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Chapter 8
Competitive Firms and Markets
1.1
a. The ease of entry makes the residual demand curve for the firm flatter. That is because if
the firm raises its price above the market price, other firms can easily enter and cut its
price, thus the quantity it can sell falls drastically.
b. The residual demand curve is more elastic the larger the number of firms in the market.
This is shown in Equation 8.2 in the chapter. The smaller the firm is relative to the total
market the smaller its residual demand.
c. The more elastic the market demand, the flatter will be the residual demand. This is
shown in Equation 8.2. The increase in price will lead to more reduction in demand, and
thus the firm will have less incentive to charge a price different from the market.
d. The more elastic the supply curve of other firms, the flatter will be the residual demand.
This is shown in Equation 8.2. The increase in price will lead to a bigger increase in
output of other firms, and thus the firm will have less incentive to charge a price different
from the market.
1.2 If buyers know the prices that other firms charges—the market price—a firm cannot raise
its price without losing its customers. In contrast, if consumers do not know the prices
that other firms charge, a firm can charge more than other firms without losing all its
customers, so its demand curve is downward sloping. Similarly, if transaction costs are
low, it is easy for a customer to buy from a rival firm if the customer’s usual supplier
raises its price. With high transaction costs, a firm can charge more than other firms
without losing all its customers.
1.4 The effect of a change in the number of firms (n) on a firm’s residual elasticity of
demand (εi) is
∂ε i
= ε − ηo
∂n ,
where ε is the elasticity of market demand and ηo is the elasticity of supply of the other
firms.
2.2 The sunk cost in the short run is $200. So, if it shuts down it loses $200. However, if it
operates it loses $300($1000 - 500 - 800 = -$300). Hence, it should shut down.
2.3 Economic profit is business profits (revenue minus explicit costs) minus the excess
profits that could be realized from alternative uses of the company’s resources (implicit
cost). Even if a company is making a negative economic profit, it may continue to
produce as long as it is making positive business profits. However, it should move to the
alternative use, which will mean making a positive economic profit and more business
profit.
2.4 A firm should shut down only if it can reduce its loss by doing so. "Spider-Man" should
not shut down because its weekly revenue (say, $1.2 million) is greater than its weekly
costs (say, $1 million). By operating, "Spider-Man" reduces its losses by $0.2 million
each week.
2.5 The first-order condition to maximize profit is the derivative of the profit function with
respect to q set equal to zero: 120 – 40 – 20q = 0. Thus, profit is maximized where q = 4,
so that R(4) = 120 × 4 = 480, VC(4) = (40 × 4) + (10 × 16) = 320, π(4) = R(4) – VC(4) – F
= 480 – 320 – 200 = –40. The firm should operate in the short run because its revenue
exceeds its variable cost: 480 > 320.
3.1 Suppose that a U-shaped marginal cost curve cuts a competitive firm’s demand curve
(price line) from above at q1 and from below at q.2. By increasing output to q1 + 1, the
firm earns extra profit because the last unit sells for price p, which is greater than the
marginal cost of that last unit. Indeed, the price exceeds the marginal cost of all units
between q1 and q2, so it is more profitable to produce q2 than q1. Thus, the firm should
either produce q2 or shut down (if it is making a loss at q2). We can also derive this result
using calculus. The second-order condition, Equation 8B.3, for a competitive firm
requires that marginal cost cut the demand line from below at q*, the profit-maximizing
quantity: dMC(q*)/dq > 0.
3.3 The competitive firm’s marginal cost function is found by differentiating its cost function
with respect to quantity: dC(q)/dq = b + 2cq +3dq2. The firm’s necessary profit-
maximizing condition is p = MC = b + 2cq + 3dq2. The firm solves this equation for q for
a specific price to determine its profit-maximizing output.
3.5 See figure below. In the long run, the average cost curve will shift down by the amount of
a per unit subsidy, and the firm’s marginal cost curve, or supply curve, will shift right.
Since the market price will not change significantly with lower costs for one firm, the
firm will increase its output to where its new marginal cost equals market price, and its
profits will go from the market equilibrium of zero to a positive amount.
A per-unit tax of t can be analyzed by increasing the marginal and average costs of
production by t units, as illustrated in the solved problem (Solved Problem 8.2).
Because an individual competitive firm takes price as given (and because the market
price for an individual firm is not affected by the ad valorem tax), an ad valorem tax on
the market price (or on firm revenue) has the same effect on the firm's output and profit
as a comparably-sized per-unit tax. That is, the per unit tax of t increases marginal cost
by the same amount that the ad valorem tax of α percent decreases the individual
firm's after-tax price.
3.8 The after-tax cost function is C = 100 + 10q – q2 + (1/3)q3 + 10q. The firm will maximize
profit by producing the quantity where price equals marginal cost. Marginal cost (MC) is
MC = 10 – 2q + q2 + 10.
Setting price equal to marginal cost, the firm’s production rule is to produce where
p = MC
p = 10 – 2q + q2 + 10
q2 – 2q + 20 – p = 0.
Using the quadratic formula, were a = 1, b = –2, and c = 20 – p,
2 ± −76 + 4 p
q=
2
for p > 19.
3.9 A firm should shut down only if it can reduce its loss by doing so. A firm cannot reduce
its loss by shutting down if revenue is greater than the avoidable cost of production (or, in
a competitive market, if price is greater than the average variable cost of production).
3.10 The logic behind the first claim is that the firm chooses not to charge the full price of one
of the inputs, the rent. The logic for the second claim is that since it is charged a lower
price for one of the inputs, the output price is also lower.
3.11 See figure below. The lower of average minimum variable cost will extend the firm’s
supply curve downward. As a result, the market supply curve shifts rightward.
3.12 Assume the high price in the figure (p2) corresponds to $1,700 per ounce and the low
price in the figure (p1) corresponds to $446 per ounce.
The average and marginal cost curves should be convex (and the marginal cost curve
should be increasing where the firm produces). The marginal cost curve (MC) intersects
the average cost curve (AC) at the average cost curve's minimum. The profit-maximizing
price and quantity at the higher price (p2) is where the marginal cost equals the higher
price. The profit-maximizing price and quantity at the lower price (p1) is where the
marginal cost equals the lower price. (Alternative, the firm may produce no output at a
price of p1 to avoid losses.) For gold extraction to be unprofitable at $446 an ounce, the
firm's average cost curve must be above p1. For gold extraction to be profitable at $1,700
an ounce, the average cost curve must be below p2 for at least some quantities.
For simplicity, assume that the firm produces at both prices.
The firm earns profit at the higher price because this price is greater than the average cost
of producing the profit-maximizing quantity (q2). The profit at the higher price is equal
to the area of a rectangle with a height equal to the difference in the market price (p2) and
the average cost of producing q2 units and a base equal to q2 units. The firm incurs a loss
at the lower price because this price is less than the average cost of producing the profit-
maximizing quantity (q1). At the lower price, the firm's loss is equal to the area of a
rectangle with a height equal to the difference in the market price (p1) and the average
cost of producing q1 units and a base equal to q1 units.
3.14 Some farms did not pick apples so as to avoid incurring the variable cost of harvesting
apples. These farmers left open the question of whether they will harvest in the future if
the price rises above the shut-down level. Other more pessimistic farmers did not expect
price to rise anytime soon, so they bulldozed their trees, leaving the market for good.
(Most planted alternative apples such as Granny Smith and Gala that are more popular
with the public and sell at a price above the minimum average variable cost.)
3.15 In the long run, farms will stay in business if their average cost is at or below the market
price. With a large annual fee (fixed cost), average costs per acre will be lower for the
larger farms than for smaller farms if smaller farms are be unable to produce at the most
efficient (lowest average cost) quantity. See figure below. If there are two types of farms,
small and large, as shown in panel (a), the large farms will have a lower average cost than
the small farms if the least cost quantity per farm is higher than the farm’s capacity.
Whether all of the smaller farms go out of business depends on the number of larger
farms and the shape of the demand curve, as shown in panel (b).
d. See figure below. When the price falls below p1, the firms will shut down temporarily. If
the price is below p2 in the long run, the firms will shut down permanently.
3.17
a. Assuming that the average cost and marginal cost all have a U-shape, a firm’s marginal
and average costs are likely to rise with extra business, at least in the short-term.
b. As shown in the figure below, since the increased demand is only seasonal, it will not
affect firms’ long-run supply curve and the number of firms in the market if there is
considerable entry cost. During peak demand period, firms will operate to the right of the
minimum of the short-run average cost curve.
3.19 As shown in the figure below, due to the lower marginal cost, the long-run average cost
curve shifts downward and firms’ supply curves shift rightward. As a result, the
horizontal market supply curve shifts downward. The entire incidence (benefit) of the
subsidy accrues to consumers.
3.20 Such a tax will not affect the marginal cost of the product because it is the “price” of a
bag and the consumer can choose not to purchase one (they may bring their own bag).
However, the tax incidence will be shared by the grocers and the consumers. The amount
of tax passed on to consumers will be determined by the demand elasticity of grocery
bags.
3.22 The market equilibrium price is where market supply equals market demand. If market
demand shifts, then the new market equilibrium will be where the new demand curve
intersects the market supply curve.
4.3 The shutdown notice reduces the firm’s flexibility, which matters in an uncertain market.
If conditions suddenly change, the firm may have to operate at a loss for six months
before it can shut down. This potential extra expense of shutting down may discourage
some firms from entering the market initially.
4.4 At a long-run equilibrium, firms produce at minimum average cost. Firm average cost
(AC) is
AC = C/q
AC = q,
which is minimized as q approaches zero. Firms earn zero economic profits in long-run
equilibrium. When the market price equals this minimum average cost (AC = 0), firms
earn zero economic profits. Market price approaches zero as the quantity produced
approaches 24. So, in its limit, the long-run equilibrium is where price approaches zero,
4.5 Panel (a) below shows that the average cost decreases with the lower fixed cost as hand-
held camera technology becomes cheaper. The new supply curve is not only lower than
the old one, but has a longer “flat” portion as more firms are able to enter the market
without the higher cost of entry. Price decreases and consumption increases assuming a
downward-sloping demand curve.
4.6 If the world demand curve crosses the supply curve in the flat section of the Brazil
supply, there will be a unique equilibrium price and quantity, and Pakistan, Argentina,
Australia, and some Brazilian firms will provide cotton. If the world demand curve
crosses the supply curve in the following vertical section, all of the Brazilian firms will
supply, but the price will still not be high enough for Turkey or Nicaragua to produce. In
either case, farmers in the United States will not supply cotton.
4.7 Suppose the market quantity increases due to an increase in demand, increasing industry
output and lowering market price from p1 to p2.
The initial profit-maximizing price and quantity is where the initial marginal cost curve,
MC1, hits the horizontal demand curve, p1. When market demand increases, increasing
the equilibrium market output, the cost of production decreases, decreasing each
individual firm's marginal cost and long-run average cost curves (to MC2 and AC2). The
profit-maximizing price and quantity at the new market price is where the lower marginal
cost curve MC2 hits the horizontal demand curve, p2. The new long-run market
equilibrium is where the new market price, p2, equals the minimum long-run average cost
of production (on AC2).
4.8 To derive the expression for the elasticity of the residual or excess supply curve in
Equation 8.7, we differentiate the residual supply curve (Equation 8.6), S r(p) = S(p) -
Do(p), with respect to p to obtain
dS r dS dD o
= − .
dp dp dp
Let Qr = S r(p), Q = S(p), and Qo = D(p). We multiply both sides of the differentiated
expression by p/Qr, and for convenience, we also multiply the second term by Q/Q = 1
and the last term by
Qo/Qo = 1:
dS r p dS p Q Q dD o p Qo
= − − .
dp Qr dp Qr Q Q dp Qr Qo
We can rewrite this expression as Equation 8.7,
η 1−θ
nr = − ε ,
θ θ o
4.9 See the answer to Question 4.8 for details on the residual supply elasticity:
a. The incidence of the federal specific tax is shared equally between consumers and firms,
whereas the firms bear virtually none of the incidence of the state tax (they pass the tax
on to consumers).
b. From Chapter 3, we know that the incidence of a tax that falls on consumers in a
competitive market is approximately h/(h – e). Although the national elasticity of supply
may be a relatively small number, the residual supply elasticity facing a particular state is
very large. Using the analysis about residual supply curves, we can infer that the supply
curve to a particular state is likely to be nearly horizontal—nearly perfectly elastic. For
example, if the price rises even slightly in Maine relative to Vermont, suppliers in
Vermont will be willing to shift up to their entire supply to Maine. Thus, we expect the
incidence on consumers to be nearly one from a state tax but less from a federal tax,
consistent with the empirical evidence.
c. If all 50 states were identical, we could write the residual elasticity of supply equation as
hr = 50h – 49eo.
Given this equation, the residual supply elasticity to one state is at least 50 times larger than
the national elasticity of supply, ηr ≥ 50η , because eo < 0, so the -49eo term is positive and
increases the residual supply elasticity.
4.10 See figure below. Assume each firm uses the same size plant in the short and the long
run. Before the change in demand, the market will have reached a long-run equilibrium,
where each firm produces Q1 at the minimum average cost, the market produces where
the long-run supply curve intercepts the demand curve, and there will be N1 firms
producing. When demand shifts to D2, in the short run each firm will increase production
to Q2. If the shift is expected to be permanent, in the long run more firms will enter
increasing their number to N2, each producing once again Q1. If the shift is temporary,
demand will eventually shift back down, and the number of firms and quantity will revert
to the original levels.
Suppose the top figure to the right shows the cost of production for a representative non-
Internet travel agent in 1975 (with marginal cost of MC1 and long-run average costs of
LRAC1). Throughout the analysis, assume the non-Internet travel agents are identical.
5.1 In either case, marginal cost is unaffected. The only difference is the magnitude of the
upward shift in average cost. If the same amount of tax is collected every year instead of
only once, the average cost curve is shifted upward by more due to the increase intotal
tax (fixed cost), and long-run supply is shifted upward due to the increase in the
minimum point of the average cost.
5.2 In the short run, since there is no change in marginal cost, there will be no change in the
equilibrium output level or price. Profits will be reduced by the amount of the tax. The
only exception is if the firms were close enough to the shut-down point such that the
payment of the tax increases losses beyond fixed costs (assuming payment of the tax is
5.3 See figure below. We assume that Mexican costs are lower than U.S. costs, but that the
number of Mexican truckers is limited. If the demand curve looks like D1, all U.S.
truckers would be replaced by Mexican truckers as the new supply curve becomes
stepped, as in panel (b). If there is higher demand, the U.S. may still retain some trucking,
but it will be greatly reduced to QT – QM2 . If the number of Mexican firms is unlimited,
U.S. trucking firms will be forced out of the market.
5.4 The market supply curve is horizontal at the minimum average cost of a typical clinic. A
lump-sum tax that caused the minimum average cost to rise by 10% would cause the
market supply curve to shift up by the amount of the tax, so the price of abortions would
rise by 10%. Given that the price elasticity of demand is -1.071, the number of abortions
would fall by about 9.3%.
Muorin tarina.
— Jos teillä joskus olisi ollut se, jatkoi eukko, niin myöntäisitte,
että se on vielä paljon pahempaa kuin maanjäristys.
"Aga", joka oli hyvin naisiin menevä mies, vei koko haareminsa
mukanaan ja sijoitti meidät Palus-Meotiksen rannalla olevaan
pieneen linnoitukseen, jonka suojelijoiksi hän jätti kaksi mustaa
eunukkia ja kaksikymmentä sotilasta. Ryssiä tapettiin summattomat
määrät ja he antoivat takaisin samalla mitalla. Koko Asova oli
pelkkää verta ja tulta. Ei mitään ikäkautta eikä sukupuolta säästetty.
Lopulta oli valloittamatta enää vain meidän pieni linnoituksemme ja
viholliset päättivät kukistaa meidät nälällä. Nuo kaksikymmentä
janitsaaria olivat vannoneet olla antautumatta ja kun nälänhätä kävi
aivan sietämättömäksi, katsoivat he olevansa pahoitetut syömään
nuo meidän kaksi eunukkiamme, jotta heidän ei tarvitsisi rikkoa
valaansa. Muutamien päivien kuluttua he päättivät syödä myöskin
naiset.
Kun kaunis Kunigunda oli kuullut muorin tarinan, osoitti hän tälle
kaikkea sitä kunnioitusta, minkä niin ansiokas ja korkeasäätyinen
henkilö oli oikeutettu saamaan. Hän otti myös varteen hänen
ehdotuksensa sekä pani kaikki matkustajat vuoron perään
kertomaan elämäntarinansa. Kunigundan ja Candiden täytyi
myöntää, että muori oli oikeassa.
Tieto siitä että "alkadi" oli tullut kaupunkiin ottamaan kiinni suur-
inkvisiittorin murhaajia, levisi heti kaikkialle.
Viisas muori oli heti selvillä siitä, kuinka tässä tapauksessa oli
meneteltävä.
Hän oli hyvin kaunis nuori mies, jolla oli täyteläiset posket, hieno,
valkea ja verevä iho, kaarevat kulmakarvat, eloisat silmät, ruusuiset
korvat, heleänpunaiset huulet. Hän oli ylpeän näköinen, mutta ei
samalla tavoin kuin espanjalaiset tai jesuiitat. Candidelle ja
Cacambolle annettiin takaisin aseet, jotka heiltä äsken oli riistetty,
samoin nuo molemmat andalusialaiset hevoset. Cacambo antoi niille
kauraa lehtimajan kuistin suulla ja piti kaikkien äkkiyllätysten varalta
koko ajan niitä tiukasti silmällä.
— Missä?