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FB 2400 Economics I
Tutorial Exercises 7: Perfect Competition
Essential readings: Chapter 7.
1.
Consider the short-run equilibrium of a perfectly competitive market. The market demand schedule
for a particular product is shown as follows:
Price (dollars per unit)
0.75
1.75
2.75
3.75
4.75
5.75
6.75
7.75
8.75
9.75
10.75
11.75
12.75
Quantity demanded (units per week)
440,000
430,000
420,000
410,000
400,000
390,000
380,000
370,000
360,000
350,000
340,000
330,000
320,000
The market is perfectly competitive and there are 1000 firms in the industry. Each firm has the
same cost structure described by the following table:
Output
(units per week)
150
200
250
300
350
400
450
500
(a)
(b)
(c)
(d)
2.
Marginal cost
(dollars)
4.82
4.09
4.63
6.75
9.75
13.95
19.62
26.57
Average variable cost
(dollars)
8.80
7.69
7.00
6.75
6.91
7.50
8.52
9.97
Average total cost
(dollars)
15.47
12.69
11.00
10.07
9.75
10.00
10.74
11.97
What is the industry price and quantity traded?
What is the output of each firm?
What is the economic profit of each firm?
What is the shutdown price?
The Silk Street attracts approximately 20,000 visitors daily (from 9am to 9pm) on weekdays and
between 50,000 and 60,000 on weekends as of 2006. Many of the stalls have over the years gained
local and international reputation for selling counterfeit luxury designer brands at relatively low
prices.
In an opinion piece published in The Wall Street Journal on 17 June, 2008, Chinese Vice-Premier
Wang Qishan mentioned that Beijing’s Silk Market has gone “through rectification and has since
become a distribution centre of famous brands”. But in reality, many stalls have carried on selling
counterfeit luxury designer brands despite growing pressures from the Chinese government and
famous brand name companies.
According to the article, the problem persists because of weak enforcement of the intellectual
property law. “In reality the cost of proving a criminal charge is very high,” said National
Copyright Administration deputy director – general Xu Chao. “It’s very difficult, hence the limited
number of criminal arrests.” (Source: SCMP, July 7, 2008)
(a)
Consider the counterfeiters industry, which is highly competitive. Suppose the government
runs a confiscation program to arrest the counterfeiters from time to time. The program
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FB 2400 Economics I
can only arrest limited number of counterfeiters. What would happen to the profits and
prices of the remaining firms, which were not arrested in short run?
(b)
What would be the long run adjustment in the market after the confiscation program? Is
this kind confiscation program an effective way to deal with the piracy problem?
(c)
Many people suggested other measures to be more effective, e.g. educating the youngsters
about the importance of protecting the intellectual property rights were more effective
ways to deal with piracy in long run. Do you agree?
3.
A report published in Hong Kong Economics Times on 11 June 2008 concerns the fishing market
in Hong Kong. It is reported that the diesel price increased by 2.4 times in a year, which raised the
cost of fishing significantly. How would this regulation affect the market and individual fishermen
in the short run and long run?
4.
Suppose the book-printing industry is competitive and begins in a long-run equilibrium.
(a)
Hi-Tech Printing Company employs an extra-ordinary manager that sharply reduces the
cost of administrative costs (i.e. fixed cost in the short run). What happens to Hi-Tech’s
profits and the price of books in short run? Will it attract new firms to enter the market in
long run?
(b)
Suppose you were the owner of Hi-Tech. What is the maximum amount that you would
offer to keep the extra-ordinary manager to your own firm?
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FB 2400 Economics I
Suggested (Not Restrictive) Answers
1.
(a)
Equilibrium price = $9.75; Equilibrium quantity = 350,000
Market
P
30
25
20
15
10
5
0
200,000
(b)
SS
D
250,000
300,000
350,000
400,000
450,000
500,000
550,000
Q
To maximizing profit, the firm’s output level is 350 units
Market
Individual Firm
P
P
30
30
SS
SMC
25
25
20
20
15
15
10
10
5
5
D
0
0
200,000
250,000
300,000
350,000
400,000
450,000
SAC
AVC
d = MR = P
500,000
Q
550,000
0
100
(c)
Economic profit = (P – SAC) x q
In this case, it’s zero as P = SAC = $9.75.
(d)
Shutdown price = $6.75 that is the lowest level of AVC.
200
300
400
500
In short run, a firm in perfect competition has to decide “Produce or not (Shutdown)”
Case 1 Not produce (Shutdown)
Economic Loss = TFC
Case 2 When P > ATC
P x q > ATC x q
TR > TC
Economic Profit = TR – TC
Case 3 ATC > P > AVC
ATCxq > Pxq > AVCxq
TC > TR > TVC
Economic Loss = TC – TR < TC – TVC (= TFC)
Case 4 When ATC > AVC > P
ATCxq > AVCxq > Pxq
TC > TVC > TR
Economic Loss = TC – TR > TC – TVC (=TFC)3
600q
FB 2400 Economics I
2.
(a)
Short run effect on remaining firms after confiscation program (Fig 1):
o
o
o
o
(b)
Initially, in long run equilibrium: P = LAC = LMC = SAC = SMC: Zero equilibrium profit.
Confiscation program decreases the supply of counterfeit goods, shifting the market supply curve
from S1 to S2, resulting in higher market price (P2).
Although market quantity drops, the profit maximizing output level of each remaining firm
increases to the corresponding output level where MC1 = MR2.
At the new output level, each remaining firm is making economic profit.
Long run effect on remaining firms after confiscation program (Fig 1):
o
o
o
o
o
o
In short run equilibrium: Positive equilibrium profit
Long-run adjustment: The profit earned by the existing firms attracts potential entrants. Free Entry
increases the supply of counterfeit goods until the price drops back to its original level (S2 to S1) so
that there is no profit incentive for potential entrants to enter the market.
The market price (P0) is lowered.
Although market quantity rises, the profit maximizing output level of each individual firm
decreases to the corresponding output level where LMC = SMC = MR1.
At this output level, each firm is making zero economic profit again.
This policy is ineffective at all as the market quantity goes back to the original level in long run.
(c) Effect on remaining firms if consumers change their preference due to education (Fig 2 & Fig 3):
o
o
o
o
o
o
Initially, in long run equilibrium: P = LAC = LMC = SAC = SMC: Zero equilibrium profit.
Education successfully lowers the demand for counterfeit goods shifting the market demand curve
from D1 to D2, lowering the market price (P2).
Both the market quantity and the profit maximizing output level of each remaining firm drops,
resulting in an economic loss in short run.
Long-run adjustment: Some of the existing exit the market due to the economic loss. It reduces
supply from S2 to S1. It stops when price goes back to its original level (P 1).
The individual firm is making zero economic profit again.
Although market quantity drops, the profit maximizing output level of each individual firm
decreases to the corresponding output level where LMC = SMC = MR1.
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FB 2400 Economics I
Market
P
Individual Firm
S2
P ($)
S1
SMC
LMC
LAC
SAC
P2
MR2
P1
MR1
D
Q2
Q1
Q
q1 q2
q
Figure 1: Short-run equilibrium: Decrease of Supply.
5
FB 2400 Economics I
Market
Individual Firm
P
P ($)
S1
SMC
LAC
SAC
P1
MR1
P2
MR2
D
D2
Q2
Q1
Q
q2 q1
q
Figure 2: Short-run equilibrium: Decrease in Demand
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FB 2400 Economics I
S2
Market
P
Individual Firm
P ($)
S1
SMC
LMC
LAC
SAC
P1
MR1
P2
MR2
D2
Q3
Q2
Q1
D1
Q
q2 q1
q
Figure 3: Adjustment to long-run equilibrium: Exit of Existing Firms
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FB 2400 ECONOMICS I
3.
The increase in diesel price increases both the variable cost in the short run. In the long-run, the total cost
will increase.
(a)
Short run effect of the increase in diesel price on fishing industry in HK (Fig 4):
o
o
o
o
o
o
(b)
o
o
o
o
Initially, in long run equilibrium: P = LAC = LMC = SAC1 = SMC1: Zero equilibrium profit.
The increase in diesel price increases the firms’ marginal cost. Shifts SMC1 to SMC2 and SAC1 to
SAC2.
The market supply curve shifts up by the same vertical amount as the MC (why?) from S1 to S2.,
resulting in a higher market price (P2).
Both the market quantity and the profit maximizing output level of each firm drops.
At the new output level, each firm is making economic loss.
Depending on its AVC, some firms may shutdown if p < AVC.
Long run effect of the increase in diesel price on fishing industry in HK (Fig 5)
In short run equilibrium: Economic Loss.
Long-run adjustment: The loss incurred by the existing firms induces some firms to exit the
market. Exit decreases the supply of electronic equipment until the price increases to P3 so that
there is economic profit is zero again.
Although market quantity drops, the profit maximizing output level of a remaining firm increases
at which LMC2 = SMC2 = MR3.
At this output level, each firm is making zero economic profit again.
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FB 2400 ECONOMICS I
Market
Individual Firm
P
P ($)
S2
S1
SMC2
SMC1
SAC2
SAC1
P2
LAC2
LAC1
MR2
MR1
P1
D
Q2 Q1
Q
q2
q1
q
Figure 4: Short-run Equilibrium: An increase in marginal costs.
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FB 2400 ECONOMICS I
Market
Individual Firm
P
P ($)
S3
S2
S1
SMC2
SMC1
SAC2
P3
P2
SAC1
LAC2
LAC1
MR2
MR1
P1
D
Q3Q2 Q1
Q
q2 q3 q1
q
Figure 4: Adjustment to Long-run Equilibrium: Exit of Existing Firms
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FB 2400 ECONOMICS I
4.
(a)
(b)
Figure 4 shows the Hi-Tech’s initial situation, with long-run average cost LAC1, long-run
marginal cost LMC, and price P1. The short-run cost curves are not shown in the diagram to avoid
too many lines in the diagram. The extra-ordinary manager reduces Hi-Tech’s average cost to
LAC2, but the price remains at P1 since other firms can’t use the new process. It is because HiTech is a very small firm and cannot affect the market price. Thus Hi-Tech remains producing at
q1 where LMC = MR and earns positive economic profits. It will not attract new firms to enter the
market in long run since new firms cannot make profit without the extra-ordinary manager. HiTech’s economic profit will not be driven away by new entrants and therefore can exist even in
the long run.
In part (a), your economic profit (say $50, 000) will not be driven away even in long run, but your
long run economic profit is zero in part (b). Therefore, other firms will try getting your technology
so as to make profit. To keep it for your exclusive use, the maximum amount you are willing to
spend should be the economic profit (the $50,000) that you can enjoy in part (a), which is the
benefit of having such special technology. Even if you want to pay less, other firms will try to get
this resource from you and competition will drive the cost of keeping it for exclusive use to
$50,000. In economics, we call this economic rent. This is the economic surplus that is attributable
to an extraordinarily productive input or technology whose supply is limited. It is often confused
with economic profit. Therefore, in long run, Hi Tech’s economic profit is still zero, because the
part of economic rent is in fact the opportunity cost that you have to pay so as to keep the
extraordinarily productive input or technology.
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FB 2400 ECONOMICS I
Market
Hi-Tech
P
P ($)
S
SMC
SAC1
SAC2
P1
MR1
D
Q1
Q
q1
q
Figure 5: The cost-saving technology is exclusively used by Hi-Tech only.
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