloped long-run supply curve
- possibly due to increasing returns to scale at the industry level or in the production of one or more of the industry’s inputs
Explain how a firm could earn economic rent in perfect competition and what does economic rent mean?
Although firms in LR PC cannot earn economic profit, this assumes all producers have identical cost curves, but they don’t
*some firms are more efficient than others > more efficient firms can earn economic rent (returns to specialized inputs above what firms paid for them)
In this kind of situation in PC LR, the LR market price equals the minimum LATC of the highest-cost firm in the industry > this highest-cost firm makes zero profit and zero producer surplus
*Economic rent DOES NOT equal economic profit
> economic rent is included in the opportunity costs associated with the use of an input (economic profit considers accounting costs and opportunity costs, and economic rent is included in oppt. cost)
ex. if you have a genius manager, they’re giving you value above and beyond, and they’ll be valuable in other ventures as well so this is like an oppt. cost
- so firms could have some economic rent but still 0 economic profit
