Firms in Competitive Markets
REVIEW QUESTIONS
Describe the difference between average revenue and marginal revenue. Why are both of these revenue measures important to a profit maximizing firm? ANSWER: Average revenue is total revenue divided by the amount of output. Marginal revenue is the change in total revenue from the sale of each additional unit of output. Marginal revenue is used to determine the profit maximizing level of production and average revenue is used to help determine the level of profits.
Explain what it means if a firm in a competitive market is labeled as a price taker. ANSWER: A price taker is a firm whose production decisions have no influence on market price.
List and describe the characteristics of a perfectly competitive market. ANSWER: There are many buyers and sellers in the market. The goods offered by the various sellers are largely the same. Firms can freely enter or exit the market.
Use a graph to demonstrate the circumstances that would prevail in a competitive market where firms are earning economic profits. Can this scenario be maintained in the long run? Carefully explain your answer. ANSWER: In a competitive market where firms are earning economic profits, new firms will have an incentive to enter the market. This entry will expand the number of firms, increase the quantity of the good supplied, and drive down prices and profit.
Explain the role of opportunity costs in differentiating between economic profits and accounting profits. ANSWER: Accounting profits do not account for the opportunity cost of doing business. Economic profits take into account the opportunity cost of production (or conducting business).
Explain how a firm in a competitive market identifies the profit maximizing level of production. When should the firm raise production, and when should the firm lower production? ANSWER: By selecting the level of output at which marginal revenue is equal to marginal cost. If MR > MC, profit will increase if the firm increases Q. If MR < MC, profit will increase if the firm decreases Q.
Explain the relationship between a firm's supply curve and its costs. ANSWER: The marginal cost curve above the minimum of average variable cost is the supply curve for a firm in a competitive market.
Give two reasons why the long-run industry supply curve may slope upward. Use an example to demonstrate your reasons. ANSWER: Some resource used in production may be available only in limited quantities and firms may have different cost structures. The example provided in the text for the first reason is the market for farm products. As more people become farmers, the price of land is bid up since its supply is limited. As the price of farm land is bid up, the cost of all farmers in the market rises. The example used to support the second reason is the market for painters. Anyone can enter the market for painting services, but not everyone has the same costs because some painters work faster than others.
There are 500 profit maximizing firms in a competitiv e market. When market price is $5 per unit each firm produces exactly 10 units of output. What is the total quantity supplied to the market and the marginal revenue per unit? ANSWER: 5,000, $
Why would a firm in a perfectly competitive market always choose to set its price equal to the current market price? If a firm set its price below the current market price, what effect would this have on the market? ANSWER: It could not sell any more of its product at the lower price than it could sell at the higher price. As a result, it would needlessly forgo revenue if it set a price below the going price.
Use a graph to demonstrate the circumstances that would prevail in a perfectly competitive market where firms are experiencing economic losses. Identify costs, revenue, and the economic losses on your graph. Using your graph, determine whether this firm will shut down in the short run, or choose to remain in the market. Explain your answer. ANSWER:
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ANSWER:
a. (See figure above, panel a.) Demand will increase, the quantity exchanged in the market will increase from Q 0 to Q 1 and market price will rise from P 0 to P 1. b. (See figure above, panel b.) The market price will rise from P 0 to P 1 and individual firm output will rise from Q 0 to Q 1. c. (See figure above, panel c.) If the price of red grapes rises as producers increase production of wine, then average total cost will increase (from ATC 0 to ATC 1 ) as output is increased. This will lead to upward sloping industry supply as reflected in the market figure of panel c.
If identical firms that remain in a competitive market over the long run make zero economic profit, why do these firms choose to remain in the market? ANSWER: Because a normal rate of return on their investment is included as part of the opportunity cost of production.