Perfect Competition

Which of the following is a characteristic of perfectly competitive markets?

• restricted entry to new firms

• market power

• homogenous goods

• firms set the price they charge

Answer explanation

All firms in a perfectly competitive market sell homogeneous goods, meaning that all goods in the market are perfectly identical. For example, if the market for sausage is perfectly competitive, all firms sell sausage that tastes

identical to every other firms’ sausage.

Which of the following best describes a firm’s demand curve in a perfectly competitive market?

• downward sloping

• straight and horizontal

• upward sloping

• downward sloping then upward sloping

Answer explanation

The individual firm’s demand in a perfectly competitive market is horizontal at the market price because it can sell however much it wants at that market price. It doesn’t need to decrease price to increase the quantity demanded of its

good.

Which of the following best describes the profit-maximizing rule for a perfectly competitive firm?

• Choose the price where its marginal revenue is highest.

• Choose the price where average total cost equals average revenue.

• Choose the quantity where marginal cost equals average total cost.

• Choose the quantity where marginal cost equals price.

Answer explanation

The profit-maximizing rule is to produce the quantity where marginal cost equals marginal revenue. For a perfectly competitive firm, its marginal revenue equals the market price.

This graph shows the cost curves and marginal revenue curves for a firm. How much is this firm’s profit?

• -$135,000

• $450,000

• $950,000

• $400,000

Answer explanation

Profit is the profit-maximizing choice of quantity multiplied by the difference between price and average total

cost:

If a firm produces the quantity where the private marginal cost of the last unit produced equals the private marginal

benefit of the last good consumed, which of the following must also be true?

• All firms are making losses

• All firms are earning a profit

• The firm is cost-efficient.

• The quantity produced is allocatively efficient.

Answer explanation

When the marginal cost of the last unit produced equals the marginal benefit of the last unit produced, then the amount produced is allocatively efficient. A perfectly competitive firm produces an allocatively efficient quantity.

Eggs are a normal good sold in a perfectly competitive market that is currently in long-run equilibrium. How will price, output, and profit change if consumer incomes increase?

• price decreases; output increases; profit decreases

• price increases; no change in output; no change in profit

• price increases; output increases; profit increases

• price decreases; output decreases; profit increases

Answer explanation

The market demand for a normal good increases when income increases which raises the price of eggs. When price increases, a perfectly competitive firm’s marginal revenue increases, so the profit-maximizing level of output increases. An increase in price also increases profit.

Fried Breads Revisited is a food truck in a perfectly competitive industry. Its total cost of producing 100 donuts is $300 and the market price for a donut is $4. If this firm is representative of a typical firm in the market, which of the following can be inferred?

• The marginal cost of the 100th unit is greater than $4.

• Firms will enter this market in the long run.

• There is no incentive for firms to enter or exit this market.

• This firm is earning economic loss.

Answer explanation

This firm is earning a profit because its average total cost is $3 and its price is $4.When firms are earning profits, they are operating on the increasing portion of their average total cost curve. Also, when firms earn profits, this attracts

other firms into the industry.

If a firm in a perfectly competitive market chooses its profit-maximizing quantity, which of the following MUST be

true?

• MR > MC

• P = MC

• MC > ATC

• MR < P

Answer explanation

A profit-maximizing firm in a competitive market chooses the quantity where marginal revenue equals marginal cost (MC). A perfectly competitive firm’s marginal revenue equals the market price, so the price must also equal MC.

Which of following best describes a perfectly competitive firm in the short run and the long run?

• Short run: productively efficient only; long run: allocatively efficient only

• Short run: neither allocatively efficient nor productively efficient; long run: neither allocatively efficient nor

  productively efficient

• Short run: allocatively efficient; long run: allocatively efficient and productively efficient

• Short run: allocatively efficient and productively efficient; long run: neither allocatively efficient nor productively

  efficient

Answer explanation

Allocative efficiency occurs when a firm produces the quantity where marginal benefit (MB) equals marginal cost (MC). A perfectly competitive firm always produces the allocatively efficient quantity because the good’s price reflects its marginal benefit, and a perfectly competitive firm always produces where P=MR=MC. Productive efficiency

occurs when a firm produces the quantity where average total cost is minimized, and a perfectly competitive firm produces this quantity in the long run.

The market for happy face stickers is perfectly competitive, and the market price for these stickers is greater than the

average total cost (ATC) of a typical firm. Which of the following is true about this market?

• Firms are earning positive economic profits and more firms will enter this industry.

• Firms are producing an allocatively inefficient quantity and firms will exit this industry.

• Firms are charging prices higher than the marginal cost of producing stickers.

• Firms are producing a cost-efficient quantity

Answer explanation

Economic profit is positive when the price is greater than ATC, and firms enter an industry with free entry and exit when there are economic profits.