Economics Principles and Policy 13th

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 Chapter 10/The Firm and the Industry under Perfect Competition

CHAPTER 10
THE FIRM AND THE INDUSTRY UNDER PERFECT
COMPETITION
TEST YOURSELF
1. Under what circumstances might you expect the demand curve of the firm to be
a. Vertical?
b. Horizontal?
c. Negatively sloping?
d. Positively sloping?
(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. Explain why P = MC in the short-run equilibrium of the perfectly competitive firm,
whereas in long-run equilibrium P = MC = AC.
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. Explain why it is not sensible to close a business firm if it earns zero economic profits.
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.
4. If the firm’s lowest average cost is $52 and the corresponding average variable cost is
$26, what does it pay a perfectly competitive firm to do if
a. The market price is $51?
b. The price is $36?
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 Chapter 10/The Firm and the Industry under Perfect Competition

c. The price is $12?

(a) If the market price is $51, the firm should reduce output to produce at the point where
MC = $51. The firm will lose money, but the price is more than AVC, and therefore it
loses less money than if it quit altogether, and had to pay its fixed costs with no
income coming in. In the long run, when all costs are variable costs, the firm will shut
down.
(b) If the market price is $36, in the short run, the firm should cut back production, so
that MC is only $36. It will lose money, but the price exceeds AVC, and therefore it
loses less money than if it quit altogether, and had to pay its fixed costs with no
income coming in. In the long run, when all costs are variable costs, the firm will
close down.
(c) If the market price is $12, the firm cannot even cover its variable costs by producing.
It will lose less money if it quits business immediately, and only has to pay the fixed
costs, not a portion of the variable costs as well.
5. If the market price in a competitive industry were above its equilibrium level, what
would you expect to happen?
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. Explain why a perfectly competitive firm does not expand its sales without limit if its
horizontal demand curve indicates that it can sell as much as it desires at the current
market price.
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.
2. Explain why a demand curve is also a curve of average revenue. Recalling that when
an average revenue curve is neither rising nor falling, marginal revenue must equal
average revenue, explain why it is always true that P = MR = AR for the perfectly
competitive firm.
The demand curve shows the price, P, at which different levels of output can be sold. But
P = PQ/Q, (where Q is output), and PQ is equal to total revenue, TR. Therefore, P =
TR/Q = AR, or average revenue. So the demand curve is a curve of average revenue.
When MR, marginal revenue, is less than AR, MR is pulling AR down and AR is falling;
when MR exceeds AR, AR is rising. Therefore, when AR is horizontal, as it is for a
purely competitive firm, MR = AR. More intuitively, P = MR for a purely competitive
firm, because each extra unit adds its full price to total revenue, and there is no deduction
from revenue caused by a declining price on earlier units. Thus: P = AR = MR.
3. Regarding the four attributes of perfect competition (many small firms, freedom of
entry, standardized product, and perfect information):
a. Which is primarily responsible for the fact that the demand curve of a perfectly
competitive firm is horizontal?
b. Which is primarily responsible for the firm’s zero economic profits in long-run
equilibrium?
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 Chapter 10/The Firm and the Industry under Perfect Competition

(a) The fact that all firms sell a standardized product is primarily responsible in that
customers have no reason to stay with one supplier if its price is higher than others.
Perfect information also plays a role in that consumers know the prices being charged
by different producers.
(b) The fact that there is freedom of entry is primarily responsible in that new
competitors can enter the industry easily if profits are positive.
4. We indicated in this chapter that the MC curve cuts the AVC (average variable cost)
curve at the minimum point of the latter. Explain why this must be so. (Hint: Because
marginal costs are, by definition, entirely composed of variable costs, the MC curve
can be considered the curve of marginal variable costs. Apply the general relationships
between marginals and averages explained in the appendix to Chapter 8.)
Total costs are equal to total fixed costs plus total variable costs. Marginal costs are equal
to the change in fixed costs plus the change in variable costs. However, since fixed costs,
by definition, do not vary, marginal costs are equal to marginal variable costs. So if MC
is less than AVC, it is pulling AVC down, while if MC is above AVC, it is pulling AVC
up—and consequently if MC is just equal to AVC, AVC must be neither rising nor
falling but at a minimum.
5. (More difficult) In this chapter we stated that the firm’s MC curve goes through the
lowest point of its AC curve and also through the lowest point of its AVC curve.
Because the AVC curve lies below the AC curve, how can both of these statements be
true? Why are they true? (Hint: See Figure 4.)
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.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.