METU Department of Economics 2022-2023 Spring

Econ. 101 - Section 1 & Section 2

Intstructors: Meltem Dayıoğlu T.A.: Cankutcem Ünal

Gül İpek Tunç (cemunal@[Link])

SOLUTIONS
PROBLEM SET 8
(Colander Chapter 13)
Note: Please solve the PS and upload your answers to the assignment folder on odtuclass.

1) What are the conditions for the perfect competitive market structure?

For a market to be called perfectly competitive, it must meet some stringent conditions. Some
of them are: Both buyers and sellers are price takers. The number of firms is large. There are
no barriers to entry. Firms’ products are identical. There is complete information. Selling
firms are profit-maximizing entrepreneurial firms. These and other similar conditions are
needed to ensure that economic forces operate instantaneously and are unimpeded by political
and social forces.

2) What is the major difference between the long run and the short run in a perfectly
competitive market? Explain in terms of the number of firms and the flexibility of firms.

In the short run there is no entry or exit of firms in pure competition. The number of firms
and plant size are fixed. Firms can either produce or shut down. If they shut down, they do
not have time to liquidate their assets or go out of business. In the long run there can be entry
and exit of firms into an industry. Firms that shut down in the short run because they are
experiencing economic losses will eventually liquidate assets and go out of business if the
losses persist over time. Existing firms in the long run can expand or contract their capacity to
produce. In the long run, new firms can enter an industry and increase the industry output.

3) A profit-maximizing business incurs an economic loss of $10,000 per year. Its fixed cost
is $15,000 per year. Should it produce or shut down in the short run? Should it stay in the
industry or exit in the long run? Suppose instead that this business has a fixed cost of
$6,000 per year. Should it produce or shut down in the short run? Should it stay in the
industry or exit in the long run?
 In the short run, the business should produce. If it shuts down, the short-run annual loss will
be $15,000, its fixed cost; but if it produces, the loss will be only $10,000. In the long run, the
business should exit the industry because it is incurring a loss. In the short run, the business
should shut down. If it shuts down, the short-run loss will be $6,000, its fixed cost; if it
continues to produce, the loss will be $10,000. In the long run, the firm should exit the
industry because it is incurring a loss.

4) You are given the following information about industry of X-netbook:

• Long-run average costs:
Labour cost: 3 TL per unit of output; Capital cost: 4 TL per unit of output
• The industry is in long-run equilibrium.
• Industry is perfectly competitive: with each of 50 firms producing the same amount of
output
• Total industry output = 8000 units

i) Show the current conditions by drawing two diagrams: one showing the industry
(demand and supply) and one showing a representative firm (short-run and long-run
costs). Mark clearly the prevailing price in the market in both of the diagrams.

ii) Indicate the profit/loss level of the representative firm on the diagram.

Profit = TR – TC = 0 since Average Total Cost=Average Revenue.

Now assume that, the demand of X-netbook is expected to grow rapidly over the next few years to a
level of twice as high it is now. But due to short-run diminishing returns the existing firms in the
industry could only increase the quantity supplied by % 50.

iii) Show and explain the effect of the above developments on the industry in the short-
run by using the diagram you have drawn in part (i) as your initial point.

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As demand doubled, we move from D0 to D1. But on the same supply curve, equilibrium
quantity supplied increases to 12000; (8000 + 50% ∗ 8000). So, as demand increases, price
also increases.

iv) Show the effect of the above developments on a typical firm in the short-run by using
the short-run and long-run cost curves. Use the diagram you have drawn in part (i) as
your initial point. Also show the level of profits/losses in your diagram.

Loss=(P1-SRATC1)*240
v) Explain how the typical firm and the industry as a whole will move to the new long-
run equilibrium.

Since profit is positive, the number of firms that entered to the market will increase. So, as
quantity supplied increases, price will go down and profits will be zero.

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vi) Show the final long-run equilibrium of the industry after all the adjustments have
taken place assuming that long-run equilibrium price is the same as initial long-run
equilibrium.

5) Use the figure below to answer the following questions.

i) How can you determine that the figure represents a graph of a perfectly
competitive firm? Be specific; indicate which curve gives you the information and
how you use this information to arrive at your conclusion.

The perfectly competitive firm is a price taker and therefore faces a perfectly
elastic demand curve which is also the MR curve. The firm's short run supply
curve is its MC curve above minimum AVC (from point b and above).

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 ii) What is the market price?
Market price = $40
iii) What is the profit-maximizing output?
Profit maximizing output = 200
iv) What is total revenue at the profit-maximizing output?
Total revenue = $40 × 200 = $8,000
v) What is the total cost at the profit-maximizing output?
Total cost = ATC × total output = $24 × 200 = $4,800
vi) What is the profit or loss at the profit-maximizing output?
Profit = Total revenue - total cost = $8,000 - 4,800 = $3,200
vii) What is the firm's total fixed cost?
Total fixed cost = AFC × total output = (ATC - AVC) × 150 = $6 × 150 = $900.
(Note: fixed cost has the same value at all output levels)
viii) What is the total variable cost at the profit-maximizing output?
The total variable cost at the profit maximizing output level = ($4,800 - 900)
=$3,900
ix) Identify the firm's short-run supply curve.
The firm's short run supply curve is its MC curve above minimum AVC (from
point b and above).
x) Is the industry in a long-run equilibrium?
No, the industry is not in a long-run equilibrium because the firm earns an
economic profit.
xi) If it is not in long-run equilibrium, what will happen in this industry to restore
long-run equilibrium?
Some firms will enter the industry, causing the industry supply curve to shift
rightward. This causes market price to fall. Entry stops when economic profits are
eliminated, and all firms break even.
xii) In long-run equilibrium, what is the firm's profit maximizing quantity?
In the long run equilibrium, the firm's profit maximizing quantity = 150, where
price will equal marginal cost.

6) Suppose that there are 100 consumers in a perfectly competitive market and individual
demand curves of these consumers are identical. Also, assume that there are 10 firms in
the industry and these firms are identical as well. The following information is provided
about this competitive market:

Individual Demand Curve: 𝑃 = 100– 10𝑄𝐷

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Total Cost of a Representative (individual) Firm: 𝑇𝐶 = 20𝑄 + 6 𝑄 2 + 100

i. Find total variable cost (TVC), total fixed cost (TFC) and marginal cost (MC)
functions of the representative firm.
1 1
𝑇𝑉𝐶 = 20𝑄 + 6 𝑄 2 , TFC = 100, MC=20+(3)Q

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ii. Find average total cost (ATC), average variable cost (AVC), average fixed cost
(AFC) functions of the representative firm.

𝑇𝐶 1 100 𝑇𝑉𝐶 1
𝐴𝑇𝐶 = = 20 + ( ) 𝑄 + , 𝐴𝑉𝐶 = = 20 + ( ) 𝑄,
𝑄 6 𝑄 𝑄 6
100
𝐴𝐹𝐶 = 𝑇𝐹𝐶/𝑄 =
𝑄

iii. What is the market demand function?

To find the market demand we need to horizontally sum the individual demand
curves for each of these firms; P = 100 – (1/10) Q

iv. What is the market supply function?

To find the market supply curve we need to horizontally sum the MC curves for
each of these firms. Thus, with each firm’s MC=20+(1/3)Q then P=20+(1/30)Q

v. What is the equilibrium price and quantity in this market?

QD=QS
100 – (1/10) Q = 20 + (1/30) Q => Q = 600 units P = 40 TL

vi. What is the quantity produced by the representative firm?

The representative firm is a price taker and will see the market price of $40 as its
marginal revenue curve. It will profit maximize by producing that level of output
where MR equals MC. Thus, 40=20+(1/3)Q −> Q = 60 units

vii. Calculate the level of profits that the representative firm is earning.
Profit = TR – TC = 2400−1900 = 500 TL
TR = 40∗60 = 2400 TL
𝑇𝐶 = 20(60) + (1/6)(60)2 + 100 = 1200 + 600 + 100 = 1900 𝑇𝐿

viii. Holding everything else constant, what do you predict will happen in this industry
in the long run? Explain your answer fully with a verbal description rather than a
numeric calculation.
Since the representative firm is earning positive economic profit, we can conclude
that this is a short-run equilibrium. We know that when the industry is in a long-
run equilibrium that the representative firm in the industry will earn zero
economic profit. Thus, we can predict that in the long run there will be entry of
new firms into this industry. This entry will cause the market supply curve to shift
to the right and this shift will result in the market equilibrium quantity increasing
while the market equilibrium price will decrease relative to its current levels.
There will be more firms in the industry, and each firm will produce an output that
is smaller than 60 units.

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7) This question traces some of the long-run adjustments that take place in a perfectly
competitive market in response to a change in demand. Each firm currently in the
industry, as well as each potential entrant, has the cost structure depicted in the left panel
below. The right panel shows the industry's short-run supply curve and the current market
demand curve 𝐷0 .

At the initial equilibrium,

a. What are the equilibrium price and output in the industry? 𝑃0 = $10 𝑎𝑛𝑑 𝑄0 = 2,000
b. What is the output and profit of each firm in the industry? 𝑞=100 units and Profit =0
c. How many firms are operating in this industry? # Firms = 𝑄/𝑞=2000/100=20
d. Is the industry in long-run equilibrium? Explain.
Yes. Economic Profit = 0 -> long-run equilibrium

Suppose demand shifts to 𝐷1 . At the new short-run equilibrium

e. What are the equilibrium market price and quantity in the industry?
𝑃 𝑆 =$15 and 𝑄 𝑆 =3000
f. What is the output of each firm in the industry?
Each firm increases q from 100 to 150 (where MC = new MR)
g. What is each firm's profit? Profit = 150(15−𝐴𝐶)=150(15−13)=300

h. Explain the changes in the industry's short-run supply curve after sufficient time has
elapsed for entry and exit to occur given a constant cost industry in the long run?
Entry shifts Supply curve right until P = $10 gives zero economic profit and long-run
equilibrium is reached.

At the new long-run equilibrium,

i. What are the market price and quantity? P1=10 and 𝑄1=4000
j. What is the output and associated profit of each firm? q= 100 and Economic Profit = 0
k. How many firms will be active in this industry? #Firms = 𝑄/𝑞=4000/10=40