533578082
Foundations of Economic Analysis
Homework #5
Stratton
Name _________________________
Objective: to provide practice and assessment of your understanding of perfect competition. Your
ability to demonstrate understanding, insight and/or the ability to use the material is the primary
purpose of the assessment. Thus full credit will only be earned if you follow the directions
carefully and provide the explanation, description, and thought process as directed. (Hint: you
may want to work out your answers on another sheet of paper and transfer your work to this one
to avoid submitting a messy worksheet.) {See HW05_PC for graphs}
Instructions: For each term, write a short definition in your own words of the term in the space
provided or attach additional sheets if necessary. Each numbered question is worth 2 points –
total 50 points.
Definitions:
1.
Industry concentration – measures the output distribution of firms in an industry.
Concentration implies that fewer firms control a large percentage of the total market
(industry) output.
2.
Perfect competition – a market model in which many firms produce and sell
undifferentiated output; there are no (few) barriers to entry; buyers and sellers have full
information; thus firms have little or no control over the price at which they sell their
output. (price takers).
3.
Price-cost margin – the price-cost margin is one measure of the extent of concentration
(market power). It is calculated as (P – MC)/P. In perfect competition, since profit
maximization occurs at P = MC, the price-cost margin is zero for perfect competition.
4.
Total revenue in perfectly competitive markets – TR = P * Q; in all market structures.
5.
Marginal revenue in perfectly competitive markets – MR = change in TR caused by
selling one more unit of output. In perfect competition the firm’s demand curve is
horizontal (they can sell as much output as they desire at the market price). Thus MR = P.
6.
Average revenue in perfectly competitive markets – AR = TR/Q = (P * Q)/Q = P; in all
market structures.
7.
Profit maximizing rule – To maximize profits the firm should produce each unit of output
for which the additional cost of producing the unit is less than the addition revenue
generated by its sale. Thus the rule is often stated as: produce at MC = MR. For perfect
competition the rule is: MC = P.
8.
Price taker – a term indicating that firms in the market have no (little) control over the
price at which they can sell their output. Characteristic of perfect competition.
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9.
Foundations of Economic Analysis
Stratton
Price searcher – a term indicating that firms can control (at least to some extent) the price
at which they can sell their output.
10. Economic Profit – the difference between total revenue and total cost; where total cost
includes both explicit and implicit costs. In perfect competition profits tend toward zero
in the long run.
Instructions: Answer the questions in the space provided or attach additional sheets if necessary
Problems
Scenario 1:
Below are a hypothetical market demand function for a perfectly competitive
market and the cost functions for a representative (typical) firm in the market. Use this
information to describe the current short run situation in the market. Be sure to show all of your
work to receive credit.
Price
Market
Supply
Market
Demand
Firm
Output
Firm MC
Firm
ATC
Firm
AVC
$25
$26
$27
$28
$29
$30
$31
$32
$33
$34
$35
10,000
25,000
39,000
52,000
64,000
75,000
85,000
94,000
102,000
109,000
115,000
110,000
100,000
90,000
85,000
80,000
75,000
70,000
65,000
60,000
55,000
50,000
10
25
39
52
64
75
85
94
102
109
115
$15
$16
$18
$21
$25
$30
$36
$43
$51
$60
$71
$45
$28
$24
$23
$24
$25
$26
$28
$29
$31
$33
$25
$20
$19
$20
$21
$22
$24
$25
$27
$30
$32
Market
Firm Costs
$40
$35
$35
$30
$30
AR
Price
Price
$40
$25
$25
$20
$20
$15
$15
0
20,000
40,000
60,000
80,000
100,000
120,000
0
20
40
60
Quantity
Market Supply
80
100
120
140
Quantity
Market Demand
MC
ATC
AVC
11. What is the market equilibrium price and quantity? Explain. - At a price of $30, the
quantity demand and the quantity supplied are equal at 75,000. Thus the equilibrium
price is $30 and the equilibrium quantity is 75,000.
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12. What is the average revenue function for firms in this market? Explain. – AR = price. So
the AR function is a horizontal line at $30. See graph above.
13. Calculate the total revenue function for this firm. Explain. – TR = P*Q. Thus the TR
function equals $30 q. It is a straight line from the origin, with a slope of 30.
14. Calculate the total cost function for this firm. Explain. – Total cost is ATC times output.
TC = ATC*Q. It relates the level of total cost at each level of output.
Output
10
25
39
52
64
75
85
94
102
109
115
ATC
$45
$28
$24
$23
$24
$25
$26
$28
$29
$31
$33
TC
$450
$690
$942
$1,215
$1,515
$1,845
$2,205
$2,592
$3,000
$3,420
$3,846
TC
$450
$700
$936
$1,196
$1,536
$1,875
$2,210
$2,632
$2,958
$3,379
$3,795
First TC calculated without rounding, second column with data in table (which was rounded).
15. What is the profit maximizing output level for this firm? Explain. – Profit max occurs at
the output level at which MR = MC; in this case MR = $30. This occurs at 75 units of
output.
16. Calculate the profit (or loss) for this firm. Explain. – Profit = TR – TC = (AR – ATC) *
Q. At 75 unit of output this is: ($30 - $25) * 75 = $5 * 75 = $375.
17. Estimate the number of firms in this market. Explain. – If this is a representative firm and
it produces 75 units, then there must be about 1000 firms to produce the 75,000 units of
output.
18. Estimate the price/cost margin for this firm. Explain. – The price/cost margin = (P-
MC)/P. In this case: ($30 – $30)/$30 = 0/30 = 0.
Alternatively one might use the Census proxy, which tries to approximate the Lerner
Index. In that formulation (also known as operating profit rate of return) we approximate
MC with AVC: (P-AVC)/P = (P-AVC)*Q / P*Q = (TR – TVC) / TR. In this case (as a
percentage): (30 – 22) / 30 = 8/30 = 26.67%.
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If one approximates MC with ATC the formula becomes (TR – TC) / TR or profit/TR:
PMC (as a percent) = 375 / 2250 * 100 or 16.67%
http://www.cpbis.org/research/findings/Industry%20Consolidation%20and%20PriceCost%20Margins.pdf
19. Below what market price would this firm choose to shut down (in the short run)? Explain.
– The short run shut down price is one below minimum AVC. For this firm that is $19.
Scenario 2:
Below are a hypothetical market demand function for a perfectly competitive
market and the cost functions for a representative firm in the market. Use this information to
describe the current long run situation in the market.
Price
Market
Supply
Market
Demand
Firm
Output
Firm MC
Firm
ATC
Firm
AVC
$25
$26
$27
$28
$29
$30
$31
$32
$33
$34
$35
10,000
25,000
39,000
52,000
64,000
75,000
85,000
94,000
102,000
109,000
115,000
110,000
100,000
90,000
85,000
80,000
75,000
70,000
65,000
60,000
55,000
50,000
10
25
39
52
64
75
85
94
102
109
115
$15
$16
$18
$21
$25
$30
$36
$43
$51
$60
$71
$45
$28
$24
$23
$24
$25
$26
$28
$29
$31
$33
$25
$20
$19
$20
$21
$22
$24
$25
$27
$30
$32
20. Is this market in long run equilibrium? Explain how you came to this conclusion. – This
market is NOT in long run equilibrium. LR equilibrium for perfect competition requires
that firms make zero economic profit. This firm is making an economic profit. Since it is
representative of the industry, other firms are also making a profit.
21. Would you expect firms to enter or leave the market? Explain why. – Since firms in this
industry are making economic profits, these profits will entice firms to enter the industry.
The profits indicate that resources will earn more here than in alternative uses.
22. Would you expect the short run industry supply curve to shift? If yes, explain in what
direction and why. If no, explain why not. – The SR industry supply will shift to the right
(increase) as new firms enter the industry.
23. Estimate the long run equilibrium price in this market. Explain. [Assume the demand is
constant and that this is a constant cost industry.] – The LR equilibrium price is at
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minimum ATC for representative firms in the industry. Since this is a constant cost
industry, as more firms enter the industry, costs curves will NOT shift. Thus, I expect the
LR equilibrium price is at SR minimum ATC for this firm. Minimum ATC is $23.
24. Calculate the economic profit for this firm at the long run equilibrium market price.
Explain. – Profit = TR – TC = (AR – ATC) * Q. At a price of $23 and ATC = $23, (23 –
23) * 52 = 0. Or simply, firms in perfectly competitive firms make zero economic profit
in the LR.
25. Explain how your answer in #4 would differ if this were an increasing cost industry. – If
this were an increasing cost industry, as new firms entered the market, input prices would
increase, increasing costs. Thus the LR equilibrium price would be higher than the
current minimum ATC of $23 for representative firms in the industry.
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