Competition

Question 1

Perfect competition

Answer 1

Firms are price takers for both inputs and outputs; can’t independently influence the price that is charged for their goods or for the goods they need as inputs.

This is true under two conditions:
Demand for firm’s outputs = perfectly elastic
Supply for the firm’s inputs = perfectly elastic

Question 2

Demand is perfectly elastic when…

Answer 2

Consumers believe that firms sell identical products, consumers know all prices, and there are low transaction costs (i.e. it’s easy/low cost to shop across firms)

Question 3

Long-run cost curve

Answer 3

Cost minimizing way to produce any one of the given number of quantities; long-run expansion path

Question 4

Firm’s demand curve (in relation to the whole market)

Answer 4

q(p) = Q(p) - S(p)

firm’s demand curve = market demand minus supply of all other firms in the market

Question 5

The elasticity of demand for any given firm equation

Answer 5

If q = Q/N (all firms are identical) and supply for all firms is S = (n-1)q

Then, we can say that the elasticity of demand facing a given firm E = n * elasticity fo demand for the whole market minus (N-1) * elasticity of supply

Ei = nE - (n-1)*elasticity of supply

Question 6

Why is the elasticity of demand of ONE FIRM so much larger than the elasticity of demand for the MARKET?

Answer 6

The elasticity of demand facing a single firm in a perfectly competitive market is much larger in magnitude (i.e. more negative) than the market elasticity of demand. This is because, with a small price change, the consumer will easily abandon the firm and buy an identical product from a competitor. This is true even for inelastic goods, such as life-saving drugs.

Question 7

Profit equation

Answer 7

Profit (pi) = Revenues (R) - Cost (C)

Question 8

Accounting profits vs. economic profits

Answer 8

Economist profits measure the opportunity costs that are also paid when a decision is made, not just the financial costs

Question 9

How do firms maximize profit in the short run? (equation)

Answer 9

The profit-maximizing firm will always set Marginal Revenue MR = Marginal Cost MC

dR/dq = dC/dq at the optimum

Question 10

In a perfectly competitive market, what is the revenue I earn on the next unit I sell?

Answer 10

MC = price because MR is always the price

Not true in a non-perfectly competitive market

Question 11

How does a firm decide whether or not to keep producing?

Answer 11

At the margin! If the next unit they produce has a marginal cost higher than the marginal revenue (equal to price in perf competitive market) then they won’t produce that unit (even if TC < TR)

Question 12

Why would you stay open in the short run if your profits are negative?

Answer 12

If its still more than the losses you face when you produce q = 0 (shutdown) it makes sense to stay open, even if the profit is negative.

Only want to shutdown if p*q < VC
The revenues I earn are less than the actual cost of production beyond the fixed cost, i.e. variable costs
so, if price < AVC you’ll shutdown

**At the margin, if you lose money

Question 13

A firm’s supply curve is actually equal to…

Answer 13

the firm’s marginal cost curve

Question 14

As you have more firms, what happens to the shape of the market’s supply curve?

Answer 14

It becomes increasingly flatter; assuming that we have identical firms

The horizontal sum of each firms’ supply
n * firm’s supply

Question 15

Differences between LR and SR competition?

Answer 15

Simpler shutdown rule: If you’re losing money, you should shut down. In the SR, p < AVC but in the LR, p< AC you will shut down. If revenues are less than costs, you shut down.

We also now have entry and exit - firms can decide on whether or not to enter or leave; in a competitive market, firms will enter if profits being made & exit if profits are being lost

Question 16

In the LR, firms will enter and exit until…

Answer 16

profits are driven to zero.

Question 17

Where do profits = 0? (graphically)

Answer 17

MC = AVC; will be the minimum average costs

Question 18

Production possibilities frontier

Answer 18

shows the maximum combination of outputs that can be produced for any combination of inputs

Question 19

Linear PPF vs. PPF with economies of scope

Answer 19

Linear PPF - a minute spent on one thing is equally productive to a minute spent on the other thing - so you can choose any combination you want & it’s equally efficient

PPF with economies of scope: outward bending shape, doing a combination makes you more productive in both things; better off doing some of each

Question 20

Economy of scope

Answer 20

Doing one thing raises your productivity in the other

The cost of producing just q2 + cost of producing just q1 is greater than the cost of producing q1 & q2

Question 21

Diseconomy of scope

Answer 21

Producing each good by itself costs less than producing both; better of just producing one or the other (less productive when producing both)

Inward bending shape

Question 22

Agency problem (why firms don’t necessarily maximize their profits)

Answer 22

Sole proprietorship – you own the company and run the company

Most goods & services produced by corporations – separation between ownership & control; the guys that own the company don’t make the day to day decisions

The owners are the stockholders who invest in the corporation; the managers make day-to-day decisions

Priorities of owners vs. Managers don’t always align -
Managers don’t always care about profit maximization;
Managers care about their own self-interests/utility, not the firms’ interests

Question 23

Stock options

Answer 23

Based on stock price/strike price

Options to always buy stocks at a specific price (vs. buying at today’s price); this would be a valuable option because if the stocks rise, you make money off of that. So you’ll want the company’s value to go up

This is a lot cheaper than giving managers shares of the company.

Question 24

Name two problems that stock options commonly lead to

Answer 24

They lead to gambling – lead people to take risks that aren’t in the company’s best interests; causes a huge increase in risky investments. (you make money if it goes up, but you don’t lose money if it goes down)

Leads to cheating - there’s a huge incentive for fraudulent activity that inflates the value of the stock (i.e. backdating)

Question 25

Backdating stock options - what is this?

Answer 25

Set the strike price at an old price, that guarantees you’ll make money; stock options issued right before there was a major increase in the stock price (that you knew would happen)

Question 26

What are a board of directors? Why does this not solve the agency problem?

Answer 26

A board of directors exists to represent the owners (or shareholders) of a firm. If the board of directors is too friendly with the managers, they might be tempted to illegally offer back-dated stock options to the manager. Back-dated stock options are effectively an under-the-table cash gift. Then there would be an agency problem with the board of directors itself, in which the board of directors no longer represents the interests of the owners.

This doesn’t solve the agency problem because the board is usually incentivized to do whatever the executives want.

Question 27

Name two possible solutions to mitigate problems associated with stock options

Answer 27

1. Make the stock options longer-term, so that it is clear that any stock price increases are not illusory.
2. Create clawback provisions, so that managers have to pay back the firm if their stock options are later found to have been issued inappropriately

Question 28

Expected value

Answer 28

EV = % chance win * value win + % chance lose * value lose

Question 29

Enron example

Answer 29

An energy company that made up subdivisions of their company & sold it back to themselves; this inflated the stock price, and then the executives took out all their stocks at the peak and then the company value collapsed

Question 30

Sub-prime mortgages example

Answer 30

Gave mortgages to people who couldn’t afford their house but the expectation was that they could pay it off based on rising equity - which inflated the value of the housing market. As long as your house price keeps going up in value, the mortgage lenders could keep making money. Then, the housing market collapsed & a huge flood of foreclosures took place.

Question 31

Economies of scope must exist when…

Answer 31

…producing two or more goods jointly is more efficient than producing each good separately

Question 32

Firms suffer from an agency problem when…

Answer 32

….the incentives of the executives do not reflect the incentives of the owners

Question 33

Given the potential problem of back-dating stock options for executives, it’s important that the board of directors…

Answer 33

…represent the interests of the owners of the firm, and not be too friendly with the managers.

Question 34

No Child Left Behind Act

Answer 34

Sent money to schools who performed better

Question 35

Incentive issues with the No Child Left Behind Act?

Answer 35

Teaching to the test – might not represent the best education

Schools suspending the least talented schools on test day to bolster test scores

Carbo load the kids to improve productivity

Question 36

Firms decide how much labor to hire when…. (think about marginal benefit and cost)

Answer 36

Labor will be when the firm equates the marginal benefit of hiring the next worker to the marginal cost of hiring the next worker.

Marginal cost of hiring the next worker = wage; MRP (w); $ per hour

Question 37

Perfectly competitive input/labor market

What 3 things must be true?

Answer 37

Goods are homogenous; workers are the same

Perfect information, they know all wages

Perfect entry and exit

Question 38

In a perfectly competitive market, why are firms price takers on the input side? (i.e. labor)

Answer 38

Firms are price takers on the input side.

Firms don’t get to decide what they pay their workers; have to pay the market wage.

Question 39

The marginal benefit of next unit of labor equation

Answer 39

MRPL = p * MPL

Marginal revenue product of labor = wage/price * marginal product of labor

Question 40

Firms will hire workers until…

Answer 40

labor supply curve = MRPL (labor demand curve)

Marginal revenue product = wage * marginal product
MRPL = wage * MPL

Question 41

In a perfectly competitive market, what is the shape of the labor supply curve?

Answer 41

Flat supply curve

This doesn’t mean the labor supply overall is perfectly elastic, just that the labor supply to a given firm is perfectly elastic (if a firm won’t pay the market wage, workers will just go to another company)

Question 42

What’s different about the demand for labor in the long run (compared to the short run)?

Answer 42

You can replace labor with capital in the LR; meaning the demand for labor will be more elastic in the long run. The more I can substitute away from labor, the more elastic the curve will be.

In the long run, the labor demand curve will be flatter and more elastic. The more margins you can adjust, the more elastic you are at any margin.

Question 43

In LR perfect competition, in which situations will a firm decide to shut down?

Answer 43

• When total cost exceeds total revenue
• When average cost exceeds the price
• When average cost exceeds marginal revenue
• When average cost exceeds average revenue

In the long run, a firm should shut down when total cost exceeds total revenue. Dividing by quantity, this is also when average cost exceeds average revenue. In competition, average revenue is marginal revenue, and marginal revenue is price.

Question 44

In LR perfect competition, firms will continue to enter the market until….

Answer 44

each firm is producing at its greatest efficiency, average cost equals price for each firm in the market, the average cost is minimized for each firm in the market, profits are driven to zero for each firm in the market

Firms enter until average cost equals price, which is the point at which profits are driven to zero. This is also the point at which average cost is minimized, which is by definition the point at which the firm is operating at greatest efficiency.

Question 45

Suppose a firm exits a competitive market. What happens in the short-run?

Answer 45

Market price increases, other firms in the market realize increased profits (or decreased losses)

When a firm exits the market, the short run supply curve shifts inward and becomes less elastic. This decreases market quantity and increases price, as the market equilibrium shifts along the market demand curve. The higher market price means each other firm remaining in the market realizes increased profits (or decreased losses), as the firms are all price-takers.

Market demand depends only on consumer preferences, and is unchanged by firm entry and exit.

Question 46

What is unrealistic about the assumption that input prices are fixed?

Answer 46

Input prices are often determined by a competitive market, such as the market for labor, and their prices will be determined by supply and demand.

Input costs that rise with output, such as wages, increase the minimum average cost of higher quantities of output. This creates an upward-sloping output supply curve.

Input prices are not driven to zero by competition. Firms do minimize the cost of their inputs, but this does not explain why input prices are not fixed.

Question 47

In the long-run, with identical firms, free entry and exit and fixed input costs, firm entry and exit will….

Answer 47

drive profits to zero, drive the market supply curve to perfect elasticity and drive each firm in the market to produce at minimum average cost

Question 48

What is different about a firm’s demand for labor in the long run, relative to the short run?

Answer 48

In the long run, firms can adjust the amount of capital they use as an input. This gives them additional flexibility for determining how much labor to use as an input; in the long run, the firm can choose which short-run demand curve to use. The flexibility manifests as more elastic demand.

Question 49

What is necessarily true under perfect competition?

Answer 49

Firms are price takers on the output side, firms are price takers on the input side

Question 50

What conditions are necessary for demand for a firm’s outputs to be perfectly elastic?

Answer 50

There are low transaction “shopping” costs, consumers know all prices, consumers believe that firms sell identical products

Question 51

In the short run, what is the profit maximizing condition for firms in perfectly competitive markets?

Answer 51

In the short run, the profit maximizing condition for firms in perfectly competitive markets is that marginal cost equals price. Observe that in a perfectly competitive market, price is equal to marginal revenue.

Question 52

In the short run, when should a firm decide to shut down?

Answer 52

In the short run, a firm should shut down when total variable cost exceeds total revenue, which is also when average variable cost exceeds price. Fixed costs cannot be avoided in the short run, so they are irrelevant to the shutdown decision.

Question 53

What happens to the demand and supply curve as more firms enter the market?

Answer 53

The market supply curve becomes more elastic, the market demand curve will not change