Perfect Competition
Practice Questions
ECON2113 Microeconomics (L1/L7)
Tutorial Seven
Jeremy TO
Department of Economics, HKUST
Jeremy TO ECON2113 Microeconomics (L1/L7)
Perfect Competition
Practice Questions
Assumptions
There are many buyers and sellers in the market
Sellers sell homogeneous (identical) goods
There are no restrictions on entry into the industry
Sellers and buyers are well informed about prices (perfect
information)
Size of sellers are extremely small compared to the market
Jeremy TO ECON2113 Microeconomics (L1/L7)
Perfect Competition
Practice Questions
Price Takers
Firms in perfect competition are price takers, meaning that a
firm that cannot influence the market price and so it sets its
own price equal to the market price.
Profit Maximization: Firms operating in perfect competition
seek to maximize economic profit, which is the difference
between total revenue and its total opportunity cost of
production.
Because the firm is a price taker, its marginal revenue is
equal to the market price and remains constant as output
sold increases.
The firm’s demand is perfectly elastic and the firm’s demand
curve is a horizontal line at the market price.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Perfect Competition
Practice Questions
Marginal Analysis and Supply Decision
Marginal analysis can be used to determine the profit
maximizing quantity (q ∗ ). The firm compares the marginal
revenue to the marginal cost of producing different levels of
output.
When MR > MC , then the extra revenue from selling one
more unit exceeds the extra cost of producing one more unit,
so the firm increases its output to increase its profit.
When MR < MC , then the extra cost of producing one more
unit exceeds the extra revenue from selling one more unit, so
the firm decreases its output to increase its profits.
When MR = MC , then the extra cost of producing one more
unit equals the extra revenue from selling one more unit, so
the firm’s profit is maximized at this level of output.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Perfect Competition
Practice Questions
Production Decision and Supply Curve in the Short Run
The firm will temporarily shut down in the short run when
price falls below the shutdown point, which is the output and
price that just allows the firm to cover its total variable cost.
The minimum AVC is the lowest price at which the firm will
operate because if it operated with a lower price, the firm’s
loss would be greater than if it shut down. (The loss when the
firm shuts down is equal to its fixed cost
(
If shut down q = 0, Loss = TFC
If continue to produce q = q ∗ , Loss/Profit = TR − TVC − TFC
Jeremy TO ECON2113 Microeconomics (L1/L7)
Production Decision and Supply Curve in the Short Run
Consider the case of “continue to produce”:
π = TR − TVC − TFC
π = p × q − AVC × q − TFC
π = (p − AVC ) × q − TFC
Therefore
If p > AVC
Loss < TFC =⇒ Continue to produce at q ∗
If p = AVC Loss = TFC =⇒ Produce at q ∗ or 0
If p < AVC Loss > TFC =⇒ Shut down and produce 0
Production Decision and Supply Curve in the Short Run
The Firm’s Supply Curve: As long as the firm remains open,
it produces where MR = MC . So the firm’s supply curve is its
MC curve above the minimum AVC . At prices below the
minimum AVC , the firm shuts down and supplies zero.
Perfect Competition
Practice Questions
Short-run Equilibrium
Short Run Equilibrium: Market demand and short-run
market supply determine the market price and market output.
Each firm takes the market price as given, and produces its
profit maximizing output.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Perfect Competition
Practice Questions
Production Decision and Supply Curve in the Long Run
In the short run, a firm might break even, earn an economic
profit or incur a loss. Because of entry and exit, in the long
run a firm can only break even.
Entry and Exit: Economic profit (loss) motivates firms to
enter (exit) the industry, thereby increasing (decreasing) the
market supply. When the market supply curve shifts rightward
(leftward), the market price falls (rises). Eventually the price
falls (rises) to equal the minimum ATC for each firm in the
industry and firms have adjusted their plant size so they are
producing at the minimum long-run average cost. At this
price, firms in the industry no longer make an economic profit
(loss) and so firms no longer enter (exit) the industry.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Perfect Competition
Practice Questions
Long run Equilibrium
Long run market supply curve: It is a horizontal line (=
minimum point of ATC ).
Long Run Equilibrium: Long run equilibrium in a
competitive market occurs when there is zero economic profit
and entry and exit have stopped.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Perfect Competition
Practice Questions
Competition and Efficiency
In a competitive equilibrium, the quantity demanded equals
the quantity supplied. If there are no externalities, the
demand curve is the same as the marginal social benefit curve
and the supply curve is the same as the marginal social cost
curve, so at the competitive equilibrium, the marginal social
benefit equals the marginal social cost.
Resource use is efficient: Because resources are used
efficiently, at the competitive equilibrium there is no other
allocation of resources that will generate greater net benefits
to society. (Social Surplus is maximized)
Jeremy TO ECON2113 Microeconomics (L1/L7)
Perfect Competition
Practice Questions
Problem 1
Suppose you are given the following information about a particular
industry:
Q d = 6500 − 100P
Q s = 1200P
q2
C (q) = 722 +
200
q
MC (q) =
100
Assume that all firms are identical and that the market is
characterized by pure competition.
(1) Find the equilibrium price, the equilibrium quantity, the
output supplied by the firm, and the profit of each firm.
(2) Would you expect to see entry into or exit from the
industry in the long run? Explain. What effect will entry or
exit have on market equilibrium?
Jeremy TO ECON2113 Microeconomics (L1/L7)
Problem 1
(3) What is the lowest price at which each firm would sell its
output in the long run? Is profit positive, negative, or zero at
this price? Explain.
(4) What is the lowest price at which each firm would sell its
output in the short run? Is profit positive, negative, or zero at
this price? Explain.
Perfect Competition
Practice Questions
Problem 2
Consider a city that has a number of hot dogs stands operating
throughout the down- town area. Suppose that each vendor has a
marginal cost of $1.50 per hot dog sold, and no fixed cost. Suppose the
maximum number of hot dogs any one vendor can sell in a day is 100.
(1) If the price of a hot dog is $2, how many hot dogs does each
vendor want to sell?
(2) If the industry is perfectly competitive will the price remain at
$2 for a hot dog? If not, what will the price be?
(3) If each vendor sells exactly 100 hot dogs a day and the demand
for hot dogs from vendors in the city is Q = 4400 − 1200P , how
many vendors are there?
(4) Suppose the city decides to regulate hot dog vendors by issuing
permits. If the city issues only 20 permits, and if each vendor
continues to sell 100 hot dogs a day, what price will a hot dog sell
for?
(5) Suppose the city decided to sell the permits. What is the
highest price a vendor would pay for a permit?
Jeremy TO ECON2113 Microeconomics (L1/L7)