Firms in Competitive Markets – Solved Question Paper

Review Questions 6
316-660 Managerial Economics
Microeconomics
TOPIC 6
FIRMS IN COMPETITIVE MARKETS
1. (Krugman and Wells, p.228) The Big DVD Co. produces movies for sale, which
requires a building, a machine that copies the original movie onto a DVD, and labour.
The market in which the Big DVD Co. operates is perfectly competitive. The Big
DVD Co. rents a building for $30,000 a month and rents a machine for $20,000 a
month. Its variable costs are:
Qty of DVDs
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
Variable cost
0
$5000
$8000
$9000
$14000
$20000
$33000
$49000
$72000
$99000
$150000
a) Calculate the SRATC and SRMC for each quantity of output.
b) Suppose the price of a DVD is $7. What is the profit maximizing decision for Big
DVD Co.? What will short-run total profit be?
c) Now suppose the price of a DVD is $20. What is the profit maximizing decision
for Big DVD Co.? What will short-un total profit be?
2. Each of the following situations could exist for a firm in a perfectly competitive
market in the short-run. In each case, indicate whether:
i) The firm should produce in the short-run;
ii) The firm should shut down in the short-run;
iii) Additional information is needed to determine whether to produce in the short-run.
a) Total cost exceeds total revenue at all output levels;
b) Total variable cost exceeds total revenue at all output levels;
c) Marginal revenue exceeds marginal cost at the current output level;
d) Total revenue exceeds total fixed cost at all output levels; and
e) Price exceeds average total cost at all output levels.
3. Barry’s Battery Co. produces car batteries. The market for batteries is perfectly
competitive. Information on MC for Barry’s firm is as follows:
Qty
MC
1
1
2
2
3
3
4
4
5
12
6
24
a) Suppose the market price is 15. What is the profit-maximising quantity the firm
will produce?
b) Suppose the market price is 15 and the firm has a fixed cost of 30. Should the firm
operate in the short-run?
c) In long-run equilibrium what must be the equilibrium market price? If Barry’s firm
remains in the market, what quantity will his firm produce?
Market demand for car batteries:
Price
7
Qty
160
demanded
8
140
9
120
10
100
11
80
12
60
d) Suppose all firms in the car battery market are identical to Barry’s firm. In longrun equilibrium what number of firms will operate on the battery production market?
Suppose that market demand changes to:
Price
7
Qty
250
demanded
8
225
9
200
10
175
11
150
12
125
e) In the short-run what will be the effect on: i) Price; ii) Market quantity traded; iii)
Number of firms; and iv) Quantity of output produced by each firm.
f) In the long-run what would you expect to happen to the number of firms in the
market?
4. The market for roses in Melbourne can be characterised as a perfectly competitive
market. Regent Roses is a grower that competes in this market along with many other
rose growers. Regent has a U-shaped long run average cost curve and upwardssloping marginal cost curve. Regent measures price in dollars per bunch of roses and
quantity as the number of bunches of roses sold per day.
a) What is meant by market power and why do firms in perfectly competitive
markets have no market power?
b) Explain and illustrate, using a diagram, a short- run situation in which Regent is
making positive economic profits. How is the profit maximising quantity and
price determined? What are economic profits? Ensure that your diagram clearly
indicates the price Regent charges per bunch of roses, the number of bunches of
roses sold as well as the profit the firm makes.
c) Describe the nature of long run equilibrium profits and the mechanism by which
this equilibrium is reached. Illustrate the long run situation on a new diagram.
Review Questions 6
316-660 Managerial Economics
Microeconomics
SOLUTIONS TO REVIEW QUESTIONS
TOPIC 6:
FIRMS IN COMPETITIVE MARKETS
1. a)
Qty
VC ($)
FC ($)
SRTC
($)
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
0
5000
8000
9000
14000
20000
33000
49000
72000
99000
150000
50000
50000
50000
50000
50000
50000
50000
50000
50000
50000
50000
50000
55000
58000
59000
64000
70000
83000
99000
122000
149000
200000
SRMC
AVC per SRATC
per DVD DVD ($) per DVD
($)
($)
5
3
1
5
6
13
16
23
27
51
5
4
3
3.5
4
5.5
7
9
11
15
55
29
19.66
16
14
13.83
14.14
15.25
16.55
20
b) If the price of a DVD is $7 then:
Profit maximizing quantity of DVDs is 5000. This assumes the firm can only choose
multiples of a thousand. Increasing output to 6000 would have a SRMC of $13 per
DVD which is greater than MR of $7 per DVD. Profits are equal to 5000($7-$14) =
– $35000. (The firm makes negative profits, but does cover its variable costs – equal
to $20,000.)
c) If the price of a DVD is $20 then:
Profit maximizing quantity of DVDs is 7000. This assumes the firm can only choose
multiples of a thousand. Increasing output to 8000 would have a SRMC of $23 per
DVD which is greater than MR of $20 per DVD. Profits are equal to 7000($20$14.14) = $41020.
2. a) Need more information. The firm may still decide to produce in the short-run if
total revenue is greater than total variable cost for some levels of output.
b) Shut down. The firm cannot cover its short-run opportunity cost of production.
c) Need more information. Marginal revenue being above marginal cost at a specific
level of output could be consistent with situations where average variable cost is
above price (marginal revenue) at all output levels (in which case the firm would
choose to shut down). [See for example, Figure 13.6 on p.271 of the GKM textbook
and suppose p = $0.50.] But it could also be consistent with situations where the firm
would choose to produce in the short-run. [See for example, Figure 13.5 on p.269 of
the GKM textbook and suppose p = $1.00.]
d) Need more information. Total fixed cost is not relevant to the short-run production
decision. What matters are total revenue and total variable cost.
e) Produce. The firm makes positive economic profits.
3 a) The firm will maximize profits by producing 5 units. For the first 5 units MR >
MC (where P = 15). But for any subsequent units MR MC for each of the first 4 units; but MR ATC.
Profit is equal to ABCD.
100
120
Bunches of roses
per day
The above diagram shows how a competitive firm makes its short run profit
maximising decision. It faces a horizontal demand curve, as the firm takes the market
price of $3 per bunch of roses as given. The profit maximising output for Regent is
100 bunches of roses a day. This is where MR (P) = SMC and the difference between
total revenue and total costs is at its maximum. At this quantity, average total cost is
$2.50, so Regent is making a positive economic profit of $0.50 per bunch of roses or a
total economic profit of $50 per day, given by the rectangle ABCD. Economic profit
is the difference between a firm’s total revenue and the opportunity costs of
production. The opportunity costs of production includes not only explicit accounting
costs, but the next best alternative or lost investment opportunities to which a firm
could devote its scarce resources.
c)
Long-Run Competitive Equilibrium
Profit attracts firms  Supply increases until profit = 0
$ per
Bunch of
roses
$ per
Bunch of
roses
Firm
Industry
S1
LMC
$3
LAC
$2
$3
S2
$2
D
q2
Bunches of roses
Q1
Q2
Bunches of roses
For equilibrium to arise in the long run, certain economic conditions must prevail.
Firms must have no desire to withdraw at the same time that no firms outside the
market wish to enter. The incentive to enter and exit an industry relates to the
existence or absence of economic profits. When economic profit becomes zero in the
long run, there is no incentive for firms to enter or exit the industry. Zero economic
profit signifies not that firms are performing poorly, but rather that the industry is
earning a competitive rate of return on its investments.
In the long run, as Regent is earning a positive economic profit, other firms have an
incentive to enter the industry. Eventually the increased production associated with
new entry causes the supply curve to shift to the right (from S1 to S2). As a result, a
new equilibrium will be reached where market output increases from Q1 to Q2 and the
market price falls from $3 to $2. This will lower industry profits. For Regent a new
profit maximizing output will be achieved where LMC = LAC = MR (P). This
indicates that Regent and the other firms in the industry can only earn zero economic
profits in the long run.
In summary, a long run competitive equilibrium occurs when three conditions hold:
1. All firms in the industry are maximizing economic profits
2. No firm has an incentive to either enter or exit the industry because all firms are
earning zero economic profit.
3. The price of the product is such that the quantity supplied by the industry is equal
to the quantity demanded by consumers.
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