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Perfect Competition Study Sheet Principles of Microeconomics - Ryan

1. Short-Run Costs of Production Suppose the following table includes the partial cost numbers for a firm. Q FC VC TC MC AFC AVC 0 100 1 100 2 80 3 70 4 450 5 500 6 800 ATC

116.7

a. Based on your knowledge of the firms cost structure, fill in the missing values in the table for the firms cost curves. b. Is this a short-run or a long-run for the firm? How can you tell? c. Plot the MC, AFC, AVC and ATC curves. d. Now suppose this firm is producing and selling its product in a perfectly competitive market where the equilibrium market price is $100. On the same graph, draw a picture of the demand curve and a picture of the Marginal Revenue (MR) curve facing this firm. e. Now find the profit maximizing point of production for this firm. How much revenue is the firm making? How much is the firm spending? How much profit (or loss) is the firm making? Show the profit on the graph by shading in the profit area. f. What kind of rate of return is this firm making? g. Should this firm continue to produce in the short-run or shut down immediately? What is the short-run shut-down rule? h. Should this firm continue to produce in the long-run or shut down immediately? What is the long-run shut-down rule? i. If all firms in this market face similar costs of production, what will happen to the market for this good in the long-run as a result of this profit (loss) situation? j. What will be the long-run market price for this good and what will be the longrun rate of return for this firm?

Answer Key
1. Short-Run Costs of Production Suppose the following table includes the partial cost numbers for a firm. Q FC VC TC MC AFC AVC 0 100 0 100 ------------1 100 100 200 100 100 100 2 100 180 280 80 50 90 3 100 250 350 70 33.3 83.3 4 100 350 450 100 25 87.5 5 100 500 600 150 20 100 6 100 800 900 300 16.67 133.3

ATC ----200 140 116.7 112.5 120 150

a. Based on your knowledge of the firms cost structure, fill in the missing values in the table for the firms cost curves. b. Is this a short-run or a long-run for the firm? How can you tell? This is clearly a short-run since there are fixed costs so there must be fixed inputs. c. Plot the MC, AFC, AVC and ATC curves.

$ MC ATC AVC d=MR

112.5 100 87.5

6 quantity

MC curve hits the ATC and AVC at their lowest points.

Can you identify the shapes of the MP and AP curves from this information. (upside-down bowls with maximum at about Q=3 (L=?) for the MP and at about Q=3.5 (L=?) for AP). Can you identify where this firm benefits from specialization and teamwork and where it starts to be affected by crowding of the fixed inputs. (Teamwork and specialization and rising MP up to about Q=3; crowding and falling MP after that) d. Now suppose this firm is producing and selling its product in a perfectly competitive market where the equilibrium market price is $100. On the same graph, draw a picture of the demand curve and a picture of the Marginal Revenue (MR) curve facing this firm. Since this is a perfectly competitive industry, this firm is a price taker, which means it can only charge the market equilibrium price of $100, regardless of how much it sells, so its firm demand curve (d) is flat at d=$100. Since this firm always sells each now product at the same constant price of $100, this means its revenue must rise by $100 every time it produces and sells one more unit which means its MR=d=$100. e. Now find the profit maximizing point of production for this firm. How much revenue is the firm making? How much is the firm spending? How much profit (or loss) is the firm making? Show the profit on the graph by shading in the profit area. Firms maximize profit by producing as long as MRMC. This also means the profit maximizing point is exactly where MR=MC and this is at q=4. TR=(price)x(quantity)=$100x4=$400 (Show them this area on the graph.) TC=(ATC)x(quantity)=$112.5x4=$450 (Show them this area on the graph.) Profit = TR TC = $400 - $450 = - $50 (economic loss of $50) (Show them this area on the graph. f. What kind of rate of return is this firm making? This is a below normal rate of return. g. Should this firm continue to produce in the short-run or shut down immediately? What is the short-run shut-down rule? This firm will continue to produce in the short-run because its loss of $50 is smaller than the loss of all the fixed costs ($100) if it shut down.

4 SR shut down rule: as long as PAVC, then produce in short-run even if making a loss. h. Should this firm continue to produce in the long-run or shut down immediately? What is the long-run shut-down rule? This firm should shut-down as soon as it can get rid of its fixed inputs. In this case, it would make $0 of loss if it shuts down in the long-run versus the continuing loss of $50 if it continues to produce. LR shut down rule: as long as PATC, then produce in the long-run. i. If all firms in this market face similar costs of production, what will happen to the market for this good in the long-run as a result of this profit (loss) situation? Firms will eventually begin shutting-down, leading to a decrease in market supply and rising prices. As the equilibrium price rises, the remaining firms will see their losses get smaller and smaller. j. What will be the long-run market price for this good and what will be the longrun rate of return for this firm? In the long-run all the remaining firms will make normal rates of return. In the long-run we can expect P=min ATC, so we can expect price to equal approximately $112.50.