Download Perfect Competition: Maximizing Profits and Market Equilibrium and more Schemes and Mind Maps Accounting in PDF only on Docsity!
Chapter 1 7
PERFECTLY COMPETITIVE MARKETS
Principles of Economics in Context (Goodwin, et al.), 2 nd^ Edition
Chapter Summary
This chapter presents the traditional, idealized model of perfect competition. In it, you will learn how perfectly competitive firms theoretically make production decisions to maximize their profits. Perhaps the most surprising concept in the chapter is the idea that perfectly competitive firms make zero economic profit. The chapter will end with some real-world considerations that indicate even perfectly competitive markets may not always produce economically efficient outcomes.
After reading and reviewing this chapter, you should be able to:
- Describe the four different views of market power.
- List the assumptions behind the traditional model of perfectly competitive markets.
- Describe how a perfectly competitive firm maximizes its profits, based on analysis of total revenue and total cost curves.
- Describe how a perfectly competitive firm maximizes its profits, based on marginal analysis.
- Describe how the situation facing the individual firm relates to the overall market situation, in perfect competition.
- Describe why economic profits are driven to zero under perfect competition.
- Discuss why inefficiencies may persist in markets, even under conditions approaching perfect competition.
Key Term Review
market power perfect competition price taker total revenues accounting profits economic profits marginal revenue profit maximization (under perfect competition) perfectly competitive market equilibrium sunk cost path dependence network externality (in production) appendix: average variable cost (AVC)
Active Review Questions
Fill in the Blank
The ability to affect the terms and conditions of the exchanges in which you participate is referred to as ________________.
In the perfect competition model, buyers and sellers have ________________ information.
The demand curve facing a perfectly competitive firm is _______________________.
The difference between total revenues and accounting costs is known as ____________________________________.
Under conditions of perfect competition, a profit-maximizing firm will choose a level of production such that marginal cost is equal to ________________.
At competitive equilibrium, all firms make (positive/zero/negative) ________________ economic profit.
In a perfectly competitive market, the entrance of new firms into the market will drive prices (up, down) ________________.
There are (many/few) ________ real world examples of perfectly competitive markets.
The economists view generally considers market power to be (good/bad) ________________ and competition to be (good/bad) ___________________.
The term implying that “history matters” is known as ______________________.
True or False
Under conditions of perfect competition, all firms make positive economic profits.
Under perfect competition, individual economic actors have no market power.
If a perfectly competitive firm wants to sell a larger quantity of goods, it must lower its selling price.
A perfectly competitive firm maximizes its profits at the point where its total cost curve intersects its total revenue curve.
Economic profit is equal to the difference between total revenues and economic costs.
b. Sketch the marginal revenue curve for laptop computers, and explain why it looks the way it does.
- Suppose that the cost of production of laptop computers shows initially a brief span of decreasing marginal costs, followed by increasing marginal costs.
a. On the same graph as the total revenue curve you drew for Problem #1a, draw a possible total cost curve for laptop computer production. For a given quantity Q 1 (placed at any location you choose on the horizontal axis), show the corresponding profit.
b. On the same graph as the marginal revenue curve you drew for Problem #1b, draw a possible marginal cost curve for laptop computer production. Indicate the profit maximizing output level.
- A flashlight manufacturing company has the following cost structure (some columns are intentionally left blank):
Quantity
Marginal Cost ($) 0 1 12 2 8 3 10 4 13 5 17
a. Supposing that the firm is a price taker and can sell each flashlight it makes for $13, graph the Marginal Cost and Marginal Revenue curves for this flashlight manufacturer.
b. If you apply marginal analysis, what does the figure you drew in part (a) imply is the profit-maximizing output level for the firm?
c. Assume that the firm has fixed costs of $10. Calculate Total Cost, Total Revenue and Total Profit for the firm at the various production levels, using the blank columns in the table above.
d. With flashlights selling for $13, what is maximum profit the firm can make? What should it do? Explain.
Questions # 5 to # 7 refer to the following graphs:
- Suppose that at price P 1 , motorcycle manufacturers are making positive economic profits. Assuming the market in motorcycles is perfectly competitive, which of the following will occur in the long run?
a. The supply curve will shift to the right. b. The demand curve will shift to the right. c. Price will rise. d. Price will remain constant. e. Marginal costs will increase.
- Suppose now that motorcycle producers are making economic losses. Which of the following will happen in the long run?
a. Competitive pressures will drive economic profits toward zero. b. Some firms will exit the market. c. The supply curve will shift to the right. d. Both a and b are true. e. Both b and c are true.
- Suppose that competitive pressures drive the price of motorcycles downward. Which of the following statements is an accurate description of the situation that results?
a. Revenues and profits are reduced. b. Revenues fall, while profits remain constant. c. The supply curve shifts to the left. d. Marginal cost rises. e. The demand curve shifts to the right.
Quantity of motorcycles
Price of motorcycles
P 1
MC
Quantity of motorcycles
Price of motorcycles
P 1
S 1
D 1
Questions 8 – 10 refer to the following scenario.
Handy Hardware Factory produces desk lamps, according to the following cost structure. They are a price taker, and can sell any number of lamps for $8 each.
Quantity of Lamps
Marginal Cost ($)
Total Cost ($)
Marginal Revenue (= Price) ($)
Total Revenue ($)
Total Profit ($)
- What is the total cost of producing 3 lamps?
a. $ 6 b. $ 26 c. $ 50 d. $ 76 e. None of the above.
- What level of total profit will Handy Hardware make, if it produces 3 lamps?
a. less than $ 0 (that is, a loss) b. between $ 0 and $ c. between $20 and $ d. more than $ e. Cannot be determined from the information given.
- What is the profit-maximizing level of output for Handy Hardware?
a. 0 lamps b. 1 lamp c. 3 lamps d. 4 lamps e. None of the above.
Questions 14 and 15 refer to the scenario below.
Tillie’s Tack Place manufactures thumb tacks and sells them for $2.00 per box of tacks. The graph below shows marginal cost and marginal revenue for Tillie’s Tack Place.
- When Tillie’s Tack Place is producing 200 boxes of thumbtacks, which of the following statements must be true?
a. Tillie’s Tack Place is not yet making a profit. b. Producing more tacks would reduce total profits. c. Producing more tacks would increase total profits. d. Total costs exceed total revenues at this point. e. Producing one more box of tacks would mean that total accounting costs would exceed total revenues.
- When Tillie’s Tack Place is producing 200 boxes of thumbtacks, the marginal cost per box is equal to …
a. $ b. $ c. $ d. $ e. The marginal cost cannot be determined from the information given here.
- What type of cost should not affect the short-run production decisions of a perfectly competitive firm?
a. Variable costs b. Sunk costs c. Fixed costs d. Both a and b e. Both b and c
Marginal Cost and Price ($)
Boxes of Thumbtacks
Marginal Revenue
Marginal Cost
200
- In the short run, a perfectly competitive firm should keep producing as long as …
a. it is making an economic profit. b. it is making an accounting profit. c. its total revenues are greater than its fixed costs. d. its total revenues are greater than its variable costs. e. its marginal revenues are positive.
- If positive economic profits are being made in a perfectly competitive market, what two changes are likely to occur?
a. The market supply curve will shift to the left and each firms’ production quantity will fall. b. The market supply curve will shift to the right and each firms’ production quantity will rise. c. The market supply curve will shift to the left and each firms’ production quantity will rise. d. The market supply curve will shift to the right and each firms’ production quantity will fall. e. None of the above
- If negative economic profits are being made in a perfectly competitive market, what two changes are likely to occur?
a. The market supply curve will shift to the left and each firms’ production quantity will fall. b. The market supply curve will shift to the right and each firms’ production quantity will rise. c. The market supply curve will shift to the left and each firms’ production quantity will rise. d. The market supply curve will shift to the right and each firms’ production quantity will fall. e. None of the above
- Suppose that businesses tend to locate in areas that already have a high concentration of businesses. This is an example of …
a. path dependence. b. sunk costs. c. market equity. d. marginal analysis. e. perfect competition.
Answers to Problems
1.a. The total revenue curve for laptop computers is a straight upward-sloping line because in a perfectly competitive market, every laptop will sell for the same price. The slope of the line is +2000.
1.b. The marginal revenue curve is a straight line, horizontal at the market price ($2,000). Each additional laptop sold brings n the same amount.
Revenue ($)
Quantity of Computers
Total Revenue
Slope = 2000/
Revenue ($)
Quantity of Computers
$2,000 Marginal Revenue
- a.
2.b.
- a.
Total Cost Curve
Total Revenue Curve
Total Cost Curve for Laptop Computer Market
Quantity of Computers
Cost and Revenue
q 1
profit
Cost and Revenue ($)
Quantity of Computers
$2,000 Marginal Revenue
Marginal Cost
Profit maximizing level of output
0
2
4
6
8
10
12
14
16
18
0 1 2 3 4 5 6 Quantity of Flashlights
Cost and Revenue ($)
Marginal Cost
Marginal Revenue
