Solutions for Topic 8 - Perfect Competition

 Question 8.1

Suppose a perfectly competitive firm collects total revenues of $1000 when it produces 200 units; the marginal costs of producing 200 units is $5.  The firm should

            A)         expand production because price is greater than marginal costs.

            B)         contract production because price is greater than marginal costs.

            C)         expand production because price is less than marginal costs.

            D)         contract production because price is less than marginal costs.

            E)         leave production unchanged because price equals marginal costs.

The correct answer is (E)

For perfect competition, the optimal output occurs where MR (= P) = MC.

Total revenue of 200 units of output is $1000 means the price of product is $1000/200 = $5.

Since marginal cost of 200 unit is $5, the condition MR (= P) = MC is fulfilled.

Question 8.2

In the short run, if a firm chooses to operate and produce output, it must be the case that

      A)         it earns a profit.

      B)         total revenues are greater than or equal to the total cost of fixed and variable factors of production.

      C)         total revenues are greater than or equal to the cost of fixed factors of production.

      D)         total revenues are greater than or equal to the cost of variable factors of production.

      E)         it avoids a loss.

The correct answer is (D).

In the short run, a perfectly competitive may earn a profit, break even or incur a loss.

If it incurs a loss, it will stay in the industry TR > TVC or P > AVC

If TR < TVC or P < AVC, it will shut down in the short run.

In the long run, the firm will only remains if it can at least break even.  That is, TR = TC or P = ATC

Question 8.3

If all firms in a perfectly competitive industry are experiencing economic losses, then 

      A)         some firms will enter the industry, seeking new opportunities.

      B)         all firms will increase their prices, until economic profits occurs.

      C)         all firms will continue in the industry, hoping for better times.

      D)         some firms will exit the industry, until no economic losses occur for remaining firms.

      E)         all firms will exit the industry, until economic profits are positive.

The correct answer is (D).

If all firms are making losses, then in the long run some firms which cannot withstand the loss will exit the industry.

Industry supply decreases, price increases, losses of existing firms become smaller until all existing firms earn normal profit (zero economic profit).

Question 8.4

(1) A profit maximizing perfectly competitive firm must decide on both price and quantity of output.  Do you agree?  Explain.

(2) In the long run a perfectly competitive firm can only earns normal profit.  Do you agree?  Explain.

Solution 8.4

(1) The statement is not valid.  Firms have no control over the price in perfect competition.  They only decides on the output and the optimal output is P = MR = MC.

(2) The statement is valid.  There is free entry and exit of firms under perfect competition.  If firms are making profits then new firms will enter until no more profit to be made.  If firms are incurring losses then existing firms will exit the industry until all remaining firms incur no losses.

Question 8.5

If a single firm, belonging to a perfectly competitive industry in long run equilibrium, discovers a significant cost saving methodology, then what will happen to this firm in the short run and in the long run?

Solution:

In the short run, this firm will make positive economic profit since the cost is lower.

But in the long run, new firms will enter the industry with the same cost savings technique (due to perfect information).  With supply increases, price will drop until this firm can only earn normal profit.