Chapter 8 questions 1,2,3

1) In the short run firms have to cope with different costs, variable and fixed. The variable cost are usually wages, it can vary in the short run, for example, longer work days or hiring more workers. Fixed cost are rents and interest, they cannot change in the short run. The short run is also when are unable firms enter or leave the market.

Perfect competition, an economical theory, is where all the many firms are equal in size and produce identical products as well as same amount of output. Moreover, they also face equal costs and since there are no barriers of entry or exit, firms are allowed to enter or leave as they see put. Firms in perfect competition are “price takers” which means that the firm is not influential enough to affect the price of a good or service. In this case the market price is determined by the demand and supply of the market. Furthermore, the demand for goods in a perfectly competitive market is perfectly elastic. This means that the firm can only sell at that price because if they raise the price no consumer would buy a good at that particular firm. Likewise, if the firm decreased its price, then infinite amount of consumers would buy their good; however this is unrealistic.

When the marginal revenue intersects the marginal cost, it is known as the profit maximization rule, in order to maximize a firm’s profits, the firm must produce at that quantity. On the graph MR=MC.

When the firm is producing at the profit maximization point it is most efficient at producing. When the average total cost is below the price of the good then the firm is producing abnormal profits. For example, if a kebab’s cost is 8 CHF to produce and the kebab producer can sell it for 10 CHF then the producer has made profits of 2 CHF.

However, it is only possible for firms to earn abnormal profits in the short run. Since firms can only enter or exit a market the supply of the industry’s product will not vary. When a firm in a perfectly competitive market is earning abnormal profits, many new firms will enter the market because firms are profit seekers. The supply for goods in the market will increase with the increased number of firms. The price of the good will thus decrease. On the graph, the supply shifts to the right, from Qe1 to Qe2, the price moves from Pe to Pe1. Since firms in the perfect completion are price takers, they receive the price of the market. It has now decreased to Pe1. Firms must now charge at price Pe1 for consumers to buy at their firm, if they don’t, no one would buy there because the firms demand is perfectly elastic.

1) 2) In the short run firms face no fixed costs, wages, rent and interest on a firms costs are all variable, this why the long run is considered the variable plant size. Unlike the short run, firms are able to enter or exit the market in perfect competition in the long run.

It is possible for firms in perfect competition to earn abnormal profits. When the selling price of goods is higher than the cost of production then the firm is earning abnormal profits. When a firm is earning abnormal profits it attracts other firms because firms are profit seekers. With more firms entering the market the overall supply of the market increases. The supply shifts to the right and thus the price drops. There will be a new equilibrium point; the firms will now be earning normal profits. Since normal profits are points where the cost s equals the revenue, no more firms would enter the market because there is no more chance of earning abnormal profits.

When firms make losses in the short-run, some firms will pull out of the market. This will decrease the supply and thus the price will increase. Firms will now be able to sell their goods at the increased price. Since this will help raise the revenues, the loss will not be as big, if the costs remain the same.

The market is constantly changing, thus there will be new equilibrium points. The firms in perfectly competitive markets will never earn abnormal profits, only normal profits.

1) 3) Abnormal profits are when the revenue earned exceeded the costs. When a firm is producing at the profit maximization point, MC=MR, at Q then the firm is being most efficient at producing. When the average total cost is lower than the price of sell the good the firm earns abnormal profits.

Productive efficiency is the point where P= minimum ATC. The firm is using its resources to it maximum efficiency by producing at the lowest average total cost. Since all firms are equal in size and output there is a huge competition going on. There is a large incentive for reducing the costs as much as possible because the output and price is the same; the only thing variable is the costs, so if a firm has a lower cost than another the other firm and could possible shut down due to higher costs.

Allocative efficiency is where P=MC. At that point the right amount of output is produced. If the price were higher that the marginal cost, this is a signal that more output is desired, if the price were lower than the marginal cost, the signal from buyers to sellers is that less output is desired.

If a firm produces at the minimum ATC then it is productively efficient. However in this case it is not, because the price doesn’t intersect the minimum point on the ATC. The firm is still producing at the profit maximization point because MC=MR. The ATC is however, intersected by the MC. So the firm is earning abnormal profits but not productively efficient. Since the P=MC at the profit maximization point the firm is allocative efficient.