Competitive Markets

Question 1

Accounting Profits

Answer 1

All the revenue a firm gets minus any costs it pays out. Accounting profits do notinclude opportunity costs.

Question 2

Economic Profits

Answer 2

All the revenue a firm gets minus any costs it pays out, including opportunity costs.

Question 3

Perfect Competition

Answer 3

A market structure where there is a large number of firms in a market, where no single firm can affect the price, and when there are low (or no) barriers to entry.

Question 4

Price Takers

Answer 4

Demand for firms output is perfectly horizontal perfectly elastic demand (price does not change with demand)

Perfectly Elastic Conditions:

1. Consumers believe firms sell same product
2. Consumers know the prices charged by all firms in the market
3. Easy to search for places to buy goods

Question 5

Transaction Costs

Answer 5

How hard it is to search for places to buy a good

Question 6

If a perfectly competitive firm increases the price of a good above the market price, which of the following will be true?

Answer 6

The firm will sell zero units of that good. If a perfectly competitive firm raises the price of a good above the market price, consumers will stop purchasing the good from that firm and instead buy it at the lower market price from another firm. As a result, the original firm will sell zero units of that good.

Submit

Question 7

All of the following characteristics are true of perfectly competitive markets except

Answer 7

Firms earn a small accounting profit in the long run but negative economic profit. Firms in a perfectly competitive market earn zero economic profit in the long run (NOT negative economic profit). If a firm were to be experiencing negative economic profit, in the long run it would exit the market.

Question 8

In the short run in perfect competition, the market demand curve is _____________ and the firm’s demand curve is ______________?

Answer 8

Downward-sloping; Horizontal. The law of demand says that as the price of a good in the market increases, the quantity demanded by consumers will decrease. So the market demand curve is downward-sloping. An individual firm under perfect competition, on the other hand, is a price taker and is not big enough to be able to influence the market price. Demand for this single firm’s output is perfectly elastic, or horizontal. If the firm increased its price by even a bit, it would lose all its customers.

Question 9

Michelle is a successful professional basketball player who makes $17 million per year, but she decides to quit her job as a basketball player and open a restaurant instead. The restaurant earns $10 million in revenue per year and has costs of $2 million. As a restaurant owner, Michelle’s economic profits are ___________ and her accounting profits are _____________.

Answer 9

Negative; Positive. Michelle’s economic profits are negative since the opportunity cost of the $17 million she could have made playing basketball is greater than the accounting profit she is making from the restaurant. This accounting profit is positive: $10m in revenue - $2m in costs = $8 million in accounting profit.

Question 10

Which of the following best describes a market with perfect competition?

Answer 10

Many small firms producing an identical product and facing no barriers to entry. Perfectly-competitive markets are characterized by many firms producing identical products with no barriers to entering or exiting the market.

Question 11

Which of the following best explains why firms earn zero economic profit in the long run under perfect competition?

Answer 11

There are no barriers to entry or exit.Under perfect competition, if a firm would make negative economic profit in the long run, that firm would be free to exit the market. And if firms in the market are making positive economic profits, other firms will see this and they would be free to enter the market and drive these economic profits down to zero in the long run. This all depends on the lack of barriers to firms entering or exiting the market.

Submit

Question 12

Which of the following is always true of a perfectly competitive firm in the long run?

Answer 12

It produces output at the minimum average total cost. In the long run, a perfectly-competitive firm makes zero economic profits. This means that the price it gets for each good (the marginal revenue) must be equal to the average total cost (ATC) to produce the goods. And since the firm is trying to maximize profit, we know that marginal cost (MC) must equal marginal revenue (which we’ve already determined is just the price). Therefore, at the quantity chosen by the perfectly-competitive firm, MC = ATC. Since we know the MC curve crosses the ATC curve at the minimum value of ATC, the firm must be producing output at this minimum average total cost.

Question 13

At a firm’s current rate of output, marginal cost is $10, average variable cost is $5, average fixed cost is $20, and the price of the product is $10. Which of the following statements is true for the firm?

Answer 13

Economic profits are negative because price is less than average total cost.Average total cost (ATC) is average variable cost (AVC) plus average fixed cost (AFC), or $5 + $20 = $25. On average, each unit of the good cost a total of $25 to produce, but only sold for a price of $10. This means the firm has negative economic profit, since its total cost is greater than its total revenue.

Question 14

Profit Maximization

Answer 14

Marginal benefit = Margnial cost

Revenue the firm gets from selling one more good = Additional cost required to produce one more good

Question 15

Firm produces until price is equal to

Answer 15

Marginal cost

Question 16

If Marginal cost is less than Marginal benefit

Answer 16

Produce more

Question 17

If marginal cost is less than marginal benefit, then

Answer 17

produce less

Question 18

Profit maximization graph

Answer 18

Question 19

Profit for firms graph

Answer 19

Question 20

Profit for firms after penalty graph

Answer 20

Question 21

Marginal Cost Curve

Answer 21

The increase in total cost for a firm of producing another unit of a good

Question 22

If the market price for the good is $50, what is the firm’s profit-maximizing quantity of output, according to the data in the table in Question 1a?

Answer 22

4. In a perfectly-competitive market, marginal revenue is equal to the price of the good. To maximize profit, the firm should choose the quantity at which marginal revenue ($50 in this case) is equal to marginal cost. The marginal cost of producing the first unit is the difference in total cost to produce 1 unit and the total cost to produce 0 units: 110 – 100 = $10. Since this marginal cost ($10) is less than the marginal revenue ($50), the firm should produce more. Using a similar computation, we can find the marginal costs for units 2 ($20), 3 ($25), 4 ($35), and 5 ($60). The marginal costs are less than the marginal revenue of $50 for all these units except the fifth. The cost of producing that fifth unit ($60) is more than the firm will get from selling it ($50), so the firm should stop producing after 4 units.

Question 23

The table below shows the short-run total cost for a typical firm producing a good in a perfectly-competitive industry for various levels of production of that good.

What is the marginal cost of producing the sixth unit of output, according to the data in the table?

Answer 23

$70. The total cost of producing 5 units is $250, and producing a sixth unit brings the total cost up to $320. The marginal cost of that sixth unit must be 320 – 250, or $70.

Question 24

Which of the following is true of marginal revenue for a firm in a perfectly-competitive industry?

Answer 24

It is constant. The marginal revenue of a firm in a perfectly-competitive industry is equal to the market price, which is constant.

Question 25

If a perfectly-competitive firm wishes to maximize profits and is producing where price exceeds both marginal cost and average variable cost, then the firm is ___________.

Answer 25

Producing too little output. A profit-maximizing firm should produce at a point where marginal revenue (price) is equal to marginal cost. In a perfectly-competitive market, the firm is a price taker, so it can’t lower the price. But it can increase the marginal cost by increasing production. The firm is currently producing too little output, and it should increase its output until marginal cost is equal to marginal revenue.

Question 26

Which of the following best describes the relationship between the average total cost curve and the marginal cost curve in the short run?

Answer 26

If the average total cost curve is falling, the marginal cost curve is below the average total cost curve. If marginal cost is below average cost, producing one more unit will bring down the average cost since that unit will cost less to produce than the average of the previous units. If the average total cost is decreasing as more units are added, the average total cost curve is falling.

Question 27

Suppose a perfectly-competitive, profit-maximizing firm is in long-run equilibrium. This firm produces 200 units, makes a total revenue of $800, and has a fixed cost of production of $200. Based on this information, what is the marginal cost (MC) and average variable cost (AVC) at this production level?

Answer 27

MC = $4; AVC = $3. The firm is profit-maximizing, so marginal cost must be equal to marginal revenue. Marginal revenue is simply the price of the good, and if 200 units are sold for a total of $800, the price must be 800 / 200, or $4. So MC = $4. The total variable cost is the total cost ($800) minus the fixed costs ($200), or $600. The average variable cost is the total variable cost divided by the quantity: 600 / 200, or $3. So AVC = $3.

Question 28

Sunk Costs

Answer 28

Costs that have already been incurred and cannot be recovered

Question 29

Shut-Down Price

Answer 29

The price below which it makes no sense for a firm to keep producing. In the short run, the shut-down price is average variable cost. In the long run, the shut-down price is average total cost.

Question 30

Revenue

Answer 30

Price x Quantity

Question 31

Revenue > Variable costs

Answer 31

Stay open

Question 32

Revenue < variable

Answer 32

Shut down

Question 33

Purity Hand Soap has a year remaining on a lease for its building, which it can’t legally break. The lease requires a payment of $10,000 per year. If Purity stays open for the rest of the year, its revenues will be $9,000, and its expenses, in addition to the lease, will be $7,000. Which of the following statements is true?

Answer 33

Purity should operate, since its revenues are higher than its variable costs. If Purity shuts down, it still must pay the $10,000 lease – this is a fixed cost. In this case, Purity would incur a $10,000 loss overall. If Purity continues to operate, it pays the $10,000 lease, but it also $9,000 in revenue and incurs $7,000 in variable costs. In this case, the overall loss is only $8,000 – the difference between the $17,000 in costs and $9,000 in revenue. Even though Purity will incur a loss if it continues to operate, this loss will be less than the loss it would incur if it shut down because the revenues are higher than the variable costs for this period.

Question 34

In the short run, a perfectly competitive firm should shut down whenever ___________.

Answer 34

Minimum average variable cost is higher than price. If the minimum average variable cost is higher than the price, each unit the firm sells is losing the firm money since that unit costs more to make than it brings in for revenue. In this case, not only is the firm losing money overall, but it has not chance to reduce these losses through additional sales since each unit loses money on average.

Question 35

In a perfectly-competitive industry, the market price of a product is $10. A firm produces at a level of output where average total cost is $19, marginal cost is $19, and average variable cost is $3. To maximize its profit, the firm should _____________.

Answer 35

Decrease output but keep producing. To maximize profit, a firm should produce at a level where marginal revenue (in this case, the price of $10) is equal to marginal cost. Since the firm is in a perfectly-competitive industry, it cannot affect the price, but it can affect the marginal cost through changing the production level. Currently, marginal cost ($19) is greater than marginal revenue ($10), so the firm needs to change quantity to decrease the marginal cost to $10. Because of diminishing marginal productivity, marginal costs tend to increase with output, so to decrease marginal cost, the firm should decrease output.

Question 36

Suppose a profit-maximizing firm in a perfectly-competitive market has negative economic profits in the short run. If the firm decides to continue producing in the short run, which of the following must be true?

Answer 36

The firm’s average variable costs are below the market price. If the firm has decided to continue operating in the short run, average variable costs must be below the market price. If average variable costs were above the market price, the firm would not be able to cover its variable costs with its revenue, let alone its fixed costs, and the firm would shut down.

Question 37

A profit-maximizing firm will shut down in the short run any time the firm’s total revenue is less than its _____________.

Answer 37

Total variable cost. A firm should shut down in the short run if average revenue (price) is less than average variable cost. Since average revenue is simply total revenue divided by quantity of output, and average variable cost is simply total variable cost divided by that same quantity of output, it follows that the firm should shut down if total revenue is less than total variable cost.

Question 38

When two or more firms produce the good the supply curve becomes

Answer 38

flatter (price elasticity is greater).

Question 39

Market Exit

Answer 39

In long run…

Firm will exit when it can’t make profit

Question 40

Market Entry

Answer 40

In long run

Firm will enter when it can make profit

Question 41

Zero Profit Condition

Answer 41

In a perfect market competition

–> Profit minimum average cost

Question 42

Minimum Average Cost

Answer 42

Price = Average Cost

Price = Marginal Cost

Marginal Cost = Average Cost

Question 43

Profits =

Answer 43

Revenue - Costs

Question 44

Revenue > Costs

Answer 44

Firm Stays in business

Question 45

Revenue/q > Cost/q =

Answer 45

Price > Average Cost

Question 46

The short-run supply curve for a firm in a perfectly competitive industry is ___________.

Answer 46

Its marginal cost curve above the minimum point of its average variable cost curve. A profit-maximizing firm chooses a quantity such that marginal cost is equal to marginal revenue (price). So the marginal cost curve traces out the quantity a firm would supply at a given price – the supply curve. But if the price is below the minimum point of the average variable cost curve, the firm should shut down (see Question 2), so the supply curve should consist only of the portion of the marginal cost curve that is above this point.

Question 47

The graphs below display a competitive market in the immediate aftermath of a positive demand shock, which creates an economic profit represented by the shaded region.

If there are no barriers to entry in this market, what will happen to the shaded profit rectangle in the long-run equilibrium?

Answer 47

It will disappear. In the long run, new firms enter because the market is profitable. This causes supply to increase, which leads to a lower price. Price keeps dropping until profit is zero, at which point the shaded profit rectangle disappears.

Question 48

Assume that a competitive industry producing an inferior good is in long-run equilibrium. If average consumer income decreases, which of the following will occur?

Answer 48

Both short-run industry output and short-run price increase, and firms enter. Remember that for inferior goods, when consumer income drops, demand increases. An upward shift in the demand curve means that in the short-run, output and price increase. This creates profit, which attracts new firms.

Question 49

Consider the three side-by-side graphs below, each displaying a competitive market. In these graphs, S is supply, D is demand, MC is marginal cost, ATC is average total cost, P is price, and MR is marginal revenue.

Belarus Springs is a firm in a perfectly-competitive market for bottled water and is currently earning positive short-run economic profits in the short run. Which of the graphs above best depicts Belarus Springs’ situation in the short run and in the long run?

Answer 49

Graph 1 in the short run; Graph 3 in the long run. The firm will produce at the point where marginal cost intersects marginal revenue (price). In Graph 1, that intersection is above the average total cost curve, so price is higher than average total cost and the firm makes a positive economic profit in the short run. But in the long run, firms will continue to enter until these positive profits are driven to zero and price is equal to average total cost, as in Graph 3.