SOLUTIONS TO SELF-CHECK QUESTIONS
7.1 Perfect Competition and Why It Matters
- The four basic assumptions are: the product is homogeneous, there are many buyers and sellers, consumers have perfect information, and there are no barriers to entry or exit. These assumptions imply that a single firm cannot do much to influence the market, but must accept conditions as it finds them.
- No, you would not raise the price. Your product is exactly the same as the product of the many other firms in the market. If your price is greater than your competitors, then your customers would switch to them and stop buying from you. You would lose all your sales.
7.2 How Perfectly Competitive Firms Make Output Decisions
- If marginal costs exceed marginal revenue, then the firm will reduce its profits for every additional unit of output it produces. Profit would be greatest if it reduces output to where MR = MC.
- The firm will be willing to supply fewer units at every price level. In other words, the firm’s individual supply curve decreases and shifts to the left.
7.3 Entry and Exit Decisions in the Long Run
- With a technological improvement that brings about a reduction in costs of production, an adjustment process will take place in the market. The existing firms will experience higher profits, which will attract other firms into the market. This entry process will stop whenever profits are driven back to zero.
- When wages increase, costs of production increase. Some firms would now be making economic losses and would shut down. The supply curve then starts shifting to the left, pushing the market price up. This process ends when all firms remaining in the market earn zero economic profits. The result is a contraction in the output produced in the market.
7.4 Efficiency in Perfectly Competitive Markets
- Think of the market price as representing the gain to society from a purchase, since it represents what someone is willing to pay. Think of the marginal cost as representing the cost to society from making the last unit of a good. If P > MC, then the benefits from producing more of a good exceed the costs, and society would gain from producing more of the good. If P < MC, then the social costs of producing the marginal good exceed the social benefits, and society should produce less of the good. Only if P = MC, the rule applied by a profit-maximizing perfectly competitive firm, will society’s costs and benefits be in balance. This choice will be the option that brings the greatest overall benefit to society.
- Perfect competition is considered to be “perfect” because both allocative and productive efficiency are met at the same time in a long-run equilibrium. If a market structure results in long-run equilibrium that does not minimize average total costs and/or does not charge a price equal to marginal cost, then either allocative or productive (or both) conditions are not met, and therefore the market cannot be labeled “perfect.”