Chapter 14 Firms in Competitive Markets Multiple Choice Short Answer

Chapter 14/Firms in Competitive Markets ❖ 95 . SHORT ANSWER T 64. 1. Describe the difference between average revenue and marginal revenue. Why are both of these revenue measures important to a profit-maximizing firm? ANS: Average revenue is total revenue divided by the quantity of output. Marginal revenue is the change in total revenue from the sale of each additional unit of output. Marginal revenue is used to determine the profitmaximizing level of production, and average revenue is used to help determine the level of profits. Note that for all firms, price equals average revenue because AR=(PxQ)/Q=P. But only for a firm operating in a perfectly competitive industry does price also equal marginal revenue. PTS: 1 DIF: 2 REF: 14-1 NAT: Analytic LOC: Perfect competition TOP: Price MSC: Definitional 96 ❖ Chapter 14/Firms in Competitive Markets 2. List and describe the characteristics of a perfectly competitive market. ANS: 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. PTS: 1 DIF: 2 REF: 14-1 NAT: Analytic LOC: Perfect competition TOP: Competitive markets MSC: Definitional 3. Why would a firm in a perfectly competitive market always choose to set its price equal to the current market price? If a firm set its price below the current market price, what effect would this have on the market? ANS: The firm could not sell any more of its product at a lower price than it could sell at the market price. As a result, it would needlessly forgo revenue if it set a price below the market price. If the firm set a higher price, it would not sell anything at all because a competitive market has many sellers who would supply the product at the market price. PTS: 1 DIF: 2 REF: 14-1 NAT: Analytic LOC: Perfect competition TOP: Profit maximization MSC: Analytical 4. Use a graph to demonstrate the circumstances that would prevail in a competitive market where firms are earning economic profits. Can this scenario be maintained in the long run? Explain your answer. ANS: In a competitive market where firms are earning economic profits, new firms will have an incentive to enter the market. This entry will expand the number of firms, increase the quantity of the good supplied, and drive down prices and profits. Entry will cease once firms are producing the output level where price equals the minimum of the average total cost curve, meaning that each firm earns zero economic profits in the long run. PTS: 1 DIF: LOC: Perfect competition MSC: Analytical 2 REF: 14-2 NAT: Analytic TOP: Profit maximization 5. Explain how a firm in a competitive market identifies the profit-maximizing level of production. When should the firm raise production, and when should the firm lower production? ANS: The firm selects the level of output at which marginal revenue is equal to marginal cost. If MR > MC, profit will increase if the firm increases Q. If MR < MC, profit will increase if the firm decreases Q. PTS: 1 DIF: 2 REF: 14-2 NAT: Analytic LOC: Perfect competition TOP: Profit maximization MSC: Analytical Chapter 14/Firms in Competitive Markets ❖ 97 6. News reports from the western United States occasionally report incidents of cattle ranchers slaughtering a large number of newborn calves and burying them in mass graves rather than transporting them to markets. Assuming that this is rational behavior by profit-maximizing "firms," explain what economic factors may influence such behavior. ANS: If the selling price is not sufficient to cover the variable cost of sending the calves to market, this (potentially emotionally upsetting) behavior makes economic sense. PTS: 1 DIF: 2 REF: 14-2 NAT: Analytic LOC: Perfect competition TOP: Profit maximization MSC: Analytical 7. Use a graph to demonstrate the circumstances that would prevail in a perfectly competitive market where firms are experiencing economic losses. Identify costs, revenue, and the economic losses on your graph. Using your graph, determine whether an individual firm will shut down in the short run, or choose to remain in the market. Explain your answer. ANS: The losses and revenues are identified on the individual firm's graph. Total cost is equal to the sum of the losses and revenue (because profit/loss=TR-TC, so TC=TR+profit/loss). The decision about whether this firm shuts down or remains in the market depends upon the position of average variable cost. If average variable cost is below P0 at output level Q0, the firm will remain in the market. If average variable cost is above P0 at output level Q0 the firm will shut down in the short run. PTS: 1 DIF: LOC: Perfect competition MSC: Analytical 2 REF: 14-2 NAT: Analytic TOP: Profit maximization 8. At its current level of production a profit-maximizing firm in a competitive market receives $12.50 for each unit it produces and faces an average total cost of $10. At the market price of $12.50 per unit, the firm's marginal cost curve crosses the marginal revenue curve at an output level of 1,000 units. What is the firm's current profit? What is likely to occur in this market and why? ANS: Profit can be calculated as (P-ATC)xQ. ($12.50-10)x1,000 = $2,500. Firms are likely to enter this market because existing firms are earning economic profits. PTS: 1 DIF: 2 REF: 14-2 NAT: Analytic LOC: Perfect competition TOP: Profit MSC: Analytical 9. Give two reasons why the long-run industry supply curve may slope upward. Use an example to demonstrate your reasons. 98 ❖ Chapter 14/Firms in Competitive Markets ANS: 1) Some resource used in production may be available only in limited quantities. 2) Firms may have different cost structures. The example provided in the text for the first reason is the market for farm products. As more people become farmers, the price of land is bid up since its supply is limited. As the price of farm land is bid up, the costs to all farmers in the market rise. The example used to support the second reason is the market for painters. Anyone can enter the market for painting services, but not everyone has the same costs because some painters work faster than others. PTS: 1 DIF: 3 REF: 14-3 NAT: Analytic LOC: Perfect competition TOP: Supply curve MSC: Interpretive 10. If identical firms that remain in a competitive market over the long run make zero economic profit, why do these firms choose to remain in the market? ANS: Because a normal rate of return on their investment is included as part of the opportunity cost of production. PTS: 1 DIF: 2 REF: 14-3 NAT: Analytic LOC: Perfect competition TOP: Economic profit MSC: Interpretive