Week 9: Perfect Competition

Question 1

A perfect competition is a market in which…

Answer 1

Many firms sell identical products to many buyers, no restrictions on entry into the market, established firms have no advantage over new ones, sellers and buyers are well-informed about prices

Question 2

How does perfect competition arise?

Answer 2

The minimum efficient scale of a single producer is small relative to the market demand for the good or service so there is room in the market for many firms

Question 3

What is a price taker?

Answer 3

A firm that cannot influence the market price because its production is an insignificant part of the total market

Question 4

What is a firm’s total revenue?

Answer 4

The price of its output multiplied by the quantity of output sold

Question 5

What does the market demand curve (D) and market supply curve (S) determine?

Answer 5

The market price and the market quantity produced

Question 6

What is the total revenue curve (TR)?

Answer 6

Upward-sloping straight line that shows the relationship between total revenue and quantity sold

Question 7

What is marginal revenue?

Answer 7

Change in total revenue that results from a one-unit increase in quantity sold

Question 8

What is a firm’s marginal revenue in perfect competition?

Answer 8

Equal to the market price because the firm is a price taker

Question 9

What is a firm’s marginal revenue curve (MR)?

Answer 9

The horizontal line at the market price

Question 10

Why is a firm’s marginal revenue curve also its demand curve for its output?

Answer 10

Firm can sell any quantity it chooses at the market price so the demand curve for the product is a horizontal line at the market price

Question 11

What does a horizontal demand curve illustrate?

Answer 11

Perfectly elastic demand for the firm’s product because it is a perfect substitute for an identical product from another firm

Question 12

Is the market demand for a firm’s product perfectly elastic?

Answer 12

No, its elasticity depends on the substitutability of the product for other goods and services

Question 13

What decisions must a firm make to maximize economic profit?

Answer 13

How to produce at minimum cost, what quantity to produce, whether to enter or exit a market

Question 14

How does a firm decide how to produce at minimum cost?

Answer 14

By operating on its long-run average cost curve or with the plant that minimizes long-run average cost

Question 15

What can we find from a firm’s cost curves and revenue curves?

Answer 15

The output that maximizes the firm’s economic profit

Question 16

What can be derived from a firm’s total revenue curve and total cost curve?

Answer 16

Economic profit curve (total revenue-total costs)

Question 17

How do you find the profit-maximizing quantity?

Answer 17

No other output rate achieves a larger profit. Other output rates would incur an economic loss or make zero economic profit (break-even point)

Question 18

What is an alternative way to find the profit-maximizing quantity?

Answer 18

Marginal analysis, which compares marginal revenue with marginal cost

Question 19

What happens to the firm’s marginal revenue and marginal cost as output increases?

Answer 19

As output increases, marginal revenue remains constant and marginal cost eventually increases

Question 20

What happens if marginal revenue exceeds marginal cost (MR>MC)?

Answer 20

Revenue from selling one more unit exceeds the cost of producing it and an increase in output increases economic profit

Question 21

What happens if marginal revenue is less than marginal cost (MR

Answer 21

Revenue from selling one more unit is less than the cost of producing it and a decrease in output increases economic profit

Question 22

What happens if marginal revenue is equal to marginal cost (MR=MC)?

Answer 22

Revenue from selling one more unit equals the cost incurred to produce it. Economic profit is maximized and either an increase or deacrease in output decreases economic profit.

Question 23

What is a firm’s profit-maximizing output?

Answer 23

Its quantity supplied at the market price

Question 24

How do profit-maximizing responses to different market prices show the law of supply?

Answer 24

If the price of a good were higher than the market price, firm would increase production. If the price were lower, firm would lower production.

Question 25

What happens if price (marginal revenue) is less than average total cost at the profit-maximizing quantity?

Answer 25

Firm incurs an economic loss. Maximum profit is a loss (a minimum loss).

Question 26

What does the firm do if maximum profit incurs a loss?

Answer 26

If the loss is expected to be permanent, firm goes out of business. If the loss is expected to be temporary, firm must decide whether to shut down temporarily and produce no output or to keep producing.

Question 27

How does a firm make the temporary shutdown decision?

Answer 27

By comparing the loss from shutting down with the loss from producing and takes the action that minimizes that loss

Question 28

What is a firm's economic loss?

Answer 28

Economic loss= TFC + TVC - TR= TFC + (AVC - P) x Q

Question 29

What happens if the firm shuts down?

Answer 29

It produces no output, has no variable costs and revenue but must pay fixed costs, so economic loss equals total fixed cost

Question 30

What happens if the firm produces?

Answer 30

Firm incurs variable costs in addition to its fixed costs and receives revenue. Its economic loss equals TFC plus TVC minus TR. If TVC exceeds TR, this loss exceeds TFC and the firm shuts down. If AVC exceeds price, this loss exceeds TFC and firm shuts down.

Question 31

What is a firm's shutdown point?

Answer 31

Price and quantity at which it is indifferent between producing and shutting down

Question 32

Where does the shutdown point occur?

Answer 32

At the price and quantity at which average variable cost is a minimum, where the firm is minimizing its loss and its loss equals total fixed cost

Question 33

Whats happens if the price falls below minimum average variable cost?

Answer 33

Firm shuts down temporarily and continues to incur a loss equal to total fixed cost

Question 34

What happens if the price is above minimum average variable cost but below average total cost?

Answer 34

Firm produces the loss-minimizing output and incurs a loss that is less than total fixed cost

Question 35

What does a perfectly competitive firm's supply curve show?

Answer 35

How its profit-maximizing output varies as the market price varies, other things remaining the same

Question 36

Where is the firm's supply curve derived from?

Answer 36

Its marginal cost curve and average variable cost curves

Question 37

What happens when the price exceeds minimum average variable cost?

Answer 37

Firm maximizes profit by producing the output at which marginal cost equals marginal revenue. If price rises, firm increases its ouput and moves up along its marginal cost curve.

Question 38

What happens when the price less than minimum average variable cost?

Answer 38

Firm maximizes output by temporarily shutting down and producing no output

Question 39

What happens when the price is equal to the minimum average variable cost?

Answer 39

Firm maximizes profit by either temporarily shutting down and producing no output or producing the output at which average variable cost is at minimum (shutdown point). Firm never produces quantity between 0 and the quantity at shutdown point.

Question 40

What is the short-run market supply curve?

Answer 40

Shows the quantity supplied by all the firms in the market at each price when each firm's plant and the number of firms remain the same

Question 41

How is the market supply curve derived?

Answer 41

From the individual supply curves. Quantity supplied by the market at a given price is the sum of the quantities supplied by all firms in the market at that price.

Question 42

What determines the market price and the market output?

Answer 42

Market demand and short-run market supply. Short-run equilibrium on short-run supply curve and market demand curve gives the market price at which each firm produces profit-maximizing output, which can give the market output.

Question 43

How does an increase in demand affect short-run market equilibrium?

Answer 43

Rightward shift in demand increases the market price and the profit-maximizing output for each firm, thus increasing market output

Question 44

How does a decrease in demand affect short-run market equilibrium?

Answer 44

Leftward shift in demand decreases the market price and the profit-maximizing output for each firm, thus decreasing market output

Question 45

What is the formula for economic profit (or loss)?

Answer 45

Economic profit (or loss)= (P - ATC) x Q

Question 46

What are the three possible short-run profit outcomes?

Answer 46

Break even, economic profit, and economic loss

Question 47

What happens if price equals average total cost?

Answer 47

A firm breaks even and the entrepreneur makes normal profit (makes zero economic profit)

Question 48

What happens if price is greater than average total cost?

Answer 48

A firm gains an economic profit

Question 49

What happens if price is less than average total cost?

Answer 49

A firm incurs an economic loss

Question 50

How do firms respond to economic profit and economic loss?

Answer 50

By entering or exiting a market

Question 51

When does entry and exit occur in a market?

Answer 51

Entry occurs when new firms come into the market and the number of firms increases. Exit occurs when existing firms leave a market and the number of firms decreases.

Question 52

What markets do firms enter or exit?

Answer 52

New firms enter markets in which existing firms are making economic profit. Firms exit a market in which they are incurring an economic loss.

Question 53

What triggers entry and exit?

Answer 53

The prospect of persistent economic profit or loss, not temporary economic profit or loss

Question 54

How does entry and exit affect the market supply, market price, quantity produced by each firm, and economic profit (or loss)?

Answer 54

As firms enter a market, increase in supply lowers the market price and economic profit of each firm. As firms exit the market, decrease in supply increases the market price and decreases the economic loss incurred on remaining firms.

Question 55

When does entry and exit stop?

Answer 55

When firms make zero economic profit (economic profit or loss is eliminated)

Question 56

Does entry and exit result in an increase or decrease in market output and firm output?

Answer 56

Increase in market output but decrease in firm output. Price fall causes each firm to move down its supply curve and produce less. Increase in number of firms causes market to produce more. Exit creates an opposite result.

Question 57

When is a competitive market in long-run equilibrium?

Answer 57

When economic profit and economic loss have been eliminated and entry and exit have stopped

Question 58

What is the difference between the initial long-run equilibrium and new long-run equilibrium?

Answer 58

The number of firms in the market

Question 59

What response does a decrease in demand trigger?

Answer 59

Brings a lower price, economic losses, and exits. As supply decreases, price stops falling and begins to rise. Enough firms have exited for supply and demand to be in balance at a price that enables firms to return to zero economic profit (long-run equilibrium).

Question 60

What response does an increase in demand trigger?

Answer 60

Brings a higher price, economic profit, and entries. As supply increases, price lowers to its original level and economic profit returns to zero in a new long-run equilibrium.

Question 61

What happens when new technology that lowers production costs becomes available?

Answer 61

First firms to use it make economic profit. Old-technology firms incur an economic loss and exit. As more firms enter and use it, market supply increases and price falls to equal the minimum average total cost using the new technology. All firms are now new-technology firms that make zero economic profit.

Question 62

Who gains from technological change?

Answer 62

In the short run, producers gain from higher profit and consumers gain from lower prices. In the long run, economic profit will be zero but consumers continue to gain from low price.

Question 63

Why does a competitive market achieve efficiency?

Answer 63

Competitive equilibrium achieves this because, with no externalities, price equals marginal social benefit for consumers and equals marginal social cost for producers. Gains from trade are maximized. Economic profit is driven to zero and consumers pay the lowest possible price.

Question 64

What choices do consumers and producers make that lead to efficiency?

Answer 64

Consumers make the best available choices on the demand curve and firms are producing at least possible cost on supply curve. Marginal social benefit equals marginal social cost so resources are used efficiently.