11175 Introduction to Economics

Answers to exam review questions module 5

Compare your responses to those provided below.

Question 1
What are the characteristics of a perfectly competitive market structure?

(i) There are many buyers and sellers; this means what each buyer is buying is small relative
to the size of the market and what each seller is selling is small relative to the size of the
market. Buyers and sellers are, therefore, price takers because they cannot influence the
market price through their actions.

(ii) All firms are selling identical products, or buyers cannot distinguish between the
products sold by the many sellers in the market. This means sellers have no incentive to
raise price since buyers will buy from other buyers who are selling the same product.

(iii) There are no barriers to firms entering the market.

Question 2
Under what conditions should a competitive firm shut down in the short run?

Students should note in their answers that the options facing firms in the short run is either
to continue operating or shut down. Shutting down doesn’t mean exiting the industry
because the firm will still be paying fixed cost in the short run. Entry and exit is a long run
phenomenon. The shutdown point in the short run is where price is equal to the minimum of
the average variable cost of the firm. When the price is equal to the minimum of the average
variable cost, the firm will cover its total variable cost by continuing to operate (i.e. Total
Revenue= Total Variable Cost) and its loss will equal its fixed cost. If the firm decides to
shut down, its loss will also equal its fixed cost. Therefore, at the shutdown point (where
price is equal to the minimum of the average variable cost), the firm is indifferent between
continuing to operate or shutting down (because its loss will equal its fixed cost in either
case).

However, if price was to fall below its minimum average variable cost, then the firm would
definitely shut down because it would minimize its loss by doing so. If price is below the
minimum of average variable cost, the firm’s total revenue would not cover the whole
variable cost of the firm and loss would be greater than fixed cost (i.e. firm’s loss would
equal its fixed cost plus some part of its variable cost). In this case, it would better for the
firm to shutdown and incur a loss equal to its fixed cost only.

In a nutshell, a firm’s consideration whether to shutdown or continue to operate in the short

run depends on whether the firm is covering its total variable cost. A firm that cannot cover
its total variable cost in the short run will decide to shut down to minimize its loss.

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Question 3
What is meant by productive efficiency? How does a perfectly competitive firm achieve productive
efficiency?

A competitive market is a market where there are many buyers and sellers interacting with
each other. The competitive market equilibrium occurs at the intersection of the market
demand and supply. The competitive market equilibrium outcome is productively efficient.
This means goods and services are produced using the least cost method of production (i.e.
cost minimisation). Alternatively, it means the goods and services produced are the
maximum that can be attained from the resources used in production.

To survive in a competitive environment, producers operating in competitive markets will

seek out the least cost method of production. Some students may also mention that, at long
run equilibrium, competitive firms will be operating on the lowest point on their Long run
Average cost curves- which is a feature that points towards cost minimisation.

Question 4
What is meant by allocative efficiency? How does a perfectly competitive firm achieve allocative
efficiency?

The competitive market equilibrium outcome is allocatively efficient because the mix of
goods and services produced in competitive markets maximise the total surplus of the
society (Total surplus= Consumer surplus + Producer surplus).

This is the case because producers will produce until the marginal benefit of consuming the
last unit is equal to the marginal cost of producing it (i.e. producers will produce a good as
long as the value people attach to it- its marginal benefit- exceeds the cost of producing it-
its marginal cost).

Thus, the mix of goods and services produced in competitive markets reflect
societies/consumers’ preferences. (Draw a diagram of demand and supply, and show the
market equilibrium outcome. At the equilibrium quantity, MB=MC. Indicate consumer and
producer surpluses in the diagram and argue the sum is maximum at competitive equilibrium
outcome).

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