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Chapter 14 SOLUTIONS TO TEXT PROBLEMS Quick Quizzes When a competitive firm doubles the amount it sells the price remains the same so its total revenue doubles The price faced by a profit maximizing firm is equal to its marginal cost because if price were above marginal cost the firm could increase profits by increasing output while if price were below marginal cost the firm could increase profits by decreasing output A profit maximizing firm decides to shut down in the short run when price is less than average variable cost In the long run a firm will exit a market when price is less than average total cost In the long run with free entry and exit the price in the market is equal to both a firm s marginal cost and its average total cost as Figure 1 shows The firm chooses its quantity so that marginal cost equals price doing so ensures that the firm is maximizing its profit In the long run entry into and exit from the industry drive the price of the good to the minimum point on the average total cost curve Figure 1 Questions for Review A competitive firm is a firm in a market in which 1 there are many buyers and many sellers in the market 2 the goods offered by the various sellers are largely the same and 3 usually firms can freely enter or exit the market Figure 2 shows the cost curves for a typical firm For a given price such as P the level 263 1 2 3 1 2 Chapter 14 Firms in Competitive Markets 264 of output that maximizes profit is the output where marginal cost equals price Q as long as price is greater than average variable cost at that point in the short run or greater than average total cost in the long run Figure 2 3 4 5 6 7 A firm will shut down temporarily if the revenue it would get from producing is less than the variable costs of production This occurs if price is less than average variable cost A firm will exit a market if the revenue it would get if it stayed in business is less than its total cost This occurs if price is less than average total cost A firm s price equals marginal cost in both the short run and the long run In both the short run and the long run price equals marginal revenue The firm should increase output as long as marginal revenue exceeds marginal cost and reduce output if marginal revenue is less than marginal cost Profits are maximized when marginal revenue equals marginal cost The firm s price equals the minimum of average total cost only in the long run In the short run price may be greater than average total cost in which case the firm is making profits or price may be less than average total cost in which case the firm is making losses But the situation is different in the long run If firms are making profits other firms will enter the industry which will lower the price of the good If firms are making losses they will exit the industry which will raise the price of the good Entry or exit continues until firms are making neither profits nor losses At that point price equals average total cost Market supply curves are typically more elastic in the long run than in the short run In a competitive market since entry or exit occurs until price equals the minimum of average total cost the supply curve is perfectly elastic in the long run Chapter 14 Firms in Competitive Markets 265 Problems and Applications 1 2 3 4 5 A competitive market is one in which 1 there are many buyers and many sellers in the market 2 the goods offered by the various sellers are largely the same and 3 usually firms can freely enter or exit the market Of these goods bottled water is probably the closest to a competitive market Tap water is a natural monopoly because there s only one seller Cola and beer are not perfectly competitive because every brand is slightly different Since a new customer is offering to pay 300 for one dose marginal revenue between 200 and 201 doses is 300 So we must find out if marginal cost is greater than or less than 300 To do this calculate total cost for 200 doses and 201 doses and calculate the increase in total cost Multiplying quantity by average total cost we find that total cost rises from 40 000 to 40 401 so marginal cost is 401 So your roommate should not make the additional dose a b Remembering that price equals marginal cost when firms are maximizing profit we know the marginal cost must be 30 cents since that is the price The industry is not in long run equilibrium since price exceeds average total cost Once you have ordered the dinner its cost is sunk so it does not represent an opportunity cost As a result the cost of the dinner should not influence your decision about stuffing yourself Since Bob s average total cost is 280 10 28 which is greater than the price he will exit the industry in the long run Since fixed cost is 30 average variable cost is 280 30 10 25 which is less than price so Bob won t shut down in the short run 6 Here s the table showing costs revenues and profits Quantity Total Cost Margina l Cost Total Revenue Margina Profit l Revenue 0 1 2 3 4 5 8 9 10 11 13 19 1 1 1 2 6 0 8 16 24 32 40 8 8 8 8 8 8 1 6 13 19 21 Chapter 14 Firms in Competitive Markets 266 6 7 27 37 8 10 48 56 8 8 21 19 The firm should produce 5 or 6 units to maximize profit Marginal revenue and marginal cost are graphed in Figure 3 The curves cross at a quantity between 5 and 6 units yielding the same answer as in part a This industry is competitive since marginal revenue is the same for each quantity The industry is not in long run equilibrium since profit is positive a b c Figure 3 7 a Figure 4 shows the short run effect of declining demand for beef The shift of the industry demand curve from D1 to D2 reduces the quantity from Q1 to Q2 and reduces the price from P1 to P2 This affects the firm reducing its quantity from q1 to q2 Before the decline in the price the firm was making zero profits afterwards profits are negative as average total cost exceeds price Chapter 14 Firms in Competitive Markets 267 Figure 4 b Figure 5 shows the long run effect of declining demand for beef Since firms were losing money in the short run some firms leave the industry This shifts the supply curve from S1 to S3 The shift of the supply curve is just enough to increase the price back to its original level P1 …


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PSU CHEM 110 - Chapter 14-17

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