BASIC ECONOMICS

TUTORIAL 5
Firms in Competitive Markets

THE TUTORIAL
This week’s tutorial looks at Firms in Competitive Markets. Please prepare these
problems prior to attending tutorials.
 Quick Quiz (Text book)
- Chapter 14
 Problems and Applications (Text book)
- Chapter 14 (6, 7, 11)
 True/False
 Multiple choice

READING GUIDE
Review Chapter 14 of Principles of Economics (9th edition) – N. Gregory Mankiw as
preparation for this tutorial. You should also look overcarefully your lectures notes for
Week 5.

CHAPTER 14 - SUMMARY

PERFECTLY COMPETITIVE MARKET

1

- Features of Prefect Competition

+ There are many buyers and sellers in the market
+ The goods offered by the various sellers are largely the same
+ Firms can freely enter or exit the market
- In perfect competition both buyers and sellers are price takers (A price taker is a firm or
individual who takes the market price as given. That means he cannot influence or
change the price)

Market equilibrium & Firm’s demand curve

2

- A perfectly competitive firm can sell any amount at that price. The demand curve facing
the perfectly competitive firm is horizontal at the market price – perfectly elastic
- The market demand curve is downward sloping

Total, average, marginal revenue – Competitive Firm

3
 Features of Cost curves
4

 The marginal cost curve is upward

sloping
 The average total cost surve is U-shaped
 The marginal cost curve crosses the
average total cost curve at the minimum
of average total cost
The firm’s MC curve above ATC =
firm’s supply curve
  For any given price, each firm supplies a quantity of output so that its marginal
cost equals price
 The market supply curve reflects the individual firms’ marginal cost curves

Profit Maximization
5

 The goal of a competitive firm is to

maximize profit

 This means that the firm will want to

produce the quantity that maximizes the
difference between total revenue and
total cost

 Profit Maximization occurs at the

quantity where marginal revenue equals
marginal cost

• When MR > MC the firm should

increase Q to increase profit

• When MR < MC the firm should decrease Q to increase profit

• When MR = MC profit is maximized

 The Firm’s Short-Run Decision
6

The three possible outcomes:

• Economic profit
• Break even
• Economic loss

Break – even point

Economic loss (AVC<P<ATC)

 Loss if shut down

 The shutdown point is the

point at which the firm's
maximized profit is the same
regardless of whether the firm
produces or temporarily shuts
down
 The shutdown point is the
point of minimum average
variable cost
 If price equals minimum
AVC, the profit is the same from producing as from shutting down temporarily
and paying the fixed costs
 Either way, the firm incurs a loss equal to total fixed cost
 If the firm produced with AVC greater than price, its loss would exceed total fixed
cost

Perfect Competition in Long run

7

 In the long run, the number of firms can change due to entry & exit
 If existing firms earn positive economic profit,
  new firms enter, SR market supply shifts right
 P falls, reducing profits and slowing entry
 If existing firms incur losses,
 some firms exit, SR market supply shifts left
 P rises, reducing remaining firms’losses
 Long-run equilibrium: The process of entry or exit is complete remaining firms
earn zero economic profit
 Zero economic profit occurs when P = ATC
 Since firms produce where P = MR = MC
 The zero-profit condition is P = MC = ATC
 Recall that MC intersects ATC at minimum ATC
 Hence, in the long run, P = minimum ATC

Market efficiency
8
 TRUE/FALSE

TRU FALS
E E
1. For a firm operating in a perfectly competitive industry, marginal x
revenue and average revenue are equal

P = AR=MR
2. Because there are many buyers and sellers in a perfectly x
 competitive market, no one seller can influence the market price
in a perfectly competitive market, both buyers and sellers are price
takers => can not influence the market price
3. When an individual firm in a competitive market increases its x
production, it is likely that the market price will fall
4. Firms in a competitive market are said to be price takers because x
there are many sellers in the market and the goods offered by the
firms are very similar if not identical

5. Firms operating in perfectly competitive markets produce an output x

level where marginal revenue equals marginal cost
Profit*: MR = MC
P=MR=AR => P = MC
6. A firm is currently producing 100 units of output per day. The x
manager reports to the owner that producing the 100th unit costs the
firm $5. The firm can sell the 100th unit for $4.75. The firm
should continue to produce 100 units in order to maximize its
profits (or minimize its losses)
Profit*: MR = MC
MR > MC : increases quantity
MR < MC: decreases quantity
MC = $5
MR = $4.75
MC > MR => The firm shouldn’t continue to produce
7. All firms maximize profits by producing an output level where x
marginal revenue equals marginal cost; for firms operating in
perfectly competitive industries, maximizing profits also means
producing an output level where price equals marginal cost
Profit*: MR = MC
P=MR=AR => P = MC
8. A firm operating in a perfectly competitive industry will continue to x
operate in the short run but earn losses if the market price is less
than that firm’s average total cost but greater than the firm’s
 average variable cost
P < ATCmin: earn losses
AVCmin < P < ATCmin: firm continue to produce
9. A firm operating in a perfectly competitive industry will shut down x
in the short run but earn losses if the market price is less than that
firm’s average variable cost
P = AVCmin: shut down point
P < AVCmin: shut down
10. In making a short-run profit-maximizing production decision, the x
firm must consider both fixed and variable cost
profit-maximizing production decision: P = MC

11. A firm will shut down in the short run if revenue is not sufficient to x
cover its variable costs of production
TR = Q * P
VC = AVC*Q
TR < VC
P*Q < AVC*Q
P < AVC => shut down
12. The supply curve of a firm in a competitive market is the average x
variable cost curve above the minimum of marginal cost
(S) P= MC
P > AVCmin
13. In the long run, when price is less than average total cost for all x
possible levels of production, a firm in a competitive market will
choose to exit (or not enter) the market
In the long run, when price is less than average total cost
 profit < 0 some firms exit the market
14. In the long run, when price is greater than average total cost, some
firms in a competitive market will choose to enter the market
In the long run, when price is greater than average total cost
 profit > 0 encourage some firms to enter the market
15. A firm operating in a perfectly competitive market may earn x
 positive, negative, or zero economic profit in the long run
16. The long-run supply curve in a competitive market is more elastic x
than the short-run supply curve

MULTIPLE CHOICE

1. A firm has market power if it can

Ⓐ maximize profits Ⓒ influence the market price of the
good it sells
.........
Ⓑ minimize costs Ⓓ hire as many workers as it needs
at the prevailing wage rate

2. For any competitive market, the supply curve is closely related to the
Ⓐ preferences of consumers who Ⓒ firms’ costs of production in that
purchase products in that market market
(S) P = MC .........
P > AVCmin
Ⓑ income tax rates of consumers in that Ⓓ interest rates on government
market bonds
3. In a competitive market, the actions of any single buyer or seller will
Ⓐ have a negligible impact on the Ⓒ affect marginal revenue and
market price average revenue but not price
Ⓑ have little effect on market Ⓓ adversely affect the profitability .........
equilibrium quantity but will affect of more than one firm in the
market equilibrium price market

4. Which of the following is not a characteristic of a perfectly competitive market?

Ⓐ Firms are price takers Ⓒ There are many sellers in the
market
.........
Ⓑ Firms have difficulty entering the Ⓓ Goods offered for sale are largely
market the same
5. Which of the following industries is most likely to exhibit the characteristic of free
entry ?
Ⓐ nuclear power Ⓒ dairy farming .........
Ⓑ municipal water and sewer Ⓓ airport security
6. When buyers in a competitive market take the selling price as given, they are said
to be
Ⓐ market entrants Ⓒ free riders .........
Ⓑ monopolists Ⓓ price takers

7. Suppose a firm in a competitive market reduces its output by 20 percent. As a

result, the price of its output is likely to
Ⓐ increase Ⓒ decrease by less than 20 percent .........
Ⓑ remain unchanged Ⓓ decrease by more than 20 percent

8. Firms operating in competitive markets produce output levels where marginal

revenue equals
Ⓐ price Ⓒ total revenue divided by output
Ⓑ average revenue Ⓓ All of the above are correct .........
MR = MC
P = AR = MR=> P = AR => MR = AR
P = MC
TR = P*Q => TR/Q=P
9. Suppose that a firm operating in perfectly competitive market sells 100 units of
output. Its total revenues from the sale are $500. Which of the following
statements is correct ?
i) Marginal revenue equals $5
ii) Average revenue equals $5
iii) Price equals $5
Ⓐ i) only Ⓒ i) and ii) only .........
Ⓑ iii) only Ⓓ i), ii), and iii)
P = AR = MR
Q = 100
TR = $500 => P = TR/Q = 500/100=$5
P = AR = MR = $5
10. For a firm operating in a competitive industry, which of the following statements
is not correct?
.........
Ⓐ Price equals average revenue Ⓒ Total revenue is constant
Ⓑ Price equals marginal revenue Ⓓ Marginal revenue is constant

11. Changes in the output of a perfectly competitive firm, without any change in the
price of the product, will change the firm's
Ⓐ total revenue Ⓒ average revenue .........
Ⓑ marginal revenue Ⓓ All of the above are correct

12. If a firm in a perfectly competitive market triples the number of units of output
sold, then total revenue will
Ⓐ more than triple Ⓒ exactly triple
TR(x3) = P*Q(x3) .........

Ⓑ less than triple Ⓓ Any of the above may be true

depending on the firm’s labor
productivity
13. Suppose a firm in a competitive market produces and sells 8 units of output and
has a marginal revenue of $8.00. What would be the firm's total revenue if it
instead produced and sold 4 units of output?
.........
Ⓐ $4 Ⓒ $32
Ⓑ $8 Ⓓ $64

14. Suppose that in a competitive market the equilibrium price is $2.50. What is
marginal revenue for the last unit sold by the typical firm in this market?
Ⓐ less than $2.50 Ⓒ exactly $2.50
Ⓑ more than $2.50 Ⓓ The marginal revenue cannot be .........
determined without knowing the
actual quantity sold by the typical
firm
15. If the market elasticity of demand for potatoes is -0.3 in a perfectly competitive
market, then the individual farmer's elasticity of demand
Ⓐ will also be -0.3 Ⓒ will range between -0.3 and -1.0
Ⓑ depends on how large a crop the Ⓓ will be infinite
farmer produces

.........

16. If a competitive firm is currently producing a level of output at which marginal

revenue exceeds marginal cost, then
Ⓐ a one-unit increase in output will Ⓒ total revenue exceeds total cost
increase the firm's profit .........
Ⓑ a one-unit decrease in output will Ⓓ total cost exceeds total revenue
increase the firm's profit

17. The Wheeler Wheat Farm sells wheat to a grain broker in Seattle, Washington.
Since the market for wheat is generally considered to be competitive, the Wheeler
Wheat Farm maximizes its profit by choosing
Ⓐ to produce the quantity at which Ⓒ to sell its wheat at a price where
average variable cost is minimized marginal cost is equal to average
total cost .........
Ⓑ to produce the quantity at which Ⓓ the quantity at which market price
average fixed cost is minimized is equal to the farm's marginal
cost of production (P=MC)
maximizes profit : MR = MC
P=MR=AR => P = MC
18. When profit-maximizing firms in competitive markets are earning profits,
Ⓐ market demand must exceed market Ⓒ new firms will enter the market
supply at the market equilibrium price
.........
Ⓑ market supply must exceed market Ⓓ the most inefficient firms will be
demand at the market equilibrium price encouraged to leave the market
19. If a profit-maximizing firm in a competitive market discovers that, at its current
level of production, price is greater than marginal cost, it should
Ⓐ shut down Ⓒ keep output the same
.........
Ⓑ reduce its output, but continue Ⓓ increase its output
operating
20. Consider a competitive market with 50 identical firms. Suppose the market
demand is given by the equation QD = 200 - 10P and the market supply is given by
the equation QS = 10P. In addition, suppose the following table shows the
marginal cost of production for various levels of output for firms in this market
Output Marginal Cost
0 --
1 $5
2 $10
3 $15
4 $20
5 $25
How many units should a firm in this market produce to maximize profit? .........
Ⓐ 1 unit Ⓒ 3 units
Ⓑ 2 units Ⓓ 4 units

maximize profit: P = MC
QD = 200 - 10P
QS = 10P
Equilirium market: QD = QS
200 – 10P = 10P
P = $10
At Q = 2, P = MC = $10
21. The accountants hired by Davis Golf Course have determined total fixed cost to be
$75,000, total variable cost to be $130,000, and total revenue to be $145,000.
Because of this information, in the short run, Davis Golf Course should
Ⓐ shut-down Ⓒ stay open because shutting down .........
would be more expensive
Ⓑ exit the industry Ⓓ stay open because the firm is
making an economic profit

22. We can measure the profits earned by a firm in a competitive industry as

Ⓐ (P - ATC) x Q Ⓒ MR x MC
.........
Ⓑ (P - MC) x Q Ⓓ (MC - ATC) x Q
23. Suppose that a firm is currently maximizing its short-run profit at an output of 50
units. If the current price is $9, the marginal cost of the 50th unit is $9, and the
average total cost of producing 50 units is $4, what is the firm's profit?
Ⓐ $0 Ⓒ $250 .........

Ⓑ $200 Ⓓ $450

24. Consider a firm operating in a competitive market. The firm is producing 40 units
of output, has an average total cost of production equal to $5, and is earning $240
economic profit in the short run. What is the current market price?
Ⓐ $9 Ⓒ $11 .........

Ⓑ $10 Ⓓ $12

Figure 1
Price
10 MC
9 ATC
8 AVC
7

6 P1
5
P2
4
P3
3

2 P4
1 .........
1 2 3 4 5 6 7 8 Quantity

25. Refer to Figure 1. If the market price is P1, in the short run, the perfectly
competitive firm will earn
Ⓐ positive economic profits Ⓒ negative economic profits and
P1 > P2 (ATCmin) will shut down
Profit > 0
Ⓑ negative economic profits but will Ⓓ zero economic profits
try to remain open
26. Refer to Figure 1. If the market price is P2, in the short run, the perfectly
competitive firm will earn
Ⓐ positive economic profits Ⓒ negative economic profits and
will shut down .........
Ⓑ negative economic profits but will Ⓓ zero economic profits
try to remain open P = P2 (ATCmin)
Profit = 0
27. Refer to Figure 1. If the market price is P3, in the short run, the perfectly
competitive firm will earn
Ⓐ positive economic profits Ⓒ negative economic profits and
will shut down
Ⓑ negative economic profits but will Ⓓ zero economic profits .........
try to remain open
AVCmin < P3 < ATCmin
profit <0 but firm continue to
produce
28. Refer to Figure 1. If the market price is P4, in the short run, the perfectly
competitive firm will earn
Ⓐ positive economic profits Ⓒ negative economic profits and
will shut down .........
P4 < AVCmin => shut down
Ⓑ negative economic profits but will Ⓓ zero economic profits
try to remain open
Figure 2
Price
19
18 MC
17
16
15
14
13
12
11
10 ATC
9
8
7
6
5
4
3
2
1

1 2 3 4 5 6 7 8 Quantity .........

29. Refer to Figure 2. If the market price is $10, what is the firm’s short-run
economic profit?
Ⓐ $9 Ⓒ $30
Ⓑ $15 Ⓓ $50
P = $10 > ATCmin
Profit*: P = MC => Q = 5
economic profit = TR – TC
= P*Q – ATC(Q = 5)*Q
= 10 * 5 – 7*5
= $15
30. Refer to Figure 2. If the market price is $10, what is the firm’s total cost?
Ⓐ $15 Ⓒ $35
TC = ATC*Q
P =10, Q = 5 .........
TC=7 *5
TC = $35
Ⓑ $30 Ⓓ $50
31. Refer to Figure 2. If the market price is $10, what is the firm’s total revenue?
Ⓐ $15 Ⓒ $35
Ⓑ $30 Ⓓ $50 .........
TR = P*Q
P = 10, Q=5
TR = $50
32. Refer to Figure 2. The firm will earn zero economic profit if the market price is
Ⓐ $0 Ⓒ $7
Ⓑ $6 Ⓓ $10 .........
The firm will earn zero economic
profit when price equals ATCmin
ATCmin = $6 => P = $6
33. A profit-maximizing firm in a competitive market is able to sell its product for $7.
At its current level of output, the firm's average total cost is $10. The firm’s
marginal cost curve crosses its marginal revenue curve at an output level of 9
units. The firm experiences a .........
Ⓐ profit of more than $27 Ⓒ loss of more than $27
Ⓑ profit of exactly $27 Ⓓ loss of exactly $27

34. If a firm operating in a competitive industry shuts down in the short run, it can
avoid paying
Ⓐ fixed costs Ⓒ total costs
.........
Ⓑ variable costs Ⓓ The firm must pay all its costs,
even if it shuts down

35. When total revenue is less than variable costs, a firm in a competitive market will
Ⓐ continue to operate as long as Ⓒ shut down
average revenue exceeds marginal
cost .........
Ⓑ continue to operate as long as Ⓓ raise its price
average revenue exceeds average
fixed cost
36. A firm's marginal cost has a minimum value of $2, its average variable cost has a
minimum value of $4, and its average total cost has a minimum value of $5. Then
the firm will shut down if the price of its product falls below,
Ⓐ $2 Ⓒ $5
.........
Ⓑ $4 Ⓓ There is not enough information
given to answer the question
Shut down: P < AVCmin ($4)
P < $4
37. In a competitive market the current price is $7, and the typical firm in the market
has ATC = $7.50 and AVC = $7.15
Ⓐ In the short run firms will shut down, Ⓒ New firms will likely enter this
and in the long run firms will leave market to capture any remaining
the market economic profits
Ⓑ In the short run firms will continue Ⓓ The firm will earn zero profits in
to operate, but in the long run firms both the short run and long run
will leave the market .........

P = $7
ATC=$7.5
AVC = $7.15
P < AVC: shut down
38. The short-run supply curve for a firm in a perfectly competitive market is
Ⓐ horizontal Ⓒ determined by forces external to
the firm
Ⓑ likely to slope downward Ⓓ the portion of its marginal cost .........
curve that lies above its average
variable cost

39. In the long run, a firm will exit a competitive industry if

Ⓐ total revenue exceeds total cost Ⓒ average total cost exceeds the
price .........
Ⓑ the price exceeds average total cost Ⓓ Both a and b are correct

40. Which of these types of costs can be ignored when an individual or a firm is
making decisions?
Ⓐ sunk costs Ⓒ variable costs .........
Ⓑ marginal costs Ⓓ opportunity costs