Perfect Competition in the Long-Run

Problem Set

1. Which of the following events will induce firms to enter an industry? Which will induce firms to exit? When will entry
or exit cease? Explain your answer.
a. A technological advance lowers the fixed cost of production of every firm in the industry. A fall in the fixed
cost of production generates a fall in the average total cost of production and, in the short run, an increase
in each firm’s profit at the current output level. So in the long run new firms will enter the industry. The
increase in supply drives down price and profits. Once profits are driven back to zero, entry will cease.
b. The wages paid to workers in the industry go up for an extended period of time. An increase in wages
generates an increase in the average variable and the average total cost of production at every output level.
In the short run, firms incur losses at the current output level, and so in the long run some firms will exit the
industry. (If the average variable cost rises sufficiently, some firms may even shut down in the short run.) As
firms exit, supply decreases, price rises, and losses are reduced. Exit will cease once losses return to zero.
c. A permanent change in consumer tastes increases demand for the good. Price will rise as a result of the
increased demand, leading to a short-run increase in profits at the current output level. In the long run, firms
will enter the industry, generating an increase in supply, a fall in price, and a fall in profits. Once profits are
driven back to zero, entry will cease.
d. The price of a key input rises due to the long-term shortage of that input. The shortage of a key input causes
that input’s price to increase, resulting in an increase in average variable and average total cost for
producers. Firms incur losses in the short run, and some firms will exit the industry in the long run. The fall in
supply generates an increase in price and decreased losses. Exit will cease when the losses for remaining
firms have returned to zero.

2. Bob produces DVD movies for sale, which requires building and a machine that copies the original movie onto a
DVD. Bob rents a building for $30,000 per month and rents a machine for $20,000 a month. Those are his fixed
costs. His variable costs per month are given in the accompanying table.
a. Calculate Bob’s average variable cost, average total cost, and marginal cost for each quantity of output.
Quantity Average Average Average
Variable Cost Marginal Cost
of DVDs Variable Costs Fixed Costs Total Costs
0 $0 --- --- --- ---
1,000 $5,000 $5.00 $50.00 $55.00 $5.00
2,000 $8,000 $4.00 $25.00 $29.00 $3.00
3,000 $9,000 $3.00 $16.67 $19.67 $1.00
4,000 $14,000 $3.50 $12.50 $16.00 $5.00
5,000 $20,000 $4.00 $10.00 $14.00 $6.00
6,000 $33,000 $5.50 $8.33 $13.83 $13.00
7,000 $49,000 $7.00 $7.14 $14.14 $16.00
8,000 $72,000 $9.00 $6.25 $15.25 $23.00
9,000 $99,000 $11.00 $5.56 $16.56 $27.00
10,000 $150,000 $15.00 $5.00 $20.00 $51.00

b. There is free entry into the industry, and anyone who enters will face the same costs as Bob. Suppose that
currently the price of a DVD is $25. What will Bob’s profit be? Is this a long-run equilibrium? If not, what will
the price of DVD movies be in the long run?
When the price is $25, Bob will sell 8,000 DVDs per month and make a profit of $78,000. If there is free entry
into the industry, this profit will attract new firms. As firms enter, the price of DVDs will eventually fall until it is
equal to the minimum average total cost. Here, the average total cost reaches its minimum of $13.83 at 6,000
DVDs per month. So the long-run price of DVDs will be $13.83.
c. What is Bob’s break-even price? What is his shut-down price?
 Bob’s break-even price is $13.83 because this is the minimum average total cost. His shut-down price is $3, the
minimum average variable cost, because below that price his revenue does not even cover his variable costs.
d. Suppose the price of a DVD is $2. What should Bob do in the short run?
If the price of DVDs is $2, the price is below Bob’s shut-down price of $3. So Bob should shut down in the short
run.
e. Suppose the price of a DVD is $7. What is the profit-maximizing quantity of DVDs that Bob should produce?
What will his total profit be? Will he produce or shut down in the short run? Will he stay in the industry or exit
in the long run?
If DVDs sell for $7, Bob should produce 5,000 DVDs because for any greater quantity his marginal cost exceeds
his marginal revenue (the market price). His total profit will be –$35,000, a loss of $35,000. In the short run, he
will produce because his short-run loss if he were to shut down would be greater; it would equal his fixed costs
of $50,000. In the long run, he will exit the industry because his profit is negative: the price of $7 per DVD is
below his break-even price of $13.83.
f. Suppose instead that the price of DVDs is $20. Now what is the profit-maximizing quantity of DVDs that Bob
should produce? What will his total profit be now? Will he produce or shut down in the short run? Will he
stay in the industry or exit in the long run?
If DVDs sell instead for $20, Bob should produce 7,000 DVDs because at this quantity his marginal cost
approximately equals his marginal revenue (the market price). His total profit will be $41,000. In the short run, he
will produce because he is covering his variable cost (the price is above the shut-down price). In the long run, he
will stay in the industry because his profit is not negative (the price is above the break-even price).

3. Use side-by-side graphs of a perfectly competitive market and an individual firm competing in that market to illustrate
the following situations:
a. A firm experiencing economic profit in the short run.

b. A firm operating with an economic loss in the short run.

c. A firm in a classic shut-down position in the short run.

d. Long-run equilibrium for a firm and industry.

 e. Economic profits disappearing in the long run.

f. Economic losses disappearing in the long run.

4. Assume that corn is produced in a perfectly competitive market. Farmer Roy is a typical producer of corn.
a. Assume that Farmer Roy is making zero economic profit in the short run. Draw a correctly labeled side-by-
side graph for the corn market and for Farmer Roy and show each of the following:
i. The equilibrium price and quantity for the corn market, labeled as P M1 and QM1, respectively.
ii. The equilibrium quantity for Farmer Roy, labeled as Q F1.
b. For Farmer Roy’s corn, is the demand perfectly elastic, perfectly inelastic, relatively inelastic, or unit elastic?
Explain.

c. Corn can be used as an input in the production of ethanol. The demand for ethanol has significantly
increased.
i. Show on your graph in part (a) the effect of the increase in demand for ethanol on the market price
and quantity of corn in the short run, labeling the new equilibrium price and quantity as P M2 and QM2,
respectively.
ii. Show on your graph in part (a) the effect of the increase in demand for ethanol on Farmer Roy’s
quantity of corn in the short run, labeling the quantity as Q F2.
iii. How does the average total cost for Farmer Roy at Q F2 compare with PM2?

d. Corn is also used as an input in the production of cereal. What is the effect of the increased demand for
ethanol on the equilibrium price and quantity in the cereal market in the short run? Explain.