Essentials of Economics 3rd Edition Brue
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Pure Competition QUESTIONS
Question 1
Briefly state the basic characteristics of pure competition, pure monopoly, monopolistic competition, and oligopoly. Under which of these market classifications does each of the following most accurately fit? (a) a supermarket in your hometown; (b) the steel industry; (c) a Kansas wheat farm; (d) the commercial bank in which you or your family has an account; (e) the automobile industry. In each case, justify your classification.
Answer
Pure competition: very large number of firms; standardized products; no control over price: price takers; no obstacles to entry; no nonprice competition. Pure monopoly: one firm; unique product with no close substitutes; much control over price: price maker; entry is blocked; mostly public relations advertising. Monopolistic competition: many firms; differentiated products; some control over price in a narrow range; relatively easy entry; much nonprice competition: advertising, trademarks, brand names. Oligopoly: few firms; standardized or differentiated products; control over price circumscribed by mutual interdependence: much collusion; many obstacles to entry; much nonprice competition, particularly product differentiation.
(a) Hometown supermarket: oligopoly. Supermarkets are few in number in any one area; their size makes new entry very difficult; there is much nonprice competition. However, there is much price competition as they compete for market share, and there seems to be no collusion. In this
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regard, the supermarket acts more like a monopolistic competitor. Note that this answer may vary by area. Some areas could be characterized by monopolistic competition, while isolated small towns may have a monopoly situation.
(b) Steel industry: oligopoly within the domestic production market. Firms are few in number; their products are standardized to some extent; their size makes new entry very difficult; there is much nonprice competition; there is little, if any, price competition; while there may be no collusion, there does seem to be much price leadership.
(c) Kansas wheat farm: pure competition. There are a great number of similar farms; the product is standardized; there is no control over price; there is no nonprice competition. However, entry is difficult because of the cost of acquiring land from a present proprietor. Of course, government programs to assist agriculture complicate the purity of this example.
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(d) Commercial bank: monopolistic competition. There are many similar banks; the services are differentiated as much as the bank can make them appear to be; there is control over price (mostly interest charged or offered) within a narrow range; entry is relatively easy (maybe too easy!); there is much advertising. Once again, not every bank may fit this model smaller towns may have an oligopoly or monopoly situation.
(e) Automobile industry: oligopoly. There are the Big Three automakers, so they are few in number; their products are differentiated; their size makes new entry very difficult; there is much nonprice competition; there is little true price competition; while there does not appear to be any collusion, there has been much price leadership. However, imports have made the industry more competitive in the past two decades, which has substantially reduced the market power of the U.S. automakers.
Question 2
Use the demand schedule below to determine total revenue and marginal revenue for each possible level of sales:
a. What can you conclude about the structure of the industry in which this firm is operating? Explain.
b. Graph the demand, total-revenue, and marginal-revenue curves for this firm.
c. Why do the demand, marginal-revenue, and average-revenue curves coincide?
d. “Marginal revenue is the change in total revenue associated with additional units of output.” Explain verbally and graphically, using the data in the table.
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a. The industry is purely competitive this firm is a “price taker.” The firm is so small relative to the size of the market that it can change its level of output without affecting the market price.
b. The firm’s demand curve is perfectly elastic; MR is constant and equal to P
c. True. When output (quantity demanded) increases by 1 unit, total revenue increases by $2. This $2 increase is the marginal revenue. Figure: The change in TR is measured by the slope of the TR line, 2 (= $2/1 unit).
Question 3
“Even if a firm is losing money, it may be better to stay in business in the short run.” Is this statement ever true? Under what condition(s)?
Answer
Yes, a firm may want to stay in business even if it is losing money. For example, assume the firm has a fixed cost of $1,000 that it must pay even if it stops production. Now assume that average variable cost is $10 per unit and price of the product is $15 per unit. Finally, assume that output equals 100 units using the MR = MC rule. This implies total revenue equals $1,500, variable cost equals $1,000, and total cost equals $2,000 (the sum of variable and fixed cost). The firm is losing money because profit equals –$500 (= $1,500 – $2,000). However, this loss is less than the fixed cost it would incur in the short run if it shut down, which equals $1,000. Thus, it is better to stay in business and lose $500 rather than close down and lose $1,000 in the short run.
In conclusion, as long as price exceeds the average variable cost, the firm should produce in the short run given fixed costs are present by definition.
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Question 4
Why is the equality of marginal revenue and marginal cost essential for profit maximization in all market structures? Explain why price can be substituted for marginal revenue in the MR = MC rule when an industry is purely competitive.
Answer
If the last unit produced adds more to costs than to revenue, its production must necessarily reduce profits (or increase losses). On the other hand, profits must increase (or losses decrease) so long as the last unit produced the marginal unit is adding more to revenue than to costs. Thus, so long as MR is greater than MC, the production of one more marginal unit must be adding to profits or reducing losses (provided price is not less than minimum AVC). When MC has risen to precise equality with MR, the production of this last (marginal) unit will neither add nor reduce profits.
In pure competition, the demand curve is perfectly elastic; price is constant regardless of the quantity demanded. Thus, MR is equal to price. This being so, P can be substituted for MR in the MR = MC rule. (Note, however, that it is not good practice to use MR and P interchangeably because in imperfectly competitive models, price is not the same as marginal revenue.)
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Question 5
“That segment of a competitive firm’s marginal-cost curve that lies above its average-variablecost curve constitutes the short-run supply curve for the firm.” Explain using a graph and words.
Answer
The firm will not produce if P < AVC. When P > AVC, the firm will produce in the short run at the quantity where P (= MR) is equal to its increasing MC. Therefore, the MC curve above the AVC curve is the firm’s short-run supply curve, it shows the quantity of output the firm will supply at each price level. See Figure 7.5 for a graphical illustration.
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Question 6
Explain: “The short-run rule for operating or shutting down is P > AVC, operate; P < AVC, shut down. The long-run rule for continuing in business or exiting the industry is P ≥ ATC, continue; P < ATC, exit.”
Answer
In the short run, a firm pays its fixed costs whether it operates or not. If a firm can cover its variable costs and a portion of its fixed costs (P > AVC), they lose less by operating than by shutting down. In the long run all costs are variable; if a firm cannot cover all of its costs (P < ATC), it is better off to exit the market (reducing its loss to zero).
Question 7
Using diagrams for both the industry and a representative firm, illustrate competitive long-run equilibrium. Assuming constant costs, employ these diagrams to show how (a) an increase and (b) a decrease in market demand will upset that long-run equilibrium. Trace graphically and describe verbally the adjustment processes by which long-run equilibrium is restored. Now rework your analysis for increasing- and decreasing-cost industries, and compare the three longrun supply curves.
Answer
An increase in demand in the market (industry) will lead to a shortage and thus an increase in market price. The representative firm, being a price taker, will react to this higher price (which also represents demand for the firm’s product and the firm’s marginal revenue curve) by producing more. This output decision is based on P = MR = MC.
At this higher price, the firm is earning economic profits. This will act as a signal for other firms to enter this industry there are no barriers to entry. As new firms enter, industry supply also shifts outward, placing downward pressure on market price. This process will continue until the market price is equal to the minimum average total cost of the representative firm. This represents the long-run equilibrium for the industry and firm such that neither economic profits nor losses are being realized.
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Question 8
In long-run equilibrium, P = minimum ATC = MC. What is the significance of the equality of P and minimum ATC for society? The equality of P and MC? Distinguish between productive efficiency and allocative efficiency in your answer.
Answer
The equality of P and minimum ATC means the firm is achieving productive efficiency; it is using the most efficient technology and employing the least costly combination of resources. The equality of P and MC means the firm is achieving allocative efficiency; the industry is producing the right product in the right amount based on society’s valuation of that product and other products.
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Question 9
Suppose that purely competitive firms producing cashews discover that P exceeds MC. Will their combined output of cashews be too little, too much, or just right to achieve allocative efficiency? In the long run, what will happen to the supply of cashews and the price of cashews? Use a supply-and-demand diagram to show how that response will change the combined amount of consumer surplus and producer surplus in the market for cashews.
Answer
The combined output is too little to achieve allocative efficiency. The marginal benefit of producing more cashews (as measured by P) exceeds the cost of the resources necessary to produce them.
In the long run, the supply will increase as firms enter (or expand) to capture the economic profits being earned. The increase in supply will reduce the price of cashews.
PROBLEMS
Problem 1
A purely competitive firm finds that the market price for its product is $20. It has a fixed cost of $100 and a variable cost of $10 per unit for the first 50 units and then $25 per unit for all successive units. Does price exceed average variable cost for the first 50 units? What about for the first 100 units? What is the marginal cost per unit for the first 50 units? What about for units 51 and higher? For each of the first 50 units, does MR exceed MC? What about for units 51 and higher? What output level will yield the largest possible profit for this purely competitive firm?
Answer
Consider the following example. A purely competitive firm finds that the market price for its product is $20. It has a fixed cost of $100 and a variable cost of $10 per unit for the first 50 units and then $25 per unit for all successive units.
Does price exceed average variable cost for the first 50 units? Yes, price ($20) exceeds average variable cost for the first 50 units since AVC for the first 50 units is $10 per unit [= ($10 per unit × 50 units)/50 units].
What about for the first 100 units? Yes, price ($20) exceeds average variable cost for the first 100 units since AVC for the first 100 units is $17.50 per unit [= ($10 per unit × 50 units + $25 per unit × 50 units)/100].
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The MC is $10 per unit for the first 50 units and $25 per unit for subsequent units. For each of the first 50 units, MR > MC since $20 > $10 and for units 50 and up, MR < MC since $20 < $25.
What output level will yield the largest possible profit for this purely competitive firm? The firm will produce 50 units to maximize profit because the MC of the 51st unit exceeds marginal revenue.
Problem 2
A purely competitive wheat farmer can sell any wheat he grows for $10 per bushel. His five acres of land show diminishing returns because some are better suited for wheat production than others. The first acre can produce 1000 bushels of wheat, the second acre 900, the third 800, and so on. Draw a table with multiple columns to help you answer the following questions. How many bushels will each of the farmer’s five acres produce? How much revenue will each acre generate? What are the TR and MR for each acre? If the marginal cost of planting and harvesting an acre is $7000 per acre for each of the five acres, how many acres should the farmer plant and harvest? Answer
The first step is to calculate the revenue generated by each acre (column 3). Each entry, the acre’s revenue, is found by multiplying the price per bushel by the acre’s yield. The revenue generated by the first acre is $10,000 (= $10×x 1,000); the second acre, $9,000 (= $10 × 900); the third acre, $8,000 (= $10 × 800); etc.
The next step is to calculate total revenue (column 4). Total revenue equals the sum of revenue generated by each successive acre being cultivated. Total revenue for the first acre is $10,000; total revenue for first and second acres is $19,000 (= $10,000 + $9,000); total revenue for the first, second, and third acres is $27,000 (= $10,000 + $ 9,000 + $8,000); etc.
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The final step is to calculate marginal revenue (column 5). Marginal revenue equals the change in total revenue as each successive acre is cultivated. Marginal revenue for the first unit is $10,000 because as we move from cultivating zero acres to one acre, our total revenue changes by $10,000. The marginal revenue for the second acre equals $9,000, which is the total revenue of the second acre minus the revenue generated by the first acre (= $19,000 – $10,000), etc. Using our MC = MR rule, the farmer should plant and harvest four acres. Marginal revenue for the fourth acre equals $7,000 and the marginal cost equals $7,000.
Problem 3
Karen runs a print shop that makes posters for large companies. It is a very competitive business. The market price is currently $1 per poster. She has fixed costs of $250. Her variable costs are $1000 for the first thousand posters, $800 for the second thousand, and then $750 for each additional thousand posters. What is her AFC per poster (not per thousand!) if she prints 1000 posters? 2000? 10,000? What is her ATC per poster if she prints 1000? 2000? 10,000? If the market price fell to 70 cents per poster, would there be any output level at which Karen would not shut down production immediately?
Answer
To calculate average fixed cost (AFC), divide total fixed cost by the number of posters being produced (= Total fixed cost/# of posters).
Therefore, her AFC for 1,000 posters is $0.25 (= $250/1,000); for 2,000 posters, $0.125 (= $250/2,000); and for 10,000 posters, $0.025 (= $250/10,000).
What is her ATC per poster if she prints 1,000? 2,000? 10,000?
Before we calculate the average total cost (ATC) per poster, we need to find the average variable cost (AVC) per poster using the information above. The AVC is found by dividing the total variable cost by the number of posters produced.
AVC for 1,000 posters is $1.00. This is the total variable cost of $1,000 divided by the number of posters, 1,000 (= $1,000/1,000).
AVC for 2,000 posters is $0.90. This is the total variable cost of $1,800, $1,000 for the first 1,000 and $800 for the second 1,000, divided by the total number of posters, 2,000 (= $1,800/2,000).
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AVC for 10,000 posters is $0.78. This is the total variable cost of 7,800, $1,000 for the first 1,000, $800 for the second 1,000, and $6,000 for the next 8,000 ($750 per 1,000 or 8 × $750), divided by 10,000 posters (= $7,800/10,000).
Now we can find her ATC, which equals the sum of her average fixed cost and her average variable cost (= AFC + AVC).
ATC for 1,000 posters is $1.25 (= $0.25 + $1.00). ATC for 2,000 posters is $1.025 (= $0.125 + $0.90). ATC for 10,000 posters is $0.805 (= $0.025 + $0.78).
Since the price is 70 cents per poster, Karen will shut down because average variable cost never falls below 75 cents per poster.
Problem 4
Assume that the cost data in the table below are for a purely competitive producer:
a. At a product price of $56, will this firm produce in the short run? If it is preferable to produce, what will be the profit-maximizing or loss-minimizing output? What economic profit or loss will the firm realize per unit of output?
b. Answer the questions of 4a assuming product price is $41.
c. Answer the questions of 4a assuming product price is $32.
d. In the table below, complete the short-run supply schedule for the firm (columns 1 and 2) and indicate the profit or loss incurred at each output (column 3).
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e. Now assume that there are 1500 identical firms in this competitive industry; that is, there are 1500 firms, each of which has the cost data shown in the table. Complete the industry supply schedule (column 4).
f. Suppose the market demand data for the product are as follows:
What will be the equilibrium price? What will be the equilibrium output for the industry? For each firm? What will profit or loss be per unit? Per firm? Will this industry expand or contract in the long run?
Answer
a. The rule is to produce at the level of output where marginal revenue equals (or is greater than if we are using integers) marginal cost as long as revenue is sufficient to cover fixed cost (price is greater than average fixed cost).
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In the case above, the market is competitive so marginal tevenue equals the price of $56. From the table above we see that the marginal cost for the eighth unit is $55 and the marginal cost of the ninth unit is $65. The firm will want to produce eight units where the marginal revenue of $56 is greater than the marginal cost of $55. For the ninth unit of output, this is not the case.
We also need to verify that price exceeds average variable cost at this level of production. The answer is yes; average variable cost is $40.63, which is less than the price of $56.
At this level of production, the firm will earn a positive economic profit per unit of $7.87 (= $56 (price of product) – $48.13 (average total cost for the eighth unit). The total economic profit equals $62.96 (= 8 (number of units sold) × $7.87 (profit per unit)).
b. The same process is applied here. The price of $41, which is marginal revenue, is greater than the marginal cost of the sixth unit in the table above. Beyond this level of production, marginal cost exceeds marginal revenue. Thus, the firm will produce six units as long as price covers average variable cost.
The average variable cost for six units is $37.50, which is less than the price. The firm will produce the six units of output. At this level of production, the firm will earn a negative economic profit per unit, or loss per unit, of –$6.50 (= $41 (price of product) – $47.50 (average total cost for the sixth unit). The total economic profit (loss) equals –$39.00 (= 6 (number of units sold) × (–$6.50) (loss per unit)).
c. We could go through the same exercise here. However, by recognizing that the price of $32 is below average variable cost at all levels of production, the firm will not produce. Thus, the firm shuts down and incurs the loss of $60.00 (fixed cost).
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f. Suppose the market demand data for the product are as follows:
To determine the equilibrium price, we look at the total quantity demanded schedule and the total quantity supplied schedule (for the 1,500 firms above) to find the price where quantity demanded equals quantity supplied.
This occurs at the price of $46, where quantity demanded = 10,500 and quantity supplied = 10,500. The quantity 10,500 is the equilibrium output for the industry. Note that at prices below $46 quantity demanded exceeds quantity supplied and at prices above $46 quantity supplied exceeds quantity demanded.
The equilibrium output for each firm is 7 units (= 10,500 (industry output)/1,500 (number of firms)).
Since the equilibrium price of $46 is below the average total cost for 7 units of output at the firm level, there will be a loss. The per-unit loss for the firm is –$1.14 (= $46 (price) – $47.14 (average total cost for 7 units)).
The loss per firm is –$7.98 (= 7 units produced) × (–$1.14) (loss per unit)).
This industry will contract due to the negative economic profit (or economic loss).
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