Chapter 8 Econ 101

What is a "price taker" firm?

Firm is one that cannot influence the price in the market, but must accept it as a given.

What two lines on a cost curve diagram intersect at the zero-profit point?

The average cost curve and the marginal revenue curve.

profits will be highest where

marginal revenue, which is price for a perfectly competitive firm, is equal to marginal cost.

while a perfectly competitive firm can earn profits in the short run, in the long run the process of entry will

push down prices until they reach the zero-profit level.

How does a perfectly competitive firm decide what price to charge?

Firm must charge the going market price, since it has no ability to set prices.

What price will a perfectly competitive firm end up charging in the long run? Why?

It will charge a price equal to the minimum of its average cost of production, because perfect competition drives the price down to the zero profit level.

A shift in costs of production that increases marginal costs at all levels of output—and shifts MC to the?

left—will cause a perfectly competitive firm to produce less at any given market price.

lower price of key inputs or new technologies that reduce production costs cause supply to shift to the?

right

If the market price faced by a perfectly competitive firm is above average cost at the profit-maximizing quantity of output, then the firm is

making profits

If P > AVC but P < ATC, then?

the firm continues to produce in the short-run, making economic losses.

If price falls in the zone between the shutdown point and the zero-profit point, then?

the firm is making losses but will continue to operate in the short run, since it is covering its variable costs, the losses are smaller than if the firm shut down immediately.

If the price is exactly at the zero-profit point, then?

the firm is making zero profits

If P < AVC, then?

the firm stops producing and only incurs its fixed costs.

shutdown point

The intersection of the average variable cost curve and the marginal cost curve, which shows the price where the firm would lack enough revenue to cover its variable costs, is called the?

Why will profits for firms in a perfectly competitive industry tend to vanish in the long run?

As long as someone is earning profits, there is an opportunity for a perfectly competitive firm to lower prices and steal all of their customers. The only way yo prevent this from happening is to lower prices to zero profit level.

What two lines on a cost curve diagram intersect at the shutdown point?

Average variable cost and marginal revenue

Why does entry occur?

It occurs because a firm sees the opportunity to earn a profit by producing some good.

Should a firm shut down immediately if it is making losses?

No, the firm should shut down only if it's revenues are not able to cover its variable costs. If it is able to cover its variable costs, and perhaps some of its fixed costs, it should stay open in the short run.

Long-run equilibrium in perfectly competitive markets meets two important conditions?

allocative efficiency and productive efficiency

Entry and exit to and from the market are the driving forces behind a process that,

in the long run, pushes the price down to minimum average total costs so that all firms are earning a zero profit.

bad weather or added government regulations can add to costs of certain goods in a way that causes supply to shift to the?

left

If the market price is below average cost at the profit-maximizing quantity of output, then the firm is

making losses.

As the supply curve shifts to the left, the market price starts

rising, and economic losses start to be lower. This process ends whenever the market price rises to the zero-profit level, where the existing firms are no longer losing money and are at zero profits again.

entry

the long-run process of firms entering an industry in response to industry profits

Allocative efficiency and productive efficiency have important implications?

First, resources are allocated to their best alternative use. Second, they provide the maximum satisfaction attainable by society.

As long as there are still profits in the market

entry will continue to shift supply to the right.This will stop whenever the market price is driven down to the zero-profit level, where no firm is earning economic profits.

If the market price is equal to average cost at the profit-maximizing level of output, then the firm is

making zero profits

If the firm is operating at a level of output where the market price is at a level higher than the zero-profit point, then?

price will be greater than average cost and the firm is earning profits

exit

the long-run process of firms reducing production and shutting down in response to industry losses

demand decreases, and with that,

the market price starts falling.

Entry of many new firms causes

the market supply curve to shift to the right.

Profits will be highest (or losses will be smallest) at

the quantity of output where total revenues exceed total costs by the greatest amount (or where total revenues fall short of total costs by the smallest amount).

price < minimum average variable cost

then firm shuts down

price = minimum average variable cost

then firm stays in business

Look at Table. What would happen to the firm's profits if the market price increases to $6 per pack of raspberries?

Holding total cost constant, profits at every output level would increase.

What prevents a perfectly competitive firm from seeking higher profits by increasing the price that it charges?

If a perfectly competitive firm tries to increase prices, all of its customers will simply switch to another seller.

Explain in words why a profit-maximizing firm will not choose to produce at a quantity where marginal cost exceeds marginal revenue.

If marginal costs exceeds marginal revenue, then the firm will reduce its profits for every additional unit of output it produces. Profit would be greatest if it reduces output to where MR = MC.

How does the average cost curve help to show whether a firm is making profits or losses?

If the average cost curve is below the marginal revenue curve, or the price, at the selected level of output, the firm will make profits.

How does the average variable cost curve help a firm know whether it should shut down immediately?

If the entire average variable costs curve is higher than the price, then there is no output capable of producing profits and the firm should shut down.

Why will losses for firms in a perfectly competitive industry tend to vanish in the long run?

In the long run, firms the experience losses will have to shut down, reducing supply, and raising the price to the point at the minimum of the average costs curve.

Assuming that the market for cigarettes is in perfect competition, what does allocative and productive efficiency imply in this case? What does it not imply?

It implies that producing more cigarettes would require reductions in production elsewhere, and that the market is producing what consumers most want to buy. It does not imply anything about whether cigarette consumption is desirable for society, however.

Firms in a perfectly competitive market are said to be "price takers"—that is, once the market determines an equilibrium price for the product, firms must accept this price. If you sell a product in a perfectly competitive market, but you are not happy with its price, would you raise the price, even by a cent?

No, you would not raise the price. Your product is exactly the same as the product of the many other firms in the market. If your price is greater than that of your competitors, then your customers would switch to them and stop buying from you. You would lose all your sales.

Why does exit occur?

Occurs when a firm can no longer make a profit by continuing to produce.

What two rules does a perfectly competitive firm apply to determine its profit-maximizing quantity of output?

Output is determined at the point where price equals marginal cost, and the price is set by the marketplace since the firm is a price taker.

Productive efficiency and allocative efficiency are two concepts achieved in the long run in a perfectly competitive market. These are the two reasons why we call them "perfect." How would you use these two concepts to analyze other market structures and label them "imperfect?"

Perfect competition is considered to be "perfect" because both allocative and productive efficiency are met at the same time in a long-run equilibrium. If a market structure results in long-run equilibrium that does not minimize average total costs and/or does not charge a price equal to marginal cost, then either allocative or productive (or both) efficiencies are not met, and therefore the market cannot be labeled "perfect."

Would independent trucking fit the characteristics of a perfectly competitive industry?

Possibly. Independent truckers are by definition small and numerous. All that is required to get into the business is a truck (not an inexpensive asset, though) and a commercial driver's license. To exit, one need only sell the truck. All trucks are essentially the same, providing transportation from point A to point B. (We're assuming we not talking about specialized trucks.) Independent truckers must take the going rate for their service, so independent trucking does seem to have most of the characteristics of perfect competition.

A single firm in a perfectly competitive market is relatively small compared to the rest of the market. What does this mean? How "small" is "small"?

Small in this instance, means that the firm has no ability to influence the price of its product, and must take the market price given.

The possibility that a firm may earn losses raises a question: Why can the firm not avoid losses by shutting down and not producing at all?

The answer is that shutting down can reduce variable costs to zero, but in the short run, the firm has already paid for fixed costs. As a result, if the firm produces a quantity of zero, it would still make losses because it would still need to pay for its fixed costs.

A firm's marginal cost curve above the average variable cost curve is equal to the firm's individual supply curve. This means that every time a firm receives a price from the market it will be willing to supply the amount of output where the price equals marginal cost. What happens to the firm's individual supply curve if marginal costs increase?

The firm will be willing to supply fewer units at every price level. In other words, the firm's individual supply curve decreases and shifts to the left.

Briefly explain the reason for the shape of a marginal revenue curve for a perfectly competitive firm?

The marginal revenue curve is flat for a perfectly competitive firm, because it cannot influence prices by changing the level of output.

What are the four basic assumptions of perfect competition? Explain in words what they imply for a perfectly competitive firm.

The product is homogeneous, there are many buyers and sellers, consumers have perfect information, and there are no barriers to entry or exit. These assumptions imply that a single firm cannot do much to influence the market, but must accept conditions as it finds them.

Many firms in the United States file for bankruptcy every year, yet they still continue operating. Why would they do this instead of completely shutting down?

There are costs to shutting down a business and further cost to resume operations. It is less costly for a firm to file bankruptcy and continue operating than to shut down completely due to the difference between average variable costs and average total costs.

In the argument for why perfect competition is allocatively efficient, the price that people are willing to pay represents the gains to society and the marginal cost to the firm represents the costs to society. Can you think of some social costs or issues that are not included in the marginal cost to the firm? Or some social gains that are not included in what people pay for a good?

There are often costs that are not borne directly by the consumer or the producer, such as pollution or second-hand smoke. There are also gain to society, such the improved view that comes from the gardens, or the improved smell that comes from consumers of deodorant.

Do entry and exit occur in the short run, the long run, both, or neither?

They typically occur in the long run, but in some markets cab occur in the short run as well.

Explain how the profit-maximizing rule of setting P = MC leads a perfectly competitive market to be allocatively efficient.

Think of the market price as representing the gain to society from a purchase, since it represents what someone is willing to pay. Think of the marginal cost as representing the cost to society from making the last unit of a good. If P > MC, then the benefits from producing more of a good exceed the costs, and society would gain from producing more of the good. If P < MC, then the social costs of producing the marginal good exceed the social benefits, and society should produce less of the good. Only if P = MC, the rule applied by a profit-maximizing perfectly competitive firm, will society's costs and benefits be in balance. This choice will be the option that brings the greatest overall benefit to society.

How does perfectly competitive firm calculate total revenue?

Total revenue is simply the quantity of goods sold times the market price.

Suppose that the market price increases to $6, as shown in Table. What would happen to the profit-maximizing output level?

When the market price increases, marginal revenue increases. The firm would then increase production up to the point where the new price equals marginal cost, at a quantity of 90.

A market in perfect competition is in long-run equilibrium. What happens to the market if labor unions are able to increase wages for workers?

When wages increase, costs of production increase. Some firms would now be making economic losses and would shut down. The supply curve then starts shifting to the left, pushing the market price up. This process ends when all firms remaining in the market earn zero economic profits. The result is a contraction in the output produced in the market.

If new technology in a perfectly competitive market brings about a substantial reduction in costs of production, how will this affect the market?

With a technological improvement that brings about a reduction in costs of production, an adjustment process will take place in the market. The technological improvement will result in an increase in supply curves, by individual firms and at the market level. The existing firms will experience higher profits for a while, which will attract other firms into the market. This entry process will stop whenever the market supply increases enough (both by existing and new firms) so profits are driven back to zero.

Will a perfectly competitive market display allocative efficiency? Why or why not?

Yes, Allocative efficiency requires firms to produce the level of output where P=MC. This is the level of output where perfectly competitive firms will maximize profit.

Will a perfectly competitive market display productive efficiency? Why or why not?

Yes, since firms are not able to affect prices directly, they have no reason to produce less than an efficient amount, and producing more would result in losses that would ultimately drive them out of business.

Price Taker

a firm in a perfectly competitive market that must take the prevailing market price as given

in the long run, the firm

can adjust all factors of production.

in the short run, firms

cannot change the usage of fixed inputs

If the market price faced by a perfectly competitive firm is above average variable cost, but below average cost, then the firm should

continue producing in the short run, but exit in the long run

Let's say that the product's demand increases, and with that, the market price goes up. The existing firms in the industry are now facing a higher price than before, so they will?

increase production to the new output level where P = MR = MC. This will temporarily make the market price rise above the average cost curve, and therefore, the existing firms in the market will now be earning economic profits.

Perfect Competition

each firm faces many competitors that sell identical products

As the supply curve shifts to the right, the

market price starts decreasing, and with that, economic profits fall for new and existing firms

Exit of many firms causes the

market supply curve to shift to the left.

Profits are the

measurement that determines whether a business stays operating or not.

while a perfectly competitive firm may earn losses in the short run, firms will

not continually lose money.

In the long run, firms making losses are able to escape from their fixed costs, and their exit from the market will

push the price back up to the zero-profit level.

shift in costs of production that decreases marginal costs at all levels of output will shift MC to the?

right and as a result, a competitive firm will choose to expand its level of output at any given price.

If the market price faced by a perfectly competitive firm is below average variable cost at the profit-maximizing quantity of output, then the firm should

shut down operations immediately.

The point where the marginal cost curve crosses the average variable cost curve is called the

shutdown point.

As a perfectly competitive firm produces a greater quantity of output, its total revenue?

steadily increases at a constant rate determined by the given market price.

marginal revenue

the additional revenue gained from selling one more unit

Market Structure

the conditions in an industry, such as number of sellers, how easy or difficult it is for a new firm to enter, and the type of products that are sold

if price falls below the price at the shutdown point, then?

the firm will shut down immediately, since it is not even covering its variable costs

long-run equilibrium

where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC

a shift in supply for the market as a whole

will affect the market price

The point where the marginal cost curve crosses the average cost curve, at the minimum of the average cost curve, is called the

zero profit point.

The point where MC crosses AC is called the?

zero-profit point

In the long run, this process of entry and exit will drive the price in perfectly competitive markets to the

zero-profit point at the bottom of the AC curve, where marginal cost crosses average cost.