Download Chapter 11 Practice Exam Solutions

Chapter 11: Equilibrium in competitive markets
Short Answer Questions
1. Briefly explain the fundamental assumptions for the basic model of perfect
competition.
Answer: (1) sellers are price takers; (2) sellers do not behave strategically; (3) entry
into the market is free; (4) buyers are price takers.
2. What do economists mean by “increasing cost industry”?
Answer: They mean an industry in which long-run average costs rise with the industry
output level.
3. Under what conditions a good is said to be perfectly inelastic?
Answer: If a change in the price of the good has no effect on its quantity demanded.
4. Explain the term “economic rent”.
Answer: It is what the supplier of a good or service is paid above and beyond what is
needed to induce it to supply the output.
5. What is excess burden and how it relates to welfare analysis?
Answer: The amount by which the loss of surplus suffered by consumers and
producers exceeds the tax revenue collected.
6. What does the market structure mean?
Answer: It means the economic environment in which buyers and sellers operate in.
7. Explain the definition of the statutory incidence of tax and how it differs from
the economic incidence of tax.
Answer: The statutory incidence of tax indicates the economic agent who is legally
responsible for payment of the tax. However, it does not determine which economic
agent really pays the tax. To do so, we have to calculate the economic incidence of the
tax which is the change in income distribution brought about by the imposition of the
tax.
For the remaining questions support your answers with the aid of appropriate
diagrams.
8. Using an appropriate diagram to show how to derive the short-run market
supply curve.
Answer: To find the short-run market supply curve, for any price, we horizontally
sum the associated firms’ individual quantitative supplied.
9. How is long-run equilibrium achieved in a perfectly competitive market?
Answer: When the level of industry input demand has no effect on the prices of these
inputs, the long-run supply curve for a perfectly competitive industry is flat at a price
equal to the minimum of long-run average cost. The equilibrium price is found by
looking for the price at which long-run supply and demand are equal. The long-run
equilibrium price is p1 and the equilibrium quantity bought and sold in the market is
X1. Each firm produces x* tonnes.
10. Show how a short-run equilibrium can be achieved in a market populated by
heterogeneous firms.
Answer:
Taking the horizontal sum of the individual supply curves, we find the market supply
curve, SSR in Panel B. The equilibrium price is given by the intersection of the
industry supply and demand curves in Panel B. Once we have found that price, we
can use it to construct the firm-specific demand curve, dSR, faced by each supplier.
Panel A shows the equilibrium position of each type of supplier.
Essay questions
1. “Any market structure can support fully competitive markets”. Discuss.
Answer: (a) many buyers with no market power; (b) many sellers, with no market
power (c) the outputs of different sellers are homogeneous (d) buyers are well
informed about the offerings of competing suppliers (e) neither technological nor
legal barriers to entry exit.
2. “In perfectly competitive markets, a short-run equilibrium is also a long-run
equilibrium”. Discuss.
Answer:
When the level of industry input demand has no effect on the prices of these inputs,
the long-run supply curve for a perfectly competitive industry is flat at a price equal to
the minimum of long-run average cost. The equilibrium price is found by looking for
the price at which long-run supply and demand are equal. The long-run equilibrium
price is p1 and the equilibrium quantity bought and sold in the market is X1. Each firm
produces x* tonnes.
3. Using appropriate diagrams, compare and discuss the short-run and long-run
equilibria competitive markets with heterogeneous agents.
Answer:
Taking the horizontal sum of the individual supply curves, we find the market supply
curve, SSR in Panel B. The equilibrium price is given by the intersection of the
industry supply and demand curves in Panel B. Once we have found that price, we
can use it to construct the firm-specific demand curve, dSR, faced by each supplier.
Panel A shows the equilibrium position of each type of supplier.
When there are only four good mines and entry by bad mines is free, the long-run
industry supply curve initially is upward sloping and then becomes flat at the price
equal to the minimal long-run average cost of a bad mine.
4. “Generous social security schemes are always good news for workers”.
Discuss and explain how your answer depends strictly on the properties of the
labour supply curve.
Answer:
D is the before-tax demand curve for labour, S is the before-tax supply curve and w1
is the before-tax equilibrium wage rate. The employer tax shifts the effective demand
curve downwards to D′. The employee tax shifts the effective supply curve upwards
by the amount of the tax to S′, which coincides with S. After the imposition of the tax,
the wage paid by employers to workers falls to w2, while the full price for labour paid
by employers (including the tax payments) stays constant at w1.
5. Fully explain the possible welfare impacts of rent control. Use diagrams to
support your answers.
Answer: In the absence of rent control, the competitive equilibrium is at point e1.
Imposition of a rent ceiling equal to p lowers the quantity of housing supplied from X1
to Xa. Total surplus falls by the sum of areas B and D as a result.