Chapter 14 Questions and Answers

Question 1 Refer to Table 14-1. The price and quantity relationship in the table is most likely that faced by a firm in a: a. price discriminating monopoly market. b. single price monopoly market. c. oligopoly market. d. monopolistically competitive market. e. perfectly competitive market.

Question 1 Answer E. perfectly competitive market. Competitive Markets

What is a Competitive Market? The revenue of a competitive firm Maximize profit Total revenue minus total cost Total revenue = price times quantity = P ˣ Q Proportional to the amount of output Average revenue Total revenue divided by the quantity sold

What is a Competitive Market? The revenue of a competitive firm Marginal revenue Change in total revenue from an additional unit sold For competitive firms Average revenue = Price Marginal revenue = Price

Question 2 Which of the following is NOT a characteristic of a perfectly competitive market? a. Firms are price takers. b. Firms have difficulty entering the market. c. There are many sellers in the market. d. There are many buyers in the market. e. Goods offered for sale are homogeneous.

Question 2 Answer B: Firms have difficulty entering the market Competitive Markets

What is a Competitive Market? Market with many buyers and sellers Trading identical products Each buyer and seller is a price taker Firms can freely enter or exit the market

Question 3 Refer to Table 14-2. At which quantity of output is marginal revenue equal to marginal cost? a. 2 b. 3 c. 6 d. 8 e. 9

Question 3 Answer C: 6 Profit Maximization

What is a Competitive Market? Marginal revenue Change in total revenue from an additional unit sold For competitive firms Average revenue = Price Marginal revenue = Price

A simple example of profit maximization Maximize profit Produce quantity where total revenue minus total cost is greatest Compare marginal revenue (MR) with marginal cost (MC) If MR > MC – increase production If MR < MC – decrease production

Question 4 If the firm finds that its marginal cost is $11, it should a. increase production to maximize profit. b. increase the price of the product to maximize profit. c. advertise to attract additional buyers to maximize profit. d. reduce production to increase profit. e. keep production at the current level.

Question 4 Answer D: reduce production to increase profit. Profit Maximization

Question 5 If the market price is P3, in the short run, the perfectly competitive firm will earn: a. positive economic profits. b. negative economic profits but will try to remain open. c. negative economic profits and will shut down. d. zero economic profits. e. break-even profits.

Question 5 Answer B: negative economic profits but will try to remain open. Supply Curve

Profit Maximization& Competitive Firm’s Supply Curve The marginal-cost curve and the firm’s supply decision Marginal Cost (MC) curve – upward sloping Average Total Cost (ATC) curve – U-shaped MC curve crosses the ATC curve at the minimum of ATC curve Price = Average Revenue = Marginal Revenue

Profit Maximization& Competitive Firm’s Supply Curve The marginal-cost curve and the firm’s supply decision Three general rules for profit maximization: If MR > MC - firm should increase output If MC > MR - firm should decrease output If MR = MC - profit-maximizing level of output

Profit Maximization& Competitive Firm’s Supply Curve The marginal-cost curve and the firm’s supply decision Marginal-cost curve Determines the quantity of the good the firm is willing to supply at any price Is the supply curve

Question 6 Refer to Figure 14-1. Which of the four prices corresponds to a perfectly competitive firm earning negative economic profits in the short run and shutting down? a. P1 only b. P2 only c. P3 only d. P4 only e. P3 and P4

Question 6 Answer D: P4 only Supply Curve

Question 7 Refer to Figure 14-2. When market price is P3, a profit-maximizing firm’s total revenue a. can be represented by the area P3 x Q3. b. can be represented by the area P3 x Q2. c. can be represented by the area (P3-P2) x Q3. d. can be represented by the area (P3-P2) x Q2. e. is zero.

Question 7 Answer B: can be represented by the area P3 x Q2. Total Revenue

Question 8 Refer to Figure 14-2. When market price is P3, a profit-maximizing firm’s profit a. can be represented by the area P3 x Q3. b. can be represented by the area P3 x Q2. c. can be represented by the area (P3-P2) x Q3. d. can be represented by the area P3 x Q1. e. is zero.

Question 8 Answer E: is zero Profit

Question 9 Refer to Figure 14-2. When market price is P3, a profit-maximizing firm’s total costs a. can be represented by the area P2 x Q2. b. can be represented by the area P3 x Q2. c. can be represented by the area (P3-P2) x Q3. d. can be represented by the area P3 x Q3. e. are zero.

Question 9 Answer B: can be represented by the area P3 x Q2. Total Cost

Question 10 Output TC 0 $5 1 $10 2 $12 3 $15 4 $24 5 $40 0 $5 1 $10 2 $12 3 $15 4 $24 5 $40 If the market price is $4, this firm will a. produce two units in the short run and exit in the long run. b. produce three units in the short run and exit in the long run. c. produce four units in the short run and exit in the long run. d. shut down in the short run and exit in the long run. e. produce five units in the short run and the long run.

Question 10 Answer B: produce three units in the short run and exit in the long run. Losses

Question 11 Output TC 0 $1 1 $6 2 $9 3 $10 4 $17 5 $26 0 $1 1 $6 2 $9 3 $10 4 $17 5 $26 What is the lowest price at which this firm might choose to operate? a. $1 b. $2 c. $3 d. $4 e. $5

Question 11 Answer C: $3 Supply Curve

Profit Maximization& Competitive Firm’s Supply Curve Shutdown Short-run decision not to produce anything during a specific period of time because of current market conditions Firm still has to pay fixed costs Exit Long-run decision to leave the market Firm doesn’t have to pay any costs

Profit Maximization& Competitive Firm’s Supply Curve The firm’s short-run decision to shut down TR = total revenue VC = variable costs Firm’s decision: Shut down if TR<VC (P<AVC) Competitive firm’s short-run supply curve The portion of its marginal-cost curve that lies above average variable cost

Question 12 Refer to Figure 14-3. Assume that the market starts in equilibrium at point A in panel (b). An increase in demand from D0 to D1 will result in: a. a new market equilibrium at point D. b. an eventual increase in the number of firms in the market and a new long-run equilibrium at point C. c. rising prices and falling profits for existing firms in the market. d. falling prices and falling profits for existing firms in the market. e. a new long-run market equilibrium at point B.

Question 12 Answer B: an eventual increase in the number of firms in the market and a new long-run equilibrium at point C. Long-run Supply Curve

Supply Curve in a Competitive Market Short run: market supply with a fixed number of firms Short run – number of firms is fixed Each firm – supplies quantity where P = MC For P > AVC: supply curve is MC curve Market supply Add up quantity supplied by each firm

Supply Curve in a Competitive Market Long run: market supply with entry and exit Long run – firms can enter and exit the market If P > ATC – firms make positive profit New firms enter the market If P < ATC – firms make negative profit Firms exit the market Process of entry and exit ends when Firms still in market: zero economic profit (P = ATC) Because MC = ATC: Efficient scale Long run supply curve – perfectly elastic Horizontal at minimum ATC

Supply Curve in a Competitive Market Why do competitive firms stay in business if they make zero profit? Profit = total revenue – total cost Total cost – includes all opportunity costs Zero-profit equilibrium Economic profit is zero Accounting profit is positive

Supply Curve in a Competitive Market A shift in demand in the short run & long run Market – in long run equilibrium P = minimum ATC Zero economic profit Increase in demand Demand curve – shifts outward Short run Higher quantity Higher price: P > ATC – positive economic profit

Supply Curve in a Competitive Market A shift in demand in the short run & long run Because: positive economic profit in short run Long run – firms enter the market Short run supply curve – shifts right Price – decreases back to minimum ATC Quantity – increases Because there are more firms in the market Efficient scale

Supply Curve in a Competitive Market Why the long-run supply curve might slope upward Some resource used in production may be available only in limited quantities Increase in quantity supplied – increase in costs – increase in price Firms may have different costs Some firms earn profit even in the long run Long-run supply curve More elastic than short-run supply curve

Profit Maximization& Competitive Firm’s Supply Curve Firm’s long-run decision to exit/enter a market Exit the market if Total revenue < total costs; TR < TC Same as: P < ATC Enter the market if Total revenue > total costs; TR > TC Same as: P > ATC Competitive firm’s long-run supply curve The portion of its marginal-cost curve that lies above average total cost

FRQ 1 Using correctly labeled side-by-side graphs for a market and a firm, graph a firm earning short-run economic profits. Can this scenario be maintained in the long run? Explain.

FRQ 1 Answer In a competitive market where firms are earning economic profits, new firms will have an incentive to enter the market. This entry will expand the number of firms, increase the quantity of the good supplied, and drive down prices and profits. Entry will cease once firms are producing the output level where price equals the minimum of the average-total-cost curve, meaning that each firm earns zero economic profits in the long run.

FRQ 1 Graphs

FRQ 2 Using cost curve analysis, explain the derivation of a perfectly competitive firm’s short-run supply curve.

FRQ 2 Answer A perfectly competitive firm’s short-run supply curve is the rising portion of its marginal cost curve above the variable cost curve. The supply curve for a perfectly competitive firm is represented by the various quantities the firm would willingly put on the market at each possible alternative price. In the short run, a perfectly competitive firm would operate and produce where MC=P, as long as that occurs above average variable cost. If the price were below average variable cost, the firm would shut down in the short run.