ECON CH 9

What are the three conditions for a market to be perfectly competitive? For a market to be perfectly competitive, there must be

many buyers and sellers, with all firms selling identical products, and no barriers to new firms entering the market.

Productive efficiency

is a situation in which a good or service is produced at the lowest possible cost

Allocative efficiency

is a state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it

Marginal revenue (MR)

is the change in total revenue from selling one more unit of a product

Average revenue (AR)

is total revenue divided by the quantity of the product sold

When are firms likely to be price takers? A firm is likely to be a price taker when

it sells a product that is exactly the same as every other firm.

A firm producing good Y recently increased monthly production from 1,500 units to 2,000 units. This had no impact on the market price of good Y. At the new production level of 2,000 units, the firm's average cost is $3.5 while its marginal cost of production is $4. The marginal revenue however is fixed at $5 for all levels of output. Jake Williamson is the operations head of the firm. Jake feels that, since the firm has the capacity, it should have increased production further to 2,500 units which would have maximized profits. On the other hand, Mathew Hayden of the market research team anticipates an increase in price to $5.5 in the near future. He therefore claims that the firm may not be maximizing economic profit in the short run even at 2,500 units. ---------------------------------- Which of the following is most strongly implied by this information?

---------------------------------- At the current level of production, the firm is making a profit of $3,000.

Long-run supply curve

A curve that shows the relationship in the long run between market price and the quantity supplied

A firm sells 10,000 units of X per month at the market price of $10. There are many other firms in this industry producing the same variety of X. With all firms producing an identical product, each firm is a price taker in this market. Farah Mahmood and her friend Daniela Rodriguez, both students of economics, are debating the impact of a recent increase in the demand for X. Farah feels that the demand faced by each firm will shift to the right. This in turn will increase the market price. Daniela meanwhile is not sure how much the price will rise because she thinks that the immediate response to the higher demand will be a rightward shift in each firm's supply curve. There were fifteen other firms producing 10,000 units of X per month at $10. When the demand increased, the equilibrium price went up to $11 and two new firms entered the market for X. In spite of this new entry, the supply of X by each firm increased to 10,500 units per month. ---------------------------------- Which of the following is most strongly supported by this information?

---------------------------------- Each firm faces a perfectly elastic demand curve at $11.

A student argues: "To maximize profit, a firm should produce the quantity where the difference between marginal revenue and marginal cost is the greatest. If a firm produces more than this quantity, then the profit made on each additional unit will be falling." ---------------------------------- Is the above statement true or false?

---------------------------------- False. Profit is maximized at the output level where marginal revenue equals marginal cost.

Xavier is an accountant who provides tax services through his own firm. To provide these services he must rent an office for $16,000 per year, hire a secretary for $28,000, and spend $7,000 per year in advertising. Explicit Costs Amount Office rent $16,000 Secretary $28,000 Advertising $7,000 Xavier's total revenue from his tax services is $89,000 per year. Suppose Xavier's firm is in a perfectly competitive industry and that he could otherwise earn $38,000 per year working as an accountant in another firm. ---------------------------------- Assuming Xavier's profits are representative of the industry, describe what will likely happen to Xavier's profits in the long run.

---------------------------------- Xavier is breaking even and should continue to produce to continue breaking even in the long run.

What is the difference between a firm's shutdown point in the short run and its exit point in the long run? ---------------------------------- In the short run, a firm's shutdown point is the minimum point on the

---------------------------------- average variable cost curve, while in the long run, a firm's exit point is the minimum point on the average total cost curve.

Suppose Farmer Lane grows and sells cotton in a perfectly competitive industry. The market price of cotton is $1.42 per kilogram, and his marginal cost of production is $1.67 per kilogram, which increases with output. Assume Farmer Lane is currently earning a profit. ---------------------------------- Can Farmer Lane do anything to increase his profit in the short run? Farmer Lane

---------------------------------- can increase his profit by producing less output.

The late Nobel Prize-winning economist George Stigler once wrote, "the most common and most important criticism of perfect competition... [is] that it is unrealistic." Source: George Stigler, "Perfect Competition, Historically Contemplated," Journal of Political Economy, Vol. 55, No. 1, (February 1957), pp. 1-17. ---------------------------------- Despite the fact that few firms sell identical products in markets where there are no barriers to entry, economists believe that the model of perfect competition is important because

---------------------------------- it is a benchmark—a market with the maximum possible competition—that economists use to evaluate actual markets that are not perfectly competitive.

A firm sells 10,000 units of X per month at the market price of $10. There are many other firms in this industry producing the same variety of X. With all firms producing an identical product, each firm is a price taker in this market. Farah Mahmood and her friend Daniela Rodriguez, both students of economics, are debating the impact of a recent increase in the demand for X. Farah feels that the demand faced by each firm will shift to the right. This in turn will increase the market price. Daniela meanwhile is not sure how much the price will rise because she thinks that the immediate response to the higher demand will be a rightward shift in each firm's supply curve. ---------------------------------- Farah's claim that each firm's demand curve will shift right is flawed because:

---------------------------------- she is confusing the demand curve faced by the firm with the market demand curve.

How are prices determined in perfectly competitive markets? ---------------------------------- In perfectly competitive markets, prices are determined by

---------------------------------- the interaction of market demand and supply because firms and consumers are price takers.

Explain why it is true that for a firm in a perfectly competitive market, the profit-maximizing condition MR = MC is equivalent to the condition P = MC. ---------------------------------- When maximizing profits, MR = MC is equivalent to P = MC because

---------------------------------- the marginal revenue curve for a perfectly competitive firm is the same as its demand curve.

perfectly competitive markets

A market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. Price taker A buyer or seller that is unable to affect the market price

Why are firms willing to accept losses in the short run but not in the long run?

There are sunk costs in the short run but not in the long run.

sunk costs

Fixed costs should be ignored because they are sunk costs, costs that have already been paid and cannot be recovered; even if they haven't literally been paid yet, the firm is still obliged to pay them.

the demand for wheat should be a horizontal line. But this can't be true: When the price of wheat rises, the quantity of wheat demanded falls, and when the price of wheat falls, the quantity of wheat demanded rises. Therefore, the demand for wheat is not a horizontal line."

Incorrect. The commentator is confusing the market demand for wheat with the demand line facing the representative firm.

When are firms likely to be price takers? A firm is likely to be a price taker when

It represents a small fraction of the total market

Revenue for a perfectly competitive firm is easy: the firm receives the same amount of money for every unit of output it sells. So:

Price = Average Revenue = Marginal Revenue

Briefly discuss the difference between these two concepts.

Productive efficiency pertains to production within an industry while allocative efficiency pertains to production across all industries.

We assume that all firms try to maximize profits—including perfectly competitive ones. Recall that:

Profit = Total Revenue − Total Cost

price takers

The first and second conditions imply that perfectly competitive firms are price takers: they are unable to affect the market price. This is because they are tiny relative to the market and sell exactly the same product as everyone else.

perfectly competitive market

The first market structure we will examine is the perfectly competitive market: one in which • There are many buyers and sellers, • All firms sell identical products, and • There are no barriers to new firms entering the market.

Long-run competitive equilibrium

The situation in which the entry and exit of firms has resulted in the typical firm breaking even

Why do single firms in perfectly competitive markets face horizontal demand curves?

With many firms selling an identical product, single firms have no effect on market price.

What is a price taker? A price taker is

a firm that is unable to affect the market price.

What is meant by productive efficiency? Productive efficiency is

when a good or service is produced at lowest possible cost.