Ch. 23, Perfect Competition
Suppose that the perfectly competitive firm with the costs and revenues shown in the figure to the right is contemplating whether or not to produce 12 units of output. If the firm were to produce the 12th unit and, in doing so, increase its hourly total costs to $66 from $56, what would be its marginal cost? Would producing 12 units maximize the firm's profits? What would be the firm's total revenues per hour? What would be its hourly economic profits? If it were to produce the 12th unit, the firm's marginal cost would be MC = $ ______ per unit and this price ______ the firm's marginal revenue, marginal cost ______ marginal revenue, and producing the 12th unit ______ satisfy the profit-maximizing rule. The firm's total revenue would equal $______ per hour and economic profits would equal $_______ per hour.
$10; $4; equals; is larger than; would not; $48; $-18
Consider the diagram at right, which applies to a perfectly competitive firm, which at present faces a market clearing price of $20 per unit and produces 10,000 units of output per week. What is the firm's current average revenue per unit? $______. (Same as price) What are the present economic profits of this firm? $_______ (The economic profits are the price of $20 minus the average total cost of $15.25 multiplied by the output level of: 10,000 = $4.75 × 10,000 = $47,500.) Is the firm maximizing economic profits? A. Yes, they are producing where the price equals the average cost. B. No, they are producing where the price equals the marginal cost. C. Yes, they are producing where the marginal revenue equals the marginal cost. D. Yes, they have economic profits. E. It is impossible to be sure with the given information. If the market clearing price drops to $12.50 per unit the firm should A. continue to produce since the firm can pay some of its fixed cost. B. continue to produce since the price exceeds the average variable cost. C. continue to produce since the loss is less than the fixed cost. D. All of the above. If the market clearing price drops to $7.50 per unit the firm should A. shut down since the loss is more than the fixed cost. B. shut down since the price is less than the average variable cost. C. shut down since the firm can pay none of its fixed cost. D. All of the above. E. continue to operate at a loss until the firm can exit the market.
$20; $47,500; C. Yes, they are producing where the marginal revenue equals the marginal cost. D. All of the above. Note: To determine whether the firm should produce in the short-run, compare the price with average total cost and average variable cost. If the price equals the average total cost, the firm breaks even earning a zero economic profit, or a normal profit. If the price is less than the average total cost, but greater than the average variable cost, the firm will have a loss in the short-run, but should still operate because its average variable costs are covered by the price of the product. Loss will be minimized by producing the output level where marginal revenue equals marginal cost. In this case, the loss will be less than the fixed cost the firm would lose if it shuts down. D. All of the above. Note: To determine whether the firm should produce in the short-run, compare the price with average total cost and average variable cost. If the price is less than the average variable cost, the firm will minimize loss by shutting down and paying only the fixed costs because its average variable costs are not covered by the price of the product.
Select which characteristic of a perfectly competitive industry is not met in the examples below. Four fundamental characteristics of a perfectly competitive industry: (1) there is a large number of buyers and sellers, (2) firms in the industry produce and sell a homogeneous product, (3) information is equally accessible to both buyers and sellers, and (4) there are insignificant barriers to industry entry or exit. Even though one firm produces a large portion of the industry's total output, there are many firms in the industry, and their products are indistinguishable. Firms can easily exit and enter the industry. This example violates characteristic number ________
1 Note: A perfectly competitive industry has four fundamental characteristics: (1) there is a large number of buyers and sellers so that each seller produces a very small portion of the industry output, (2) firms in the industry produce and sell a homogeneous product, (3) information is equally accessible to both buyers and sellers, and (4) there are insignificant barriers to industry entry or exit. These characteristics imply that each firm in a perfectly competitive industry is a price taker, meaning that the firm takes the market price as given and outside its control. Since in this case, one firm produces a large portion of the industry's total output it is not a perfectly competitive industry.
Select which characteristic of a perfectly competitive industry is not met in the examples below. Four fundamental characteristics of a perfectly competitive industry: (1) there is a large number of buyers and sellers, (2) firms in the industry produce and sell a homogeneous product, (3) information is equally accessible to both buyers and sellers, and (4) there are insignificant barriers to industry entry or exit. There are many buyers and sellers in the industry. Consumers have equal information about the prices of firms' products, which differ slightly in quality from firm to firm. This example violates characteristic number _________.
2 Note: A perfectly competitive industry has four fundamental characteristics: (1) there is a large number of buyers and sellers, (2) firms in the industry produce and sell a homogeneous product, (3) information is equally accessible to both buyers and sellers, and (4) there are insignificant barriers to industry entry or exit. These characteristics imply that each firm in a perfectly competitive industry is a price taker, meaning that the firm takes the market price as given and outside its control. Since in this case, firms' products, differ slightly in quality from firm to firm it is not a perfectly competitive industry. OK
Select which characteristic of a perfectly competitive industry is not met in the examples below. Four fundamental characteristics of a perfectly competitive industry: (1) there is a large number of buyers and sellers, (2) firms in the industry produce and sell a homogeneous product, (3) information is equally accessible to both buyers and sellers, and (4) there are insignificant barriers to industry entry or exit. Many taxicabs compete in a city. The city's government requires all taxicabs to provide identical service. Taxicabs are virtually identical, and all drivers must wear a designated uniform. The government also limits the number of taxicab companies that can operate within the city's boundaries. This example violates characteristic number ______.
4 Note: A perfectly competitive industry has four fundamental characteristics: (1) there is a large number of buyers and sellers, (2) firms in the industry produce and sell a homogeneous product, (3) information is equally accessible to both buyers and sellers, and (4) there are insignificant barriers to industry entry or exit. These characteristics imply that each firm in a perfectly competitive industry is a price taker, meaning that the firm takes the market price as given and outside its control. Since in this case, the government limits the number of taxicab companies that can operate within the city's boundaries it is not a perfectly competitive industry.
The table below represents the hourly output and cost structure for a local pizza shop. The market is perfectly competitive, and the market price of a pizza in the area is $12. Total costs include all implicit opportunity costs. Calculate the pizza shop's marginal cost and marginal revenue at each rate of output and fill in the values in the table. (Marginal revenue is the change in revenue divided by the change in output. For a perfectly competitive firm the marginal revenue is equal to the price. Marginal cost is the change in cost divided by the change in output.) Based on marginal analysis, what is the profit-maximizing rate of output for the pizza shop? _______ pizzas.
9 Note: The firm should continue production until the cost of increasing output by one more unit (the marginal cost) is just equal to the revenues obtainable from that extra unit (the marginal revenue).
What is a perfectly competitive firm?
A firm that is such a small part of the total industry at that it cannot affect the price of the product it sells.
What is perfect competition?
A market structure in which the decisions of individual buyers and sellers have no effect on market price.
What is the long-run industry supply curve?
A market supply curve showing the relationship between prices and quantities after firms have been allowed the time to enter into or exit from an industry, depending on whether there have been positive or negative economic profits. Note: Remember that our definition of the long run is a period of time in which all adjustments can be made
What is a price taker?
A perfectly competitive firm given because the firm cannot influence its price.
What is market failure?
A situation in which an unrestrained market operation leads to either too few or too many resources going to a specific economic activity.
What is marginal cost pricing?
A system of pricing in which the price charged is equal to the opportunity cost to society of producing one more unit of the good or service in question. The opportunity cost is the marginal cost to society.
Which of the following is not one of the assumptions of a perfectly competitive market? A. Better information for producers than consumers. B. Homogeneous product. C. Free entry and exit. D. Large number of buyers and sellers.
A. Better information for producers than consumers.
For each example below, identify which statement is not characteristic of a perfectly competitive industry. A. One firm produces a large portion of the industry's total output. B. There are many firms in the industry. C. Their products are indistinguishable. D. Firms can easily exit and enter the industry.
A. One firm produces a large portion of the industry's total output.
The demand curve for the perfectly competitive industry is A. downward sloping. B. indeterminate without more information. C. vertical. D. horizontal.
A. downward sloping. Note: The demand schedule for a perfectly competitive industry is downward sloping. The demand schedule for a perfectly competitive firm is horizontal.
The perfect competitor should produce the quantity where A. marginal revenue equals marginal cost. B. marginal revenue is maximized. C. marginal cost is zero. D. marginal cost is minimized.
A. marginal revenue equals marginal cost.
A perfectly competitive firm wants higher profits and has decided to raise the price of its product. As an economic consultant you would advise them to A. not do this since they would lose all of their sales to competitors. B. do this, but also to lower ATC to make larger profits. C. do this since higher price increases total revenue, other things remaining equal. D. do not do this since competitors will match the increase in price and the firm will be no better off.
A. not do this since they would lose all of their sales to competitors.
The demand curve for the perfectly competitive firm is A. perfectly elastic. B. elastic at lower output levels, then unit elastic, and then inelastic at higher output levels. C. unit elastic. D. perfectly inelastic.
A. perfectly elastic.
The perfectly competitive firm is said to be a A. price taker long dash— it takes the price given by the market. B. price participant long dash— it decides the price together with other firms. C. price maker long dash— it sets market prices. D. price leader long dash— it changes its price and other firms follow.
A. price taker long dash— it takes the price given by the market.
The perfect competitor should produce the quantity where A. profits are maximized. B. total revenues are maximized. C. total costs are minimized. D. All of the above.
A. profits are maximized.
All of the following are characteristics of perfect competition except A. the products sold by the firms in the industry are differentiated. B. both buyers and sellers have access to all relevant information. C. firms can enter or leave the industry without serious impediments. D. there are a large number of buyers and sellers.
A. the products sold by the firms in the industry are differentiated.
What is increasing-cost industry?
An industry in which an increase in industry output is accompanied by an increase in long-run per-unit costs, such that the long-run industry supply curve slopes upward.
What is decreasing-cost industry?
An industry in which an increase in output leads to a reduction in long-run per-unit costs, such that the long-run industry supply curve slopes downward.
What is constant-cost industry?
An industry whose total output can be increased without an increase in long-run per-unit costs. Its long-run supply curve is horizontal.
how can a firm that is sustaining economic losses in the short run tell whether it is still worthwhile not to shut down?
As long as the price per unit sold exceeds the average variable cost per unit produced, the earnings of the firm's owners will be higher if it continues to produce in the short run than if it shuts down.
STUDY Figure 23-1The Demand Curve for a Producer of Portable Power Banks
At $5—where market demand, D, and market supply, S, intersect—the individual firm faces a perfectly elastic demand curve, d. If the firm raises its price even one penny, it will sell no portable power banks. [Notice the difference in the quantities of portable power banks represented on the horizontal axes of panels (a) and (b).]
In the figure to the right, the firm should produce A. 10 units since this is the only output level with accounting profits. B. 10 units since economic profits are the greatest. C. any output level between 5 and 13. D. 5 or 13 units since the firm breaks even.
B. 10 units since economic profits are the greatest.
Firms in perfectly competitive industries will eventually have no customers if they set their prices above the competitive price. A. False B. True
B. True
The decision making process for the perfectly competitive firm boils down to A. deciding for whom to produce. B. deciding how much to produce. C. deciding when to change the price. D. deciding what price to charge.
B. deciding how much to produce.
For a perfectly competitive firm, price A. equals average revenue only. B. equals both average revenue and marginal revenue. C. equals average revenue, marginal revenue, and average total costs. D. equals marginal revenue only.
B. equals both average revenue and marginal revenue.
The demand curve for the perfect competitor is horizontal because A. demand is perfectly inelastic. B. the market dictates each firm's price. C. the firm is a price maker. D. None of the above.
B. the market dictates each firm's price. Note: The demand schedule for a perfectly competitive firm is the going market price as determined by the forces of market supply and market demand. That is where the market demand curve intersects the market supply curve.
For each example below, identify which statement is not characteristic of a perfectly competitive industry. A. There are many buyers and sellers in the industry. B. Consumers have equal information about the prices of firms' products. C. The products differ slightly in quality from firm to firm. D. Many diners compete in a city.
C. The products differ slightly in quality from firm to firm.
The perfect competitor should produce the quantity where A. marginal cost is zero. B. marginal cost is minimized. C. marginal revenue equals marginal cost. D. marginal revenue is maximized.
C. marginal revenue equals marginal cost.
Suppose that a firm in a perfectly competitive industry finds that at its current output rate, marginal revenue exceeds the minimum average total cost of producing any feasible rate of output. Furthermore, the firm is producing an output rate at which marginal cost is less than the average total cost at that rate of output. Is the firm maximizing its economic profits? A. Yes, marginal revenue exceeds the minimum average total cost of producing any feasible rate of output. B. It is impossible to draw a conclusion from the given information. C. No, if the firm was maximizing its economic profits the marginal cost would not be less than the average total cost at that rate of output. D. No, the marginal cost is less than the average cost, so the average cost must be declining at the output level where the firm is producing. E. No, the firm is producing where average total cost are a minimum.
C. No, if the firm was maximizing its economic profits the marginal cost would not be less than the average total cost at that rate of output. Note: The marginal cost is less than the average cost, so the average cost must be declining at the output level where the firm is producing. Since the marginal revenue exceeds the minimum average total cost of producing for some feasible rate of output, if the firm was maximizing its economic profits the marginal cost must also exceed the minimum average total cost for some feasible rate of output. Therefore, if the firm was maximizing its economic profits both the marginal revenue and the marginal cost would be greater than the average total cost at that rate of output. In this case, the firm is producing an output rate at which marginal cost is less than the average total cost at that rate of output.
What are market signals?
Compact ways of conveying to economic decision makers information needed to make decisions. An effective signal not only conveys information but also provides the incentive to react appropriately. Economic profits and economic losses are such signals.
For each example below, identify which statement is not characteristic of a perfectly competitive industry. A. Many taxicabs compete in a city. B. The city's government requires all taxicabs to provide identical service. C. Taxicabs are virtually identical, and all drivers must wear a designated uniform. D. The government also limits the number of taxicab companies that can operate within the city's boundaries.
D. The government also limits the number of taxicab companies that can operate within the city's boundaries.
A perfectly competitive firm is charging $7 and selling 1000 units a month. The firm raises its price by a nickel above the market price. Its profit A. will not change. B. will increase. C. will decrease. D. will go to zero.
D. will go to zero.
For a perfectly competitive firm, this rate of output is at the intersection of the demand schedule, d, which is identical to the MR curve, and the marginal cost curve, MC. When MR exceeds MC, each additional unit of output adds more to total revenues than to total costs, so the additional unit should be produced. When MC is greater than MR, each unit produced adds more to total cost than to total revenues, so this unit should not be produced. Therefore, profit maximization occurs when MC equals MR.
In our particular example, our profit-maximizing, perfectly competitive producer of portable power banks will produce at a rate of between seven and eight portable power banks per hour.
STUDY Figure 23-9Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries
Note: In panel (a), we show a situation in which the demand curve shifts from D1 to D2. Price increases from P1 to P2. In time, the short-run supply curve shifts outward because entry occurs in response to positive profits, and the equilibrium changes from E2 to E3. The market clearing price is again P1. If we connect points such as E1 and E3, we come up with the long-run supply curve SL. This is a constant-cost industry. In panel (b), costs are increasing for the industry, and therefore the long-run supply curve, S'L, slopes upward and long-run prices rise from P1 to P2. In panel (c), costs are decreasing for the industry as it expands, and therefore the long-run supply curve, S'L, slopes downward such that long-run prices decline from P1 to P2.
STUDY Figure 23-4Minimization of Short-Run Losses
Note: In situations in which average total costs exceed price, which in turn is greater than or equal to average variable cost, profit maximization is equivalent to loss minimization. Losses are minimized at the output rate at which marginal cost equals marginal revenue. Losses are shown in the red-shaded area. The vertical axis of the graph is labeled "Price and Total Costs per Unit (dollars)" and ranges from 0 to 15 in increments of 1. The horizontal axis is labeled "Portable Power Banks per Hour" and ranges from 0 to 12 in increments of 1. A line parallel to the horizontal axis at price equals 5 shows line d sub(1). Another line parallel to the horizontal axis below d sub(1) shows d sub(2) and is labeled P equals MR equals AR. The line for MC slops down from (0 comma 5) and falls down to (3.5 comma 1) and then slops upward to intersect line d sub(2) at (5.5 comma 3) and d sub(1) at point E(7.2 comma 5). The line for ATC slops down from upper part of the vertical axis intersects d sub(1) and then turns upward to pass through point (5.5 comma 4.8). The area above line d sub(2) from (0 comma 4.8) to (5.5 comma 4.8) is shaded and labeled "Losses."
STUDY Figure 23-10Long-Run Firm Competitive Equilibrium
Note: In the long run, the firm operates where price, marginal revenue, marginal cost, short-run minimum average cost, and long-run minimum average cost are all equal. This condition is satisfied at point E.
STUDY Figure 23-3Measuring Total Profits
Note: Profits are represented by the blue-shaded area. The height of the profit rectangle is given by the difference between average total costs and price ($5), where price is also equal to average revenue. This is found by the vertical difference between the ATC curve and the price, or average revenue, line d, at the profit-maximizing rate of output of between seven and eight portable power banks per hour.
STUDY Figure 23-6The Individual Firm's Short-Run Supply Curve
Note: The individual firm's short-run supply curve is the portion of its marginal cost curve at and above the minimum point on the average variable cost curve.
STUDY Figure 23-11Percentages of Firms Entering and Exiting All U.S. Industries Annually since 1978
Note: This figure shows that between 8 and 10 percent of all firms that were operating at the beginning of any given year end up exiting their industries by the close of the year. In the vast majority of years, though, a larger percentage of new firms enter than the share that exits.
STUDY Figure 23-7Deriving the Industry Supply Curve
Note: Marginal cost curves at and above minimum average variable cost are presented in panels (a) and (b) for firms A and B. We horizontally sum the two quantities supplied, 7 units by firm A and 10 units by firm B, at a price of $6. This gives us point F in panel (c). We do the same thing for the quantities supplied at a price of $10. This gives us point G. When we connect those points, we have the industry supply curve, S, which is the horizontal summation—represented by the Greek letter sigma (Σ)—of the firms' marginal cost curves above their respective minimum average variable costs.
STUDY Figure 23-2Profit Maximization
Note: Profit maximization occurs where marginal revenue equals marginal cost. Panel (a) indicates that this point occurs at a rate of sales of between seven and eight portable power banks per hour. In panel (b), we find maximum profits where total revenues exceed total costs by the largest amount. This occurs at a rate of production and sales per hour of seven or eight portable power banks. In panel (c), the marginal cost curve, MC, intersects the marginal revenue curve at the same rate of output and sales of somewhere between seven and eight portable power banks per hour.
STUDY Figure 23-8Industry Demand and Supply Curves and the Individual Firm Demand Curve
Note: The industry demand curve is represented by D in panel (a). The short-run industry supply curve is S and is equal to ΣMC. The intersection of the demand and supply curves at E determines the equilibrium or market clearing price at Pe. The demand curve faced by the individual firm in panel (b) is perfectly elastic at the market clearing price determined in panel (a). If the producer has a marginal cost curve MC, its profit-maximizing output level is at qe. For AC1, economic profits are zero. For AC2, profits are positive. For AC3, profits are negative.
STUDY Figure 23-5Short-Run Break-Even and Shutdown Prices
Note: We can find the short-run break-even price and the short-run shutdown price by comparing price with average total costs and average variable costs. If the demand curve is d1, profit maximization occurs at output E1, where MC equals marginal revenue (the d1 curve). Because the ATC curve includes all relevant opportunity costs, point E1 is the break-even point, and zero economic profits are being made. The firm is earning a normal rate of return. If the demand curve falls to d2, profit maximization (loss minimization) occurs at the intersection of MC and MR (the d2 curve), or E2. Below this price, it does not pay for the firm to continue in operation because its average variable costs are not covered by the price of the product.
Total Revenues = P x Q or (Price times quantity sold)
P x Q or (Price times quantity sold)
The firm should continue production until the cost of increasing output by one more unit is just equal to the revenues obtainable from that extra unit. This is a fundamental rule in economics:
Profit maximization occurs at the rate of output at which marginal revenue equals marginal cost.
What are total revenues?
The price per unit times the total quantity sold.
What is marginal revenue?
The change in total revenues resulting from a one-unit change in output (and sale) of the product in question.
How do you calculate economic profits?
The economic profits are the price minus the average total cost multiplied by the output level.
the marginal revenue curve is the price line, which is the firm's demand curve, d.
The fact that MR (marginal revenues), P(price), and d(firm's demand curve) are identically equal for an individual firm is a general feature of a perfectly competitive industry
What is the short-run break-even price?
The price at which a firm's total revenues equal its total costs. At the break-even price, the firm is just making a normal rate of return on its capital investment. (it is covering its explicit and implicit costs.)
What is the short-run shutdown price?
The price that covers average variable costs. It occurs just below the intersection of the marginal cost curve and the average variable cost curve.
What is profit-maximizing rate of production?
The rate of production that maximizes total profits, or the difference between total revenues and total costs. Also, it is the rate of production at which marginal revenue equals marginal cost.
Consider the market for DVD movie rentals, which is perfectly competitive. The market supply curve slopes upward, the market demand curve slopes downward, and the equilibrium rental price equals $3.50. Indicate how each of the following events will have an effect on the market clearing price and on the demand curve faced by the individual rental store. People's tastes change in favor of going to see more movies at cinemas with their friends and family members. Market Clearing Price: ________ Firm's Demand Curve: ________
decreases; shifts down Note: The demand curve for the product of an individual firm in a perfectly competitive industry is perfectly elastic at the going market price. The event described may change either the market demand or supply and consequently change the market price. When national DVD-rental chains open a number of new stores in this market, the market supply of DVD movie rentals will increase, thus lowering the market price. OK
Consider the market for DVD movie rentals, which is perfectly competitive. The market supply curve slopes upward, the market demand curve slopes downward, and the equilibrium rental price equals $3.50. Indicate how each of the following events will have an effect on the market clearing price and on the demand curve faced by the individual rental store. National DVD-rental chains open a number of new stores in this market. Market Clearing Price: ________ Firm's Demand Curve: ________
decreases; shifts down Note: The demand curve for the product of an individual firm in a perfectly competitive industry is perfectly elastic at the going market price. The event described may change the market demand or supply and consequently change the market price.
Perfectly competitive firms sell ______ products and can ______ exit or enter the industry.
homogeneous; easily
Consider the market for DVD movie rentals, which is perfectly competitive. The market supply curve slopes upward, the market demand curve slopes downward, and the equilibrium rental price equals $3.50. Indicate how each of the following events will have an effect on the market clearing price and on the demand curve faced by the individual rental store. There is a significant increase in the price of downloading movies on the Internet. Market Clearing Price: ________ Firm's Demand Curve: ________
increases; shifts up Note: The demand curve for the product of an individual firm in a perfectly competitive industry is perfectly elastic at the going market price. The event described may change either the market demand or supply and consequently change the market price. When there is a significant increase in the price of downloading movies on the Internet., the market demand for DVD rentals will increase, thus increasing the market price.
In perfectly competitive markets, there are ________ numbers of well informed _______ and sellers.
large; buyers
The demand curve for a perfect competitor is perfectly elastic at the going market price. The demand curve is also the perfect competitor's ________ revenue curve because ________ revenue is defined as the change in total revenue due to one-unit change in output.
marginal; marginal
A perfectly competitive firm is a price taker. It has ________ control over price and consequently has to take price as a given, but it can sell ________ that it wants at the going market price.
no; all
Suppose that the firm with the costs and revenues shown in the figure to the right is contemplating whether or not to produce 12 units of output. If it were to produce this many units, what (if anything) would happen to the market price? What would be the firm's marginal revenue for the 12th unit produced? What would be the firm's total revenues per hour? This firm is _______ so its output rate is ______ in relation to the industry as a whole that its production ______ influence the market price, which would ______ $5 per unit. The market price ______ the firm's marginal revenue, which therefore would be MR = $5 per unit. The firm's hourly total revenues if it were to produce 12 unites would be TR ______ $60
perfectly competitive; so small; could not; remain at; equals; =; =
Whenever marginal cost is less than marginal revenue, the firm will always make more _______ by increasing ________.
profit; production
Profit is maximized at the rate of output at which the positive difference between total revenues and total costs is the greatest. This is the same level of output at which marginal _______ equals marginal ________. The perfectly competitive firm produces at an output rate at which marginal cost equals the ________ per unit of output, because MR is always equal to P.
revenue; cost; price
Assuming that the pizza shop always produces and sells at at least one pizza per hour, this appears to be a situation of ________ equilibrium.
short-run Note: In a competitive short-run equilibrium situation firms can be making positive, zero, or negative economic profits.