Study Questions Chapter 10 Perfect Competition in a Single Market 1. How is the short run industry supply curve determined?

? Use a diagram to illustrate your answer. The short run industry supply curve is the horizontal summation of the individual firms short run supply curves (their marginal cost curves). See Figure 10-2. 2. What is an equilibrium price and what does it do? Use a diagram to illustrate your answer. The equilibrium price is the price that equates the quantity demanded by consumers to the quantity supplied by producers. It clears the market. In other words, there is no shortage nor is there a surplus. Consider this diagram:

Price per unit P1 PE

Short run supply curve (shows quantity supplied at every price)

Demand curve (shows quantity demanded at every price) QD QE QS

Quantity in units per week

In this diagram, you can see that at P1 the quantity demanded (QD) is less than the quantity supplied (QS). At this relatively high price, producers are willing to sell a lot (as the high price covers their rising marginal costs) but consumers are not willing to buy a lot (the relatively high price discourages consumption due to both the income and substitution effects). This creates a surplus. But this wont last. Producers want to sell the goods they have and they will compete by lowering their prices. As the price falls, the quantity

supplied falls (along the supply curve, move from QS to QE) and the quantity demanded increases (along the demand curve, move from QD to QE) until the price falls to PE.. At PE (the equilibrium price) there is no surplus, the amount people want to buy is exactly equal to the amount firms want to sell. Because we use the price mechanism to allocate resources in the United States, we do not see long lines (a sign of a shortage) or huge accumulations of products that cant be sold (a sign of a surplus). The price rations the production to those consumers for whom the value is the greatest. Notice in the diagram above that everyone who gets this good (those consumers along the demand curve above PE) are the consumers who are willing to pay the most for this good. The price mechanism rations goods to those consumers who are willing to pay the most. Economics uses the expression resources go to their highest valued use. This value does not have an ethical meaning. For example, someone poor wont be the highest valued user of some goods. Some pets will eat and some children will go hungry. So the word value in economics just refers to the amount someone is willing to pay for a good, it doesnt have the ethical meaning that is common in English. Because we dont always like the outcome of rationing by prices (some poor people dont get goods), social programs are set up by the government (public assistance programs) to tax higher income individuals to shift money to the poor. This shifts the demand curve out for some goods (those purchased by recipients of pubic assistance) and shifts the demand curve in for other goods (those that would have been purchased by taxpayers had they not paid taxes). Taxes are progressive. The more you earn, the greater percentage of your income you pay in taxes. The households in the top 10% in taxable income pay about 70% of all federal taxes. This has labor supply effects. Taxing income-earning individuals will discourage their productivity (labor supply). For example, given their marginal tax rates, most professors in my department are not willing to teach an additional course, even if offered $10,000 (after state and federal taxes it would be a lot less, maybe $6,000, depending on their marginal tax rate). The same is true for the poor. Transfers to the poor from public assistance programs reduce the benefits from working. For example, some

studies suggest that an increase in earned income cant increase the take home income of relatively poor families because the increase in earned income is offset by a reduction in eligibility for public assistance. So the cost to society of public assistance programs (funded by taxpayers) is to reduce economic activity overall. Most societies are OK with that, as you might imagine. 3. Define the short run and long run price elasticity of supply. See the textbook on pages 305 and 316. 3. How does an inelastic demand affect the swings in prices caused by changes in supply of a good? With an inelastic demand, you can get big swings in prices from changes in supply (an oil supply disruption for example). See Figure 10-4 (b). 4. What if the demand is relatively elastic (as for Florida oranges consumers can buy other oranges or other fruit)? With an elastic demand, a shift in supply wont produce a large swing in the price of the good. See Figure 10-4 (a).

5. If supply is relatively inelastic, will shifts in demand have a big effect on price? Yes, if supply is relatively inelastic, it means that it cant increase quickly. In this case a shift in demand will have a relatively large affect on the price of a good. For example, in the short run the supply of many goods is relatively inelastic. If all of a sudden there were an increase in a particular disease, the demand for medicine that can cure that disease would rise. As it is hard to increase production quickly, there would be a fairly large increase in the price of the medicine. See Figure 10-5 (a) to see how this is drawn. 6. If supply is relatively elastic, will shifts in demand have a big effect on price? No, just the opposite. If supply is relatively elastic, it means it can be increased fairly easily. In this case, an increase in demand will not lead to a relatively large increase in price. This is shown in Figure 10-5 (b). The supply of a product will be more elastic in the long run than in the short run. That means that Figure 10-5 (a) is more likely to apply in the short run and Figure 10-5 (b) is more likely to apply in the long run. 7. What conditions hold in long-run equilibrium? a. All firms are content with the level of output they are producing; this means that the firm is producing the profit maximizing level of output (where MC = MR). b. No firms want to leave the industry nor do firms want to enter; this means there are zero economic profits (resources earn as much in this industry as elsewhere). c. For the industry as a whole, the price is such that the quantity demanded of the industrys product equals the quantity supplied. 8. What is a constant cost industry? An increasing cost industry? A decreasing cost industry: A constant cost industry is one in which new entrants do not bid up the costs of inputs; production costs do not rise with entry of new firms, nor fall with exit of firms. An increasing cost industry is one in which new entrants bid up the costs of inputs; production costs rise with the entry of new firm and fall as firms leave the industry. 4

A decreasing cost industry is one in which new entrants generate enough activity that input prices fall perhaps because there is now sufficient demand to produce the inputs in large scale facilities and there are economies of scale in the production of the inputs. In this type of industry, production costs fall with the entry of new firms. This is thought to describe industries that are relatively small that are growing. For example, as the computer industry grew, chips could be produced on a larger scale, reducing the per chip cost. These savings are DIFFERENT from savings that result from technological innovation. Here we are just talking about cost savings from large scale production of inputs or something of the sort that lowers the cost of inputs as production in an industry increases. 9. In a constant cost industry, how will an increase in demand affect the price in the short run? In the long run? Use a diagram to illustrate your answer. What does the long run supply curve look like in a constant cost industry? In the short run the price will increase, yielding profits in the industry. This will encourage new firms to enter so that, in the long run, the price falls until there are zero economic profits. The long run supply curve in a constant cost industry is horizontal at the price that is the minimum of the long run average cost curve. Insert Figure 10-7 here. 10. What is the movie rental industry an example of? (Application 10.3, page 314) It is an example of an industry that has a relatively elastic supply. 11. In an increasing cost industry, how will an increase in demand affect the price in the short run? In the long run? Use a diagram to illustrate your answer. What does the long run supply curve look like in an increasing cost industry? In the short run the price will increase, yielding profits in the industry. This will encourage new firms to enter so that, in the long run, the price falls until there are zero economic profits. In an increasing cost industry, as firms enter, the costs of production increase (more competition for scarce inputs). This means that the long run equilibrium price will be below the short run price, but above the original long run price. The long run supply curve in an increasing cost industry is positively sloped, reflecting the increasing input costs as the industry expands. Insert Figure 10-8 here.

12. Why is the assumption that firms can enter and exit freely important to the models in this chapter? Without free entry, profits could persist over time. If entry was prohibited or limited (perhaps by the government) and demand were to increase, existing firms could earn profits forever. This is why firms lobby governments to limit entry/competition. 13. What shapes can the long run supply curve take and what conditions produce each case? Give an example of each a. Horizontal line constant cost industry; an example would be yogurt stores (Pinkberry, etc.). As demand expands new firms enter fairly easily, they hire low wage workers and use simple rental space. Neither the price of low wage workers nor simple rental space is pushed up by the entry of new yogurt stores. b. Positively sloped line increasing cost industry (firms costs rise as new firms enter); an example would be the ethanol industry. Ethanol is made from corn in the U.S. As the demand for ethanol has increased, farmers are farming land that is less productive at producing corn. As the ethanol industry expands and the demand for corn increases, the price of corn increases (without higher prices farmers would not be willing to grow corn on this less productive land). Entry of additional firms that produce ethanol pushes up the price of the inputs that are used in the production process. c. Negatively sloped line decreasing cost industry (firms costs fall as new firms enter); an example would be a restaurant industry in a small town. As the industry expands (perhaps due to population growth or people eating out more because they are wealthier), restaurant supply companies would spring up to provide supplies to the restaurants at lower cost (economies of scale in purchasing and delivering makes it so supply companies can sell the items at a price lower than the cost to an individual restaurant if it were to go out and buy the goods itself). Entry in this case pushes down the cost of operating a restaurant. 14. Explain the confusion about network externalities and a decreasing cost industry (Application 10.4, page 319).

The benefits of network externalities accrue to consumers not to the firms as the industry grows. Network externalities are not an example of a decreasing cost industry, the economies are all on the demand side(as more people join, you get more for your money as a customer). End of Chapter Questions 10.1 (The answer to this question is at end of the textbook.) 10.2 In this case (compared to 10.1) the answer will be different because the supply is no longer fixed. In question 10.1, the supply was either 400 or 1000 pounds. In this question, as demand increases, the fisherman will sell more in Cape May and less elsewhere. This will keep the price from rising as much if there is an increase in consumer demand in Cape May. (a) The lowest price at which flounder will be sold in Cape May: The quantity supplied will be zero when QS = 0 = -1000 + 2000P or when 1000 = 2000P or when P = ($0.50 per pound) If QS = -1000 + 2000P for QS 0, then
Price 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1 Quantity Supplied 0 0 0 0 0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200 2400 2600 2800 3000 3200

2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 4 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 5 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 6 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 7

3400 3600 3800 4000 4200 4400 4600 4800 5000 5200 5400 5600 5800 6000 6200 6400 6600 6800 7000 7200 7400 7600 7800 8000 8200 8400 8600 8800 9000 9200 9400 9600 9800 10000 10200 10400 10600 10800 11000 11200 11400 11600 11800 12000 12200 12400 12600 12800 13000

In the diagram that follows, note that the vertical intercept is $0.50. This means that if the price has to be above $.50/pound for the fishermen to supply fish to this market. See the table above. This holds when QS = -1000 + 2000P for QS 0. As the price rises above $0.50 per pound, the fishermen offer more fish for sale in Cape May. The price in Cape May will be determined by supply (QS = -1000 + 2000P for QS 0) and demand (QD = 1600 600P). See (b) below.
Supply Curve $8.00 Price per Pound of Fish $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 Quantity Supplied - Pounds of Fish per Day

(b) The equilibrium price: the equilibrium price in Cape May will be determined by supply (QS = -1000 + 2000P for QS 0) and demand (QD = 1600 600P). The equilibrium price is the price that clears the market or another way of saying it is that it is the price at which QD = QS At the equilibrium price, the quantity demanded by consumers equals the quantity supplied by fishermen. To find the equilibrium price, set the quantity demanded equal to the quantity supplied: 1600 600P = -1000 + 2000P

2600 = 2600P, so P = $1.00/pound is the equilibrium price in this market. It is the price at which the quantity demanded equals the quantity supplied. To check, when the price is $1.00/pound, QS = -1000 +2000(1) = 1000 QD = 1600 600(1) = 1000 (c) If demand shifts to QD = 2200 600P, the new equilibrium price can again be found by equating the quantity demanded to the quantity supplied and solving for the price that makes the two quantities equal. 2200 600P = -1000 + 2000P 3200 = 2600 P P = 3200/2600 = 32/26 = 16/13 per pound (or about $1.23 per pound) In this case the equilibrium quantity can be found using either the supply or demand equation (now that we have the price), for example: QD = 2200 600 (16/13) = 1461.54 pounds of fish. (d) The price does not rise in this case as much as it does in question 10.1 because in this case there is a supply response. What that means is that supply is not fixed in this case, it responds (increases) in response to the increase in demand. With a perfectly inelastic supply (as in 10.1) there is no increase in the quantity supplied when consumer demand increases and this puts a lot of upward pressure on the price of fish. In 10.2, the higher demand pushes up the price, but this encourages a greater quantity supplied (more is sold in Cape May and less is sold elsewhere as the price rises in Cape May), so the market clearing price (the price at which QS = QD) is not pushed up as high by the increase in consumer demand as it is in 10.1.

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(e)
Supply and Demand
$3.00 $2.50 Price per Pound of Fish $2.00 $1.50 $1.00 $0.50 $0.00 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 Quantity in Pounds of Fish per Day

Demand (1) Demand (2) Supply

You can see in the diagram above that with the original demand, Demand (1), the equilibrium price is $1.00 and the equilibrium quantity is 1,000 pounds of fish. When the demand shifts out to Demand (2), the price rises to $16/13 (about $1.23) and the equilibrium quantity is 1461.54 pounds of fish. 10.3 (The answer to this question is at the end of textbook.) The point this question makes is that the demand facing any one firm is much more elastic than the demand facing the market as a whole. In English, this means that if one firm (alone) raises its price by 1% it will lose a relatively large portion of its sales. For example, if the price of oil is $100 a barrel and ONE firm tries to charge $101/barrel, it will lose almost all its sales (if not all, but in this example, the demand curve tells us it wont lose all its sales). If the price of oil increases by 1% for the industry as a whole, the quantity demanded by consumers will fall by less than 1% (in this example). The demand for the product of any individual firm is always more elastic than the demand for the product as a whole. For example, the demand for Chevrolet automobiles is more elastic than the demand for automobiles as a whole. As another example, if the price of Pepsi goes up 10%, Pepsi may lose 20% of its sales as

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customers buy other brands of soft drinks. If the price of all soft drinks rises by 10% the reduction in sales overall wont be as high.

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