Perfect Competition

Question 1

How do we find market demand curves?

Answer 1

SEE NOTES FOR EXPLANATION

Question 2

What is Residual Demand?

Answer 2

Market demand that is not met by other firms in the industry at a given price.

(SEE GRAPH)

Question 3

Why can the Residual Demand (Dr(p)) be elastic when the market demand is inelastic?

Answer 3

An increase in price may not reduce market demand by much.
However, if one individual firm increases its price, it
may still lose most of its demand to other sellers.

Question 4

When is a firm a price taker?

Answer 4

firm is a price taker when it has no ability to increase the market price. 
In perfect competition, we assume an extreme case where residual demand is
perfectly elastic (flat) over the relevant range.

Firm can sell whatever quantity it likes at the market price, p, but no matter how much the firm could reasonably produce, it can’t influence the market price.

(SEE GRAPH)

(FOR ALL CONDITIONS OF PERFECT COMP CHECK LAST YEARS NOTES)

Question 5

When is a firm likely to be a price taker?

Answer 5

• Homogenous products – firms sell identical products (or at least, consumers think they do).
• Consumers are aware of all suppliers and are informed about their prices
• Consumers can trade with each firm at no additional costs
• Free entry and exit – firms can move costlessly in and out of the market.

Question 6

What must a firm decide when in a perfectly competitive market?

Answer 6

i) Whether to produce at all

ii) If they do produce, how much to produce?

Question 7

In order to find out a firms decision what do we assume?

Answer 7

That a firm selects their output level in order to maximise their profits

Question 8

How do we find the profit maximising level of output? (Decision i)

Answer 8

We know each firm faces the maximisation problem of:
- Max q π(q) = pq - C(q)

Find FOC in regards to Q =
dπ(q)/dq = p - dC(q)/dq = 0

Rearranging for P gives us
P=MC(q*)

SEE EXAMPLE IN NOTES

Question 9

So what the optimal level of output for a firm?

Answer 9

A firm should choose the output q* at which p = MC(q*)

Question 10

What point of Output is unprofitable?

Answer 10

Any point beyond P = MC(q*)

This would be unprofitable as p< MC(q*)

Question 11

What point of Output remains to be profitable even if its not P=MC(q*)?

Answer 11

Any point before P = MC(q*)

As P> MC (q*)

Question 12

How does a firm decide if they should produce at all?

Decision ii

Answer 12

• If profits are positive at q*, then yes firm should produce
• If profits are negative at q*, then firm may still want to produce (due to sunk costs)

Question 13

What do we have to consider in the long run before we find the shutdown rule in the Long run?

Answer 13

• Firms dont need to incur any fixed capital costs

- If earning negative profits, has the freedom and incentive to exit the industry

Question 14

What is the Long Run Shut down rule?

Answer 14

pq < C(q)

p< AC (q)

By using the firm’s output decision (p=MC(q)) and this ‘shutdown’ rule, we can see that a firm’s individual long run supply function, q*(p), will equal the marginal cost function at prices equal to AC(q) and above.

Question 15

What do we have to consider in the short run before we find the shutdown rule in the short run?

Answer 15

• In SR, the firm has to pay fixed capital costs (F) regardless of its output choice
• Since F must be paid either way the shutdown decision
  depends on whether revenues are larger than variable costs

Question 16

What is the Short run shutdown rule?

Answer 16

pq < VC (q)

p< AVC (q)

This can mean optimally producing at an overall loss if p>AVC(q) and p

Question 17

How do we calculate Individual Supply Functions?

Answer 17

• To do this we combine firm’s optimal output choice and the shutdown rule

(SEE EXAMPLE IN NOTES)

Question 18

How do we find the market supply function (Qs(p))in the SR?

Answer 18

• In the SR, the number of firms is fixed
• Therefore, the market supply function (Qs(p)) simply the horizontal sum of the individual supply functions across all firms

Question 19

How do we find the Individual Supply function if the firms are identical?

Answer 19

• Just multiply the individual supply function (q(p)) by the number of firms (n) to give Qs(p) = nq(p)

Question 20

How do we find the Short run market price (p) and quantity (q)?

Answer 20

By finding the intersection of the market supply function and market demand.

(SEE EXAMPLE IN NOTES)

Question 21

In the long run when is the Market supply curve flat at the LR min AC?

Answer 21

i) Firms can freely enter and exit
ii) There are unlimited number of firms with identical costs
iii) Input prices remain constant

Intuitively, if the price rises above this level then existing firms make positive
profits and this induces more firms to enter the market, allowing the production
of more output at this cost level

Question 22

How do we find the Market price and Quantity in the Long run?

Answer 22

• Found via the intersection LR market supply and market demand

Question 23

When does the LR market supply function become upwards sloping?

Answer 23

If (i) and (ii) does not hold

• In this case, any increase demand will raise the market price.
  This can happen in the following cases.

Question 24

Under what conditions is the LR Market supply function upwards sloping?

Answer 24

1. If entry is limited due to prohibitive costs of entry/exit or some regulation,
   then there may not be an unlimited number of firms able to enter the market.
   Instead, any increase in output will have to come from existing firms’ LR
   supply curves, which will be upward sloping at sufficiently high quantities.
2. If entering firms have higher costs, then even if there is entry, supply cannot
   be expanded at the existing price level and the LR supply curve will be upward
   sloping.
3. If firms use a common input, then it may be that an increase in demand may
   lead to a rise in the price of the common input and a rise in costs for all firms
   such that LR costs increase.