Transcript
Pure Competition
Pure Competition
ANSWERS TO END-OF-CHAPTER QUESTIONS
7 1 Briefly state the basic characteristics of pure competition. Strictly speaking, pure competition has probably never existed and probably never will. Then why study it?
Pure competition has a very large number of firms; standardized products; no control over price: price takers; no obstacles to entry or exit.
It can be shown that pure competition results in low cost production (productive efficiency)—through long run equilibrium occurring where P equals minimum ATC—and allocative efficiency—through long run equilibrium occurring where P equals MC. Given this, it is then possible to analyze real world examples to see to what extent they conform to the ideal of plants producing at their points of minimum ATC and thus producing the most desired commodities with the most efficient use of resources.
7.2 Use the following demand schedule to determine total and marginal revenues for each possible level of sales:
Product Price ($) Quantity Demanded Total Revenue ($) Marginal Revenue ($)
2 0
2 1
2 2
2 3
2 4
2 5
a. What can you conclude about the structure of the industry in which this firm is operating? Explain.
b. Graph the demand, total revenue, and marginal revenue curves for this firm.
c. Why do the demand, marginal revenue, and average revenue curves coincide?
d. “Marginal revenue is the change in total revenue associated with additional units of output.” Explain verbally and graphically, using the data in the table.
Total revenue, top to bottom: 0; $2; $4; $6; $8; $10. Marginal revenue, top to bottom: $2, throughout.
(a) The industry is purely competitive—this firm is a “price taker.” The firm is so small relative to the size of the market that it can change its level of output without affecting the market price.
See graph.
(c) The firm’s demand curve is perfectly elastic; MR is constant and equal to P, the average or per-unit revenue will equal the price P.
(d) True. Table: When output (quantity demanded) increases by 1 unit, total revenue increases by $2. This $2 increase is the marginal revenue. Figure: The change in TR is measured by the slope of the TR line, 2 (= $2/1 unit).
7-3 Assume the following cost data are for a purely competitive producer:
Total
Product Average
fixed
cost Average
variable
cost Average
total
cost
Marginal
Cost
0 1
2
3
4
5
6
7
8
9
10
$60.00
30.00
20.00
15.00
12.00
10.00
8.57
7.50
6.67
6.00
$45.00
42.50
40.00
37.50
37.00
37.50
38.57
40.63
43.33
46.50
$105.00
72.50
60.00
52.50
49.00
47.50
47.14
48.13
50.00
52.50
$45
40
35
30
35
40
45
55
65
75
a. At a product price of $56, will this firm produce in the short run? Why or why not? If it is preferable to produce, what will be the profit maximizing or loss minimizing output? Explain. What economic profit or loss will the firm realize per unit of output?
b. Answer the relevant questions of 3a assuming product price is $41.
c. Answer the relevant questions of 3a assuming product price is $32.
d. In the table below, complete the short run supply schedule for the firm (columns 1 and 2) and indicate the profit or loss incurred at each output (column 3).
(1)
Price (2)
Quantity
supplied,
single firm (3)
Profit (+)
or loss (l) (4)
Quantity
supplied,
1500 firms
$26 32
38
41
46
56
66
____
____
____
____
____
____
____ $____
____
____
____
____
____
____ ____
____
____
____
____
____
____
e. Explain: “That segment of a competitive firm’s marginal cost curve which lies above its average variable cost curve constitutes the short run supply curve for the firm.” Illustrate graphically. How does this curve relate to the law of diminishing returns (Chapter 6)?
f. Now assume there are 1500 identical firms in this competitive industry; that is, there are 1500 firms, each of which has the same cost data as shown here. Calculate the industry supply schedule (column 4).
g. Suppose the market demand data for the product are as follows:
Price Total
quantity
demanded
$26 32
38
41
46
56
66
17,000
15,000
13,500
12,000
10,500
9,500
8,000
What will be the equilibrium price? What will be the equilibrium output for the industry? For each firm? What will profit or loss be per unit? Per firm? Will this industry expand or contract in the long run?
(a) Yes, $56 exceeds AVC (and ATC) at the profit-maximizing output. Using the MR = MC rule it will produce 8 units. Profits per unit = $7.87 (= $56 - $48.13); total profit = $62.96.
(b) Yes, $41 exceeds AVC at the loss—minimizing output. Using the MR = MC rule it will produce 6 units. Loss per unit or output is $6.50 (= $41 - $47.50). Total loss = $39), which is less than its total fixed cost of $60.
(c) No, because $32 is always less than AVC. If it did produce according to the MR = MC rule, its output would be 4—found by expanding output until MR no longer exceeds MC. By producing 4 units, it would lose $82 [= 4 ($32 - $52.50)]. By not producing, it would lose only its total fixed cost of $60.
(d) Column (2) data, top to bottom: 0; 0; 5; 6; 7; 8; 9, Column (3) data, top to bottom in dollars: -60; -60; -55; -39; -7.98; +62.96; +144.
(e) The firm will not produce if P < AVC. When P > AVC, the firm will produce in the short run at the quantity where P (= MR) is equal to its increasing MC. Therefore, the MC curve above the AVC curve is the firm’s short-run supply curve, it shows the quantity of output the firm will supply at each price level. See Figure 7.4 for a graphical illustration. The upward sloping portion of the MC curve reflects diminishing returns. As each additional unit of output requires a greater input of resources, the cost will be greater than for previous units.
(f) Column (4) data, top to bottom: 0; 0; 7,500; 9,000; 10,500; 12,000; 13,500.
(g) Equilibrium price = $46; equilibrium output = 10,500. Each firm will produce 7 units. Loss per unit = $1.14, or $8 per firm. The industry will contract in the long run.
7-4 Why is the equality of marginal revenue and marginal cost essential for profit maximization? Explain why price can be substituted for marginal revenue in the MR = MC rule when an industry is purely competitive.
If the last unit produced adds more to costs than to revenue, its production must necessarily reduce profits (or increase losses). On the other hand, profits must increase (or losses decrease) so long as the last unit produced—the marginal unit—is adding more to revenue than to costs. Thus, so long as MR is greater than MC, the production of one more marginal unit must be adding to profits or reducing losses (provided price is not less than minimum AVC). When MC has risen to precise equality with MR, the production of this last (marginal) unit will neither add nor reduce profits.
In pure competition, the demand curve is perfectly elastic; price is constant regardless of the quantity demanded. Thus MR is equal to price. This being so, P can be substituted for MR in the MR = MC rule. (Note, however, that it is not good practice to use MR and P interchangeably, because in imperfectly competitive models, price is not the same as marginal revenue.)
7-5 Explain: “The short-run rule for operating or shutting down is “P > AVC, operate; P < AVC shut down.” The long-run rule for continuing in business or exiting the industry is “P ? ATC, continue; P < ATC, exit.”
In the short run, a firm pays its fixed costs whether it operates or not. If a firm can cover its variable costs and a portion of its fixed costs (P > AVC), they lose less by operating than by shutting down. In the long run all costs are variable; if a firm cannot cover all of its costs (P < ATC), it is better off to exit the market (reducing its loss to zero).
7-6 Using diagrams for both the industry and a representative firm, illustrate competitive long-run equilibrium. Assuming constant costs, employ these diagrams to show how (a) an increase and (b) a decrease in market demand will upset that long-run equilibrium. Trace graphically and describe verbally the adjustment processes by which long-run equilibrium is restored. Now rework your analysis for increasing- and decreasing-cost industries and compare the three long-run supply curves.
See Figures 7.7 and 7.8 and their legends. See Figures 7.9a and 7.9b for the supply curves for constant and increasing cost industries, respectively. The supply curve for a decreasing cost industry is below.
7-7 In long-run equilibrium, P = minimum ATC = MC. What is the significance of the equality of P and minimum ATC for society? The equality of P and MC? Distinguish between productive efficiency and allocative efficiency in your answer.
The equality of P and minimum ATC means the firms is achieving productive efficiency; it is using the most efficient technology and employing the least costly combination of resources. The equality of P and MC means the firms is achieving allocative efficiency; the industry is producing the right product in the right amount based on society’s valuation of that product and other products.
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