Economics Chapter 8 Review

Why does entry occur?

To allow new firms to enter the industry.

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

Its flat for a perfectly competitive firm, because it cannot influence prices by changing the level of output.

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

The average curve and the marginal revenue curve.

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

The curves of average variable cost (AVC) and marginal cost (MC) intersects and shows price at which the firm would lack revenue to cover variable cost of production.

break-even point

level of output where the marginal cost curve intersects the average cost curve at the minimum point of AC; if the price is at this point, the firm is earning zero economic profits

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 mean that the firm has no ability to influence the price of its product, and must take the market price as given.

Why does exit occur?

So firms have the opportunity to leave the industry if they are not profitable.

Suppose that the market price increases to $6, as Table 8.14 shows. 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.

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

Yes, Independent trucking fits the characteristics of perfect competition.

Perfect Competition and Why It Matters

A perfectly competitive firm is a price taker, which means that it must accept the equilibrium price at which it sells goods. If a perfectly competitive firm attempts to charge even a tiny amount more than the market price, it will be unable to make any sales. In a perfectly competitive market there are thousands of sellers, easy entry, and identical products. A short-run production period is when firms are producing with some fixed inputs. Long-run equilibrium in a perfectly competitive industry occurs after all firms have entered and exited the industry and seller profits are driven to zero. Perfect competition means that there are many sellers, there is easy entry and exiting of firms, products are identical from one seller to another, and sellers are price takers.

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

A perfectly competitive firm must charge the going market price, since it has no ability to set prices itself.

How perfectly Competitive Firms Make Output Decisions

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. 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). Alternatively, profits will be highest where marginal revenue, which is price for a perfectly competitive firm, is equal to marginal cost. 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 the market price is below average cost at the profit-maximizing quantity of output, then the firm is making losses. If the market price is equal to average cost at the profit-maximizing level of output, then the firm is making zero profits. We call the point where the marginal cost curve crosses the average cost curve, at the minimum of the average cost curve, the "zero profit point." If the market price that a perfectly competitive firm faces is below average variable cost at the profit-maximizing quantity of output, then the firm should shut down operations immediately. If the market price that a perfectly competitive firm faces 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. We call the point where the marginal cost curve crosses the average variable cost curve the shutdown point.

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

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

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.

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 or resulting in a loss less than the fixed costs and the firm should shut down.

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

In a completely competitive market, a business will charge a price at which it makes no economic profit in the long term.

Look at Table 8.13. What would happen to the firm's profits if the market price increases to $6 per pack of raspberries?

No change will happen to firm's profits if market price change to $6.

entry

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

exit

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

long-run equilibrium

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

perfect competition

each firm faces many competitors that sell identical products

shutdown point

level of output where the marginal cost curve intersects the average variable cost curve at the minimum point of AVC; if the price is below this point, the firm should shut down immediately

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

perfectly competitive market will display productive efficiency when firms produce on their short or long term expansion paths because input levels on expansion paths minimize the total cost of producing any particular level of output.

Entry and Exit Decisions in the long run

In the long run, firms will respond to profits through a process of entry, where existing firms expand output and new firms enter the market. Conversely, firms will react to losses in the long run through a process of exit, in which existing firms cease production altogether. Through the process of entry in response to profits and exit in response to losses, the price level in a perfectly competitive market will move toward the zero-profit point, where the marginal cost curve crosses the AC curve at the minimum of the average cost curve. The long-run supply curve shows the long-run output supplied by firms in three different types of industries: constant cost, increasing cost, and decreasing cost.

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

In the long run, instead of in the short run, entry and exit take place.

Efficiency in a Perfectly Competitive Market

Long-run equilibrium in perfectly competitive markets meets two important conditions: allocative efficiency and productive efficiency. These two conditions have important implications. First, resources are allocated to their best alternative use. Second, they provide the maximum satisfaction attainable by society.

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.

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

No. The firm should shut down only if its 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.

What is a "price taker" firm?

One that cannot influence the price of the market, but accept it as a given.

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

Perfect competition is both allocatively efficient, because price equals marginal cost, and productive efficient, because firms produce at the lowest point on the average cost curve

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?"

Solution: 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 where price is not equal to the minimum average total cost (productive inefficiency) and/or where price is not equal to marginal cost (allocative inefficiency) then the market cannot be labeled "perfect." As we will see in future chapters, industries that have monopolies, oligopolies, and are monopolistically competitive do not produce efficient results.

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.

How does a perfectly competitive firm calculate total revenue?

The quantity of goods sold times the market price.

price taker

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

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