CHAPTER 10 Perfect Competition
Test Yourself
1. (a) A demand curve might be vertical for a good that is absolutely necessary to the continuance of life, or for a good which is so cheap and which has so few close substitutes that a rise in price would barely be noticed by the consumer.
(b) A demand curve facing a firm in a perfectly competitive industry is horizontal. Because the products of the different firms are identical, and because there are so many firms, no single firm can take a production decision that is large enough to affect industry supply enough to alter the price.
(c) A firm’s demand curve will be negatively sloping if the firm’s output is a relatively large portion of the industry’s output, or if the firm’s output is differentiated from the output of the other firms and is identifiable. Under such circumstances, if the firm seeks to sell a significantly higher output, it will have to lower its selling price in order to attract new business.
(d) A firm’s demand curve might be positively sloping if it could somehow persuade the public that the quality of the good it was selling was signaled by its price.
2. In the short run, a profit-maximizing firm sets output at a point where MR = MC. In the case of a purely competitive firm, however, MR = P, and therefore the optimal output level is where P = MC. In the long run, P is still equal to MC, but P is also equal to AC. If P exceeded AC, profits would be positive, new firms would enter the industry and the increase in supply would reduce P. If P were less than AC, profits would be negative, firms would leave the industry and the reduction in supply would increase P. Therefore, in long-run equilibrium, P = MC = AC.
3. If a firm is earning zero economic profit, the owner’s invested capital is earning the same return it could earn in another use, while the owner’s labor (if she is working in the firm) is earning the same income it could earn elsewhere, so the owner has no incentive to close the firm.
5. If the market price is above equilibrium, profits will attract new firms into the industry. The increase in supply will reduce the price to its equilibrium, zero-profit level.
Discussion Questions
1. A profit-maximizing firm produces output at the point where marginal revenue equals marginal cost. A perfectly competitive firm does not face the phenomenon of declining marginal revenue, but it does experience rising marginal costs as its output rises. Once marginal costs have reached the level of the price, any further expansion of output would reduce profits.
3. (a) Standardized product: so that customers have no reason to stay with one supplier if its price is higher than others.
Many small firms: so that no firm can have a significant impact on market supply by changing its output.
Perfect information: so that consumers know the prices being charged by producers.
(b) Freedom of entry: so that new competitors can enter the industry easily if profits are positive.
Perfect information: so that potential competitors know what the profits are in the industry.
5. The MC curve consists only of variable costs, and so it goes through the low point of the AVC curve. It also goes through the low point of the AC curve. The AC curve lies above the AVC curve. Since the MC curve is positively sloped, this implies that the minimum point of the AC curve occurs when output is higher than it is at the minimum point of the AVC curve. This makes sense economically. The minimum point of the AC curve is delayed, because declining average fixed costs keep exerting a downward pull on AC, while they are not a part of and have no influence on AVC.