Chapter-12-perfect-competition

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Chapter 12 PERFECT COMPETITION

Microeconomic Theory 1 (University of Waterloo)

Studocu is not sponsored or endorsed by any college or university

Chapter 12 PERFECT COMPETITION

Microeconomic Theory 1 (University of Waterloo)

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Answers to the Review Quizzes

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1. Why is a firm in perfect competition a price taker?

One firm’s output is a perfect substitute for another firm’s output and each firm is a small part of the

market. These points imply that each firm cannot unilaterally influence the market price at which it can

sell its good or service. It must accept, or “take” the market equilibrium price—hence the term, price taker.

2. In perfect competition, what is the relationship between the demand for the firm’s output and

the market demand?

The market demand curve for the goods and services in a perfectly competitive market is downward

sloping. However, no single firm in this market can influence the price at which it sells its output. This

point means a firm that is a price taker must take the equilibrium market price as given, and the firm faces

a perfectly elastic demand.

3. In perfect competition, why is a firm’s marginal revenue curve also the demand curve for the

firm’s output?

A perfectly competitive firm’s demand curve is a horizontal line at the market price. This result means that

the price it receives is the same for every unit sold. The marginal revenue received by the firm is the change

in total revenue from selling one more unit, which is the constant market price. So a perfectly competitive

firm’s demand curve is the same as its marginal revenue curve.

4. What decisions must a firm make to maximize profit?

The firm has three decisions it must make. First it must determine how to produce at the minimum cost.

Then it must determine how much to produce. Finally it must decide whether to enter or exit a market.

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1. Why does a firm in perfect competition produce the quantity at which marginal cost equals

price?

A firm’s total profit is maximized by producing the level of output at which marginal revenue for the last

unit produced equals its marginal cost, or MR = MC. In a perfectly competitive market, MR is equal to the

market price P for all levels of output. These points imply that a perfectly competitive firm will maximize

profit by producing output where P = MC.

2. What is the lowest price at which a firm produces an output? Explain why.

The lowest price at which a firm will produce output is the price that equals the firm’s minimum AVC. At

this price the firm has just enough total revenue to cover its total variable costs. The firm’s loss is equal to

its fixed costs. At any lower market price the firm’s loss would be greater than its fixed costs. In this case

the firm can avoid losses that are greater than its fixed cost by shutting down.

3. What is the relationship between a firm’s supply curve, its marginal cost curve, and its average

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COMPETITION

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variable cost curve?

The firm will produce output as long as the price is greater than the minimum AVC. It will choose the

level of output where MC = P, which means the firm’s supply curve is the firm’s MC curve above

minimum AVC.

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1. How do we derive the short-run market supply curve in perfect competition?

The short-run market supply curve is the horizontal sum of each individual firm’s supply curve. That is,

the amount supplied by the total market equals the sum of what each firm in the industry supplies at a

given price.

2. In perfect competition, when market demand increases, explain how the price of the good and

the output and profit of each firm changes in the short run.

When market demand increases, the market price of the good rises, and the market quantity increases.

Because price equals marginal revenue, the rise in the price means marginal revenue rises. As a result, each

firm moves up its marginal cost curve and increases the quantity it produces. The firm’s profit rises (or its

economic loss decreases). If the firm had been making zero economic profit before the increase in demand,

after the increase the firm earns an economic profit.

3. In perfect competition, when market demand decreases, explain how the price of the good and

the output and profit of each firm changes in the short run.

When market demand decreases, the market price of the good falls and the market quantity decreases.

Because the price equals marginal revenue, the fall in the price means marginal revenue falls. As a result,

each firm moves down its marginal cost curve so each firm decreases the quantity it produces. The firm’s

profit falls (or its economic loss increases). If the firm had been making zero economic profit before the

decrease in demand, after the decrease the firm incurs an economic loss.

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1. What triggers entry in a competitive market? Describe the process that ends further entry.

When firms in a competitive market make an economic profit, the economic profit serves as an

inducement to other firms to enter the market. As the other firms enter, the supply increases and the price

falls. The fall in the price eventually eliminates the economic profit, at which time entry stops.

2. What triggers exit in a competitive market? Describe the process that ends further exit.

When firms in a competitive market are incurring an economic loss, some of the firms will exit the market.

As these firms exit, the supply decreases and the price rises. The rise in the price eventually eliminates the

economic loss, at which time exit stops.

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1. Describe the course of events in a competitive market following a permanent decrease in

demand. What happens to output, price, and economic profit in the short run and in the long

run?

Starting from an initial point of long-run equilibrium, a permanent decrease in demand decreases the

market quantity, and the market price falls below ATC for each firm. In the short run, firms in the industry

experience an economic loss, which leads to firms exiting the market in the long run. This exit shifts the

market supply curve leftward, raising the market price and continuing to decrease the market quantity. The

increase in market price shrinks the economic loss for each remaining firm. Exit continues until the price

again equals the minimum point on each firm’s ATC curve. At this point, firms return to zero economic

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profit and exit stops. In the long run, with no external economies or diseconomies the market price returns

to the original level, market output is less than the original amount, and economic profit for each firm

returns to zero.

2. Describe the course of events in a competitive market following a permanent increase in

demand. What happens to output, price, and economic profit in the short run and in the long

run?

A permanent increase in demand increases the market quantity, and the market price rises above ATC for

each firm. In the short run, firms in the industry experience an economic profit, attracting firms from

outside the industry to enter the industry in the long run. This entry shifts the industry supply curve

rightward, lowering the market price as the market quantity continues to increase. The fall in the market

price shrinks the firms’ economic profit until the price again equals the minimum point on each firm’s

ATC curve. At this point, firms return to zero economic profit and entry stops. In the long run, with no

external economies or diseconomies the market price returns to the original level, market output is larger

than the original amount, and economic profit for each firm returns to zero.

3. Describe the course of events in a competitive market following the adoption of a new

technology. What happens to output, price, and economic profit in the short run and in the

long run?

Technological advances result in lower costs for the firm that adopts them and initially these firms make an

economic profit. This causes two actions to occur in the market: i) firms from outside the industry that

have adopted the new technology enter the market; ii) firms with old technology either exit the market or

adopt the new technology. These two actions shift the industry supply rightward, decreasing market price

and increasing market quantity. In the long run, all firms in the industry will be new technology firms,

economic profit for each firm will return to zero, market quantity will increase, and market price will fall to

the new minimum ATC for each firm.

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1. State the conditions that must be met for resources to be allocated efficiently.

Resource use is efficient when the economy produces the goods and services that people value most highly.

This situation requires that consumers are on their demand curves, thereby allocating their budgets to get

the most possible value from their income. If the people who consume a good or service are the only ones

who benefit from it, then the market demand curve measures the benefit to the entire society and is the

marginal social benefit curve. Efficient resource use also requires that firms are on their supply curves,

thereby getting the most value out of their resources. If the firms that produce a good or service bear all the

costs of producing it, then the market supply curve measures the marginal cost to the entire society and the

market supply curve is the marginal social cost curve. And resources are used efficiently when marginal

social benefit equals marginal social cost.

2. Describe the choices that consumers make and explain why consumers are efficient on the

market demand curve.

Consumers allocate their budgets so they get the most value from their budgets. When consumers are on

their demand curves, they are getting the most value out of their resources and are efficient.

3. Describe the choices that producers make and explain why producers are efficient on the

market supply curve.

Competitive firms maximize profit. To do so, they must be technologically efficient and economically

efficient. As a result, when competitive firms are on their supply curves maximizing their profit, they are

getting the most value out of their resources and are efficient.

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4. Explain why resources are used efficiently in a competitive market.

Resources are used efficiently in a competitive market because the market demand curve is the same as the

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