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Market Structure Notes & Questions

What assumptions in the perfect competition model ensure that economic profit is zero in the long run? Explain why a firm maximizes its profits by producing the level of output at which marginal revenue equals marginal costs. Explain why a firm should continue to operate in the short run so long as market price is greater the firm's average variable cost at the profit-maximizing level of output.

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130 views3 pages

Market Structure Notes & Questions

What assumptions in the perfect competition model ensure that economic profit is zero in the long run? Explain why a firm maximizes its profits by producing the level of output at which marginal revenue equals marginal costs. Explain why a firm should continue to operate in the short run so long as market price is greater the firm's average variable cost at the profit-maximizing level of output.

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CHAPTER 7: MARKET STRUCTURE

The assumptions of perfect competition are:


1. a large number of firms in the market;
2. an undifferentiated product;
3. ease of entry into the market or no barriers to entry; and
4. complete information available to all market participants

Profit Maximization Level of Output//Optimal Level of Production:


Ch7. Question 1

1. Assume a firm is currently producing 800 units of output, P = $10, MC = $10, ATC = $8, and AVC =
$6

In this case, the firm is maximizing its profit, which equals $1,600.

2. Assume a firm is facing the following situation: At Q = 1,000, P = $10, MC = $10, ATC = $18, and
AVC = $16

This firm should shut down and, in doing so, limit its losses to $2,000 [1000 U x $2 (18-16)]

3. Summarize the characteristics of a perfectly competitive market.

A perfectly competitive firm produces a product that is identical to that of its competitors, the number of
competitors is large and each individual producer is small relative to the market, there is ease of entry into the
market, and market participants have perfect information. Perfectly competitive firms are price takers.

Ch7. Question 2

4. What assumptions in the perfect competition model ensure that economic profit is zero in the long
run? Explain.

The assumptions that:


1) market participants have perfect (complete) information and,
2) there are no barriers to entry ensure that long-run profits will equal zero in a perfectly competitive market. So
long as economic profits (losses) exist, firms will enter (leave) the market. Only when long-run profit equals zero
will there be no more incentive for entry or exit. The assumption of perfect information ensures that each firm has
access to the least-cost method of production. As such, one firm cannot have a cost advantage over other firms in the
market.

Ch7. Question 3

5. Explain why a firm maximizes its profits by producing the level of output at which marginal revenue
equals marginal costs.

Profit is equal to the difference between total revenue and total cost. Marginal revenue is the addition to total
revenue when an additional unit of output is produced and sold. Marginal cost is the addition to total cost when an
additional unit of output is produced. So long as MR > MC, more is added to total revenue than is added to total
cost. As such, the difference between total revenue and total cost, i.e., profit, increases. When MR < MC, more is
added to total cost than is added to total revenue. In this case, the difference between total revenue and total cost,
i.e., profit, decreases.

Ch7. Question 4

6. Explain why a firm should continue to operate in the short run so long as market price is greater the
firm's average variable cost at the profit-maximizing level of output.

So long as market price is greater than average variable cost at the profit-maximizing level of output, the firm's total
revenues will be greater than its total variable costs. Thus, the firm will be able to pay all of its variable costs and
have some amount of money left over to pay part of its fixed costs. If the firm decided to shut down it would have to
pay all of its fixed costs out of pocket. This amount is clearly greater than the loss it incurs if it continues to operate.

Ch7. Question 5

7. Assume a perfectly competitive firm is currently producing 5,000 units of output and is earning
$15,000 in total revenue. The marginal cost of the 5,000th unit of output is $3. The corresponding
average total cost is $3.50 and total fixed costs equal $1250. Based on this information, should this
firm continue to operate in the short run? Why or why not?
No, the firm should not continue to operate and should instead shut down. Based on the information in the question,
market price (and marginal revenue) equals $3 ($15,000/5,000) per unit. In addition, average fixed cost equals $0.25
($1250/5000). As such the firm's average variable cost, which is equal to the difference between average total cost
and average fixed cost, equals $3.25. Because price is less than AVC at the profit-maximizing (in this case loss-
minimizing) level of output, the firm will minimize its losses by shutting down.

Ch7. Question 6

In a perfectly competitive industry, the market price is $25. A firm is currently producing 10,000 units of
output, its average total cost is $28, its marginal cost is $20, and its average variable cost is $20. Given these
facts, explain whether the following statements are true or false, give reason: [Hint: You should assume
normal U-shaped cost curves for this problem.]

a. The firm is currently producing at the minimum average variable cost.

It is true that the firm is currently producing at the minimum average variable cost. Marginal cost equals average
variable cost of $20. Given U-shaped cost curves, the equality of marginal and average variable costs occurs at
the minimum point of the average variable cost curve.

b. The firm should produce more output to maximize its profit.

The firm should produce more output to maximize its profit. At the current level of output, the price of $25 is
greater than the marginal cost of $20. Because price equals marginal revenue, the firm should increase output
until marginal revenue equals marginal cost.

c. Average total cost will be less than $28 at the level of output that maximizes the firm’s profit.

At the profit-maximizing level of output, average total cost will be less than the current value of $28 because
MC < ATC at the current output, so ATC must be decreasing. Profit maximization occurs at the level of output
where P = MR = MC = $25.

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