Econ. Chapter 12

1. Which of the following are most likely to be perfectly competitive? a. Chicago Board of Trade b. fast-food industry c. computer software industry d. New York Stock Exchange e. clothing industry

Answer: A perfectly competitive market is approximated most closely by a highly organized market. Of the markets indicated, the Chicago Board of Trade and the New York Stock Exchange most closely resemble perfectly competitive markets.

15. In The Wealth of Nations, Adam Smith wrote, "Every individual endeavors to employ his capital so that its produce may be of greatest value. He generally neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own security, only his own gain. And he is led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectively than when he really intends to promote it." How does the story of long-run equilibrium in a perfectly competitive industry illustrate Adam Smith's invisible hand?

Answer: Entrepreneurs see an industry with economic profits as a place to maximize their gain. They move resources to a use that earns more than their opportunity cost. These actions increase market supply and lower equilibrium price, a result that makes consumers better off. Eventually, entry will continue until economic profits are eliminated. At this point firms will be producing where average total costs are the lowest. In a society of scarce resources producing at this efficient scale is good for all of us since it gives society the goods using the fewest resources. Consumers are also able to buy the good at a price equal to this minimum average total cost. Firms seeking to make the largest economic profit end up providing goods in the lowest cost way.

b. A firm cannot maximize profits without minimizing costs.

Answer: False. In the long run, a perfectly competitive firm maximizes profit at a level of output where average total cost is minimized. In the short-run, however, if a profit-maximizing firm is earning economic profits, it will not produce at an output level where average total cost (or any other cost) is minimized. Rather, the firm chooses output where marginal revenue equals marginal cost.

c. If a firm is minimizing costs, it must be maximizing profits.

Answer: False. The statement is too ambiguous. For example, a firm could minimize overall costs by not producing any output at all. Such a strategy would certainly not result in positive economic profits. In the long-run, if a firm is producing at the output level where average total cost is minimized, it is also maximizing its profits. However, in the short-run, choosing an output level at which average total cost is minimized is unlikely to yield maximum profits for the firm. Instead, to maximize profits, the firm should choose to produce a quantity of output where marginal revenue equals marginal cost.

17. Evaluate the following statements. Determine whether each is true or false and explain your answer. a. If economic profits are zero, firms will exit the industry in the long run.

Answer: False. When economic profits are zero, firms are earning normal profits. Total revenue is sufficient to cover all costs of production, including a normal rate of return for business owners.

5. Industry councils promote the consumption of particular types of farm products. These groups urge us to "Drink Milk" or "Eat Apples." Very little advertising is done by individual farmers. Using your understanding of the perfectly competitive market, explain this advertising strategy.

Answer: Farms can be thought of as perfectly competitive businesses, which produce products that are very close to perfect substitutes. For example, one farmer's eggs are very good substitutes for any other eggs. Any advertising for eggs will increase the market demand for all farmers' eggs. All farms will benefit since the market price will rise. In this situation no single farm has an incentive to invest in advertising since the price they can charge will increase and they will benefit from the advertising of others.

7. Explain why the following conditions are typical under perfect competition in the long run. a. P = MC

Answer: Firms maximize profits (minimize losses) by choosing output where marginal revenue equals marginal cost. Profit is also therefore maximized where the price equals marginal cost, since the marginal revenue of a perfectly competitive firm equals the price. Profit-maximizing firms will choose output where P = MC, both in the short-run and the long-run.

18. Describe what would happen to the industry supply curve and the economic profits of the firms in a competitive industry if those firms were currently earning economic profits. What if they were currently earning economic losses?

Answer: If firms are currently earning economic profits, that will attract entry into the industry, shifting the industry supply right. That will lower the price and reduce economic profits. If firms are currently earning economic losses, firms will exit the industry. That will raise the pace and reduce economic losses.

b. P = minimum ATC

Answer: In the long run, when all inputs can be varied and firms are able to freely enter and exit an industry, perfectly competitive firms will earn a normal profit. All short-run economic profits (losses) are dissipated as new firms enter (exit) the industry. Firms earn a normal profit when P = minimum LRAC.

c. Why is it possible for price to remain above the average total cost in the short run but not in the long run?

Answer: In the short-run, when not all factors of production can be varied, a firm can receive a price in excess of average total cost and thereby earn economic profits. Price cannot exceed average total cost in a perfectly competitive market in the long run, however, when all factors of production can be varied. In the long run, new firms have sufficient time to enter the industry and established firms can more readily expand output. New entry will occur until the market price falls to the level of average total cost and economic profits are eliminated.

c. Trucking industry: Uses a large portion of the trained and experienced drivers, especially long-distance drivers.

Answer: Increasing costs since industry expansion will put upward pressure on the wages offered these trained workers.

19. Given the industry description, identify each of the following as an increasing- or constant-cost industry. a. Major League Baseball: Uses the majority of pitchers. As the number of pitchers used increased, the quality declines.

Answer: Increasing costs since more teams will bid up the price of good pitchers and reduce the quality of the average pitcher.

b. If the firm is covering its AVC but not all its fixed costs, will it continue to operate in the short run? Why or why not?

Answer: Loss-minimizing (profit-maximizing) firms will continue to operate in the short-run if price exceeds average variable cost. By continuing to operate, firms can cover their variable costs, as well as a portion of their fixed costs. If they were to shut down, firms would suffer losses equal to the total dollar amount of their fixed costs

8. Discuss the following questions. a. Why must price cover AVC if firms are to continue to operate?

Answer: Price must cover AVC or firms will lose more by operating than by shutting down. Producing output when the price is less than average variable cost, will cause firms to lose not only their fixed costs, but also a fraction of their variable costs. By shutting down when average variable cost exceeds price, firms can limit their losses to their fixed costs.

9. At a price of $5 the profit-maximizing output for a perfectly competitive firm is 1,000 units per year. If the average total cost is $3 per unit, what will be the firm's profit? If the average total cost is $6 per unit, what will be the firm's profit? What is the relationship between profit, price, and average total cost?

Answer: When average total cost is $3, profit will be total revenue (1000 times $5= $5000) minus total costs (1000 times $3= $3000) or $2000. When average total cost is $6, profit will be total revenue (1000 times $5= $5000) minus total costs (1000 times $6= $6000) or -$1000. A firm will make a profit if price exceeds average total cost for the quantity produced and sold, and a loss if price is less than average total cost for the quantity produced and sold.

A perfectly competitive firm will operate in the short run only at price levels greater than or equal to average total costs.

False

Because perfectly competitive firms are price takers, each firm's demand curve remains unchanged even when the market price changes.

False

Because the short run is too brief for new firms to enter the market, the market supply curve is the vertical summation of the supply curves of existing firms.

False

In a constant-cost competitive industry, industry expansion does not alter a firm's cost curves, and the industry long-run supply curve is upward sloping.

False

It is difficult for entrepreneurs to become suppliers of a product in a perfectly competitive market structure.

False

Producing at the profit-maximizing output level means that a firm is actually earning economic profits

False

. In a perfectly competitive market, individual sellers can change their output without altering the market price.

True

A firm will not produce at all unless the price is greater than its average variable costs.

True

A perfectly competitive firm cannot sell at any figure higher than the current market price and would not knowingly charge a lower price, because it could sell all it wants at the market price.

True

A perfectly competitive market is approximated most closely in highly organized markets for securities and agricultural commodities

True

As new firms enter an industry where sellers are earning economic profits, the result will include a reduction in the equilibrium price.

True

For a perfectly competitive firm, as long as the price derived from expanded output exceeds the marginal cost of that output, the expansion of output creates additional profits.

True

For a perfectly competitive firm, the long-run equilibrium will be the point at which price equals marginal cost as well as short-run average total cost and long-run average cost.

True

In a constant-cost competitive industry, the only long-run effect of an increase in demand is an increase in industry output.

True

In a constant-cost industry, the industry does not use inputs in sufficient quantities to affect input prices.

True

In a perfectly competitive industry, the market demand curve is perfectly elastic at the market price

True

In a perfectly competitive market, marginal revenue is constant and equal to the market price.

True

In long-run equilibrium, perfectly competitive firms make zero economic profits, earning a normal return on the use of their capital.

True

In perfect competition, no single firm produces more than an extremely small proportion of output, so no firm can influence the market price.

True

Perfectly competitive forms are price takers because their influence on price is insignificant.

True

The MC curve above minimum AVC shows the marginal cost of producing any given output, as well as the equilibrium output that the firm will supply at various prices in the short run.

True

The perfectly competitive model does not assume any knowledge on the part of individual buyers and sellers about market demand and supply—they only have to know the price of the good they sell.

True

When an industry utilizes a large portion of an input, input prices will rise when the industry uses more of that input as it expands output.

True

24. In an increasing-cost industry, an unexpected increase in demand would lead to what result in the long run? a. higher costs and a higher price b. higher costs and a lower price c. no change in costs or prices d. impossible to determine from the information given

a. higher costs and a higher price

12. A profit-maximizing perfectly competitive firm would never operate at an output level at which a. it would lose more than its total fixed costs. b. it was not earning a positive economic profit. c. it was not earning a zero economic profit. d. it was not earning an accounting profit.

a. it would lose more than its total fixed costs.

13. If a perfectly competitive firm finds that price is greater than AVC but less than ATC at the quantity where its marginal cost equals the market price, a. the firm will produce in the short run but may eventually go out of business. b. the firm will produce in the short run, and new entrants will tend to enter the industry over time. c. the firm will immediately shut down. d. the firm will be earning economic profits. e. both b and d are true.

a. the firm will produce in the short run but may eventually go out of business.

23. If the domino-making industry is a constant-cost industry, one would expect the long-run result of an increase in demand for dominos to include a. a greater number of firms and a higher price. b. a greater number of firms and the same price. c. the same number of firms and a higher price. d. the same number of firms and the same price.

b. a greater number of firms and the same price.

4. In a market with perfectly competitive firms, the market demand curve is ________________ and the demand curve facing each individual firm is ________________________. a. upward sloping; horizontal b. downward sloping; horizontal c. horizontal; downward sloping d. horizontal; upward sloping e. horizontal; horizontal

b. downward sloping; horizontal

7. If a perfectly competitive firm's marginal revenue exceeded its marginal cost, a. it would cut its price in order to sell more output and increase its profits. b. it would expand its output but not cut its price in order to increase its profits. c. it is currently earning economic profits. d. both a and c are true. e. both b and c are true.

b. it would expand its output but not cut its price in order to increase its profits.

18. The short-run supply curve of a perfectly competitive firm is a. its MC curve. b. its MC curve above the minimum point of AVC. c. its MC curve above the minimum point of ATC. d. none of the above.

b. its MC curve above the minimum point of AVC.

9. In perfect competition, at a firm's short-run profit-maximizing output, a. its marginal revenue equals zero. b. its average revenue could be greater or less than average cost. c. its marginal revenue will be falling. d. both b and c will be true.

b. its average revenue could be greater or less than average cost.

11. The minimum price at which a firm would produce in the short run is the point at which a. price equals the minimum point on its marginal cost curve. b. price equals the minimum point on its average variable cost curve. c. price equals the minimum point on its average total cost curve. d. price equals the minimum point on its average fixed cost curve.

b. price equals the minimum point on its average variable cost curve.

10. In perfect competition, at the firm's short-run profit-maximizing output, which of the following need not be true? a. Marginal revenue equals marginal cost. b. Price equals marginal cost. c. Average revenue equals average cost. d. Average revenue equals marginal revenue. e. All of the above would have to be true.

c. Average revenue equals average cost.

22. In long-run equilibrium under perfect competition, price does not equal which of the following? a. long-run marginal cost b. minimum average total cost c. average fixed cost d. marginal revenue e. average revenue

c. average fixed cost

2. An individual perfectly competitive firm a. may increase its price without losing sales. b. is a price maker. c. has no perceptible influence on the market price. d. sells a product that is differentiated from those of its competitors.

c. has no perceptible influence on the market price.

5. The marginal revenue of a perfectly competitive firm a. decreases as output increases. b. increases as output increases. c. is constant as output increases and is equal to price. d. increases as output increases and is equal to price.

c. is constant as output increases and is equal to price.

6. A perfectly competitive firm seeking to maximize its profits would want to maximize the difference between a. its marginal revenue and its marginal cost. b. its average revenue and its average cost. c. its total revenue and its total cost. d. its price and its marginal cost. e. either a or d.

c. its total revenue and its total cost.

19. Darlene runs a fruit-and-vegetable stand in a medium-sized community where many such stands operate. Her weekly total revenue equals $3,000. Her weekly total cost of running the stand equals $3,500, consisting of $2,500 of variable costs and $1,000 of fixed costs. An economist would likely advise Darlene to a. shut down as quickly as possible in order to minimize her losses. b. keep the stand open because it is generating an economic profit. c. keep the stand open for a while longer because she is covering all of her variable costs and some of her fixed costs. d. keep the stand open for a while longer because she is covering all of her fixed costs and some of her variable costs.

c. keep the stand open for a while longer because she is covering all of her variable costs and some of her fixed costs.

8. A perfectly competitive firm maximizes its profit at an output in which a. total revenue exceeds total cost by the greatest dollar amount. b. marginal cost equals the price. c. marginal cost equals marginal revenue. d. all of the above are true.

d. all of the above are true.

20. The entry of new firms into an industry will likely a. shift the industry supply curve to the right. b. cause the market price to fall. c. reduce the profits of existing firms in the industry. d. do all of the above.

d. do all of the above.

3. When will a perfectly competitive firm's demand curve shift? a. never b. when the market demand curve shifts c. when new producers enter the industry in large numbers d. when either b or c occurs

d. when either b or c occurs

b. Fast-food restaurants: Uses a relatively small share of land and unskilled labor in most cities.

Answer: Constant cost since expansion of output will not significantly increase the price of these unspecialized inputs.

A competitive firm earning zero economic profits will be unable to continue in operation over time.

False

21. Which of the following statements concerning equilibrium in the long run is incorrect? a. Firms will exit the industry if economic profits equal zero. b. Firms are able to vary their plant sizes in the long run. c. Economic profits are eliminated as new firms enter the industry. d. The market price equals both marginal cost and average total cost.

a. Firms will exit the industry if economic profits equal zero.

1. Which of the following is false about perfect competition? a. Perfectly competitive firms sell homogeneous products. b. A perfectly competitive industry allows easy entry and exit. c. A perfectly competitive firm must take the market price as given. d. A perfectly competitive firm produces a substantial fraction of the industry output. e. All of the above are true.

d. A perfectly competitive firm produces a substantial fraction of the industry output.