CHAPTER 09 PURE COMPETITION IN THE LONG RUN

CHAPTER 11 OECD AVERAGE AND OECD TOTAL BOX
 CONTENTS PREFACE IX INTRODUCTION 1 REFERENCES 5 CHAPTER
 NRC INSPECTION MANUAL NMSSDWM MANUAL CHAPTER 2401 NEAR‑SURFACE

32 STAKEHOLDER ANALYSIS IN THIS CHAPTER A STAKEHOLDER ANALYSIS
CHAPTER 13 MULTILEVEL ANALYSES BOX 132 STANDARDISATION OF
CHAPTER 6 COMPUTATION OF STANDARD ERRORS BOX 61

Ch 9 Insert G

Chapter 09 - Pure Competition in the Long Run

Chapter 09 Pure Competition in the Long Run



QUESTIONS


1. Explain how the long run differs from the short run in pure competition. LO1


Answer: The entry and exit of firms in our market models can only take place in the long run. In the short run, the industry is composed of a specific number of firms, each with a plant size that is fixed and unalterable in the short run. Firms may shut down in the sense that they can produce zero units of output in the short run, but they do not have sufficient time to liquidate their assets and go out of business.

In the long run, by contrast, the firms already in an industry have sufficient time to either expand or contract their capacities. More important, the number of firms in the industry may either increase or decrease as new firms enter or existing firms leave.


2. Relate opportunity costs to why profits encourage entry into purely competitive industries and how losses encourage exit from purely competitive industries. L02


Answer: Entry or exit will continue until the market price determined by industry supply interacting with market demand generates a normal profit for firms in the industry. With firms earning a normal profit, there will be no incentive to either enter or exit the industry. This situation constitutes long-run equilibrium in a purely competitive industry. Remember that normal profit is our measure of opportunity cost.


3. How do the entry and exit of firms in a purely competitive industry affect resource flows and longrun profits and losses? LO3


Answer: Entry and exit help to improve resource allocation. Firms that exit an industry due to low profits release their resources to be used more profitably in other industries. Firms that enter an industry chasing higher profits bring with them resources that were less profitably used in other industries. Both processes increase allocative efficiency.

In the long run, the market price of a product will equal the minimum average total cost of production. Thus, long run economic profits are zero.


4. Using diagrams for both the industry and a representative firm, illustrate competitive longrun equilibrium. Assuming constant costs, employ these diagrams to show how (a) an increase and (b) a decrease in market demand will upset that longrun equilibrium. Trace graphically and describe verbally the adjustment processes by which longrun equilibrium is restored. Now rework your analysis for increasing and decreasingcost industries and compare the three longrun supply curves. LO4


Answer: See Figures 9.1 and 9.2 and their legends for the answers to (a) and (b) above. See Figure 9.4 for the supply curve for an increasing cost industry and Figure 9.5 for the supply curve for a decreasing cost industry.



CHAPTER 09  PURE COMPETITION IN THE LONG RUN





CHAPTER 09  PURE COMPETITION IN THE LONG RUN

CHAPTER 09  PURE COMPETITION IN THE LONG RUN


CHAPTER 09  PURE COMPETITION IN THE LONG RUN


5. In longrun equilibrium, P = minimum ATC = MC. Of what significance for economic efficiency is the equality of P and minimum ATC? The equality of P and MC? Distinguish between productive efficiency and allocative efficiency in your answer. LO5


Answer: The equality of P and minimum ATC means the firms is achieving productive efficiency; it is using the most efficient technology and employing the least costly combination of resources. The equality of P and MC means the firms is achieving allocative efficiency; the industry is producing the right product in the right amount based on society’s valuation of that product and other products.


6. Suppose that purely competitive firms producing cashews discover that P exceeds MC. Will their combined output of cashews be too little, too much, or just right to achieve allocative efficiency? In the long run, what will happen to the supply of cashews and the price of cashews? Use a supply and demand diagram to show how that response will change the combined amount of consumer surplus and producer surplus in the market for cashews. LO5


Answer: The combined output is too little to achieve allocative efficiency. The marginal benefit of producing more cashews (as measured by P) exceeds the cost of the resources necessary to produce them.

In the long run, the supply will increase as firms enter (or expand) to capture the economic profits being earned. The increase in supply will reduce the price of cashews.



The increase in supply will unambiguously increases the combined area under the demand curve and above the supply curve (consumer surplus and producer surplus, respectively). See figure 9.6b for reference.


7. The basic model of pure competition reviewed in this chapter finds that in the long run all firms in a purely competitive industry will earn normal profits. If all firms will only earn a normal profit in the long run, why would any firms bother to develop new products or lowercost production methods? Explain. LO6


Answer: Competition involves the never-ending attempts by entrepreneurs and managers to earn above-normal profits by either creating new products or developing lower-cost production methods for existing products. These efforts cause creative destruction, the financial undoing of the market positions of firms committed to existing products and old ways of doing business by new firms with new products and innovative ways of doing business. That is, if firms can innovate they can earn economic profit in the short run.


8. “Ninety percent of new products fail within two years—so you shouldn’t be so eager to innovate.” Do you agree? Explain why or why not. LO6


Answer: If your firm happens to be one of the 10% that succeed you can capture short run economic profits. You may even qualify for a patent on your product which allows you to act as a monopolist for a given amount of time. So, if you can capture enough expected economic profit in the short run to cover your initial investment then it is worthwhile to innovate. (This argument ignores risk. If you add risk to the investment story then you will need to receive additional expected economic profit to undertake the investment to innovate.)


9. LAST WORD How does a generic drug differ from its brandname, previously patented equivalent? Explain why the price of a brandname drug typically declines when an equivalent generic drug becomes available? Explain how that drop in price affects allocative efficiency.


Answer: Chemically there is typically no difference between a generic drug and its brand-name equivalent. There may be a difference in the market because consumers tend to react more favorably to brand names they recognize.

Despite the advantage of name recognition, the brand-name drug will typically drop in price because it now has competition. The patent granted it monopoly power, allowing the firm producing it to charge a higher price and earn economic profits.

Under monopoly conditions (with the patent), the firm producing the brand-name drug sets price above marginal cost (P>MC). As the market becomes competitive, production will increase and price and marginal cost will converge (see the Last Word figure).


PROBLEMS


1. A firm in a purely competitive industry has a typical cost structure. The normal rate of profit in the economy is 5 percent. This firm is earning $5.50 on every $50 invested by its founders. What is its percentage rate of return? Is the firm earning an economic profit? If so, how large? Will this industry see entry or exit? What will be the rate of return earned by firms in this industry once the industry reaches long-run equilibrium? LO3


Answers: Percentage rate of return is 11 percent (= $5.50/$50); Yes, it is earning an economic profit; It’s economic profit is 6 percent (= 11 percent – 5 percent); This industry will see entry; Once the industry reaches equilibrium, firms in the industry will earn the economy’s normal rate of profit, 5 percent.


Feedback: Consider the following example. The normal rate of profit in the economy is 5 percent. This firm is earning $5.50 on every $50 invested by its founders.

Since the firm is earning $5.50 on every $50 invested, the percentage rate of return is 11% (= ($5.50 / $50) x 100).

Yes, the firm is earning an economic profit of 6%, which equals the difference between the actual percentage rate of return and the normal rate of profit in the economy (=11%-5%).

This industry will see entry because the rate of return is greater than the normal rate of profit (economic profit is positive) resources could earn on average in other industries.

In the long run firms in this industry will earn the normal rate of profit. This is when entry of new firms stops.


2. A firm in a purely competitive industry is currently producing 1000 units per day at a total cost of $450. If the firm produced 800 units per day, its total cost would be $300, and if it produced 500 units per day, its total cost would be $275. What are the firm’s ATC per unit at these three levels of production? If every firm in this industry has the same cost structure, is the industry in longrun competitive equilibrium? From what you know about these firms’ cost structures, what is the highest possible price per unit that could exist as the market price in longrun equilibrium? If that price ends up being the market price and if the normal rate of profit is 10 percent, then how big will each firm’s accounting profit per unit be? LO5


Answers: The firms’ ATC per unit at 1000 units per day is $0.45 (= $450/1000); at 800 units per day it is $0.38 (= $300/800); and at 500 units per day it is $0.55 = ($275/500). This industry is not in long-run equilibrium because the firms in the industry are not producing at the minimum point on their ATC curves—they are producing at an output level higher than minimum ATC. From what we know of these three output levels, the highest that the long-run equilibrium price could be is $0.38 since that is the lowest of the three ATC per unit that we know and in long-run equilibrium firms must be producing at the lowest possible ATC per unit. If $0.38 ends up being the market equilibrium price in the long run and if the normal profit rate that must hold in long-run equilibrium is 10%, then the firm must be earning a normal profit of 3.8 cents per unit (= 10% * $0.38).


Feedback: Consider the following example. A firm in a purely competitive industry is currently producing 1000 units per day at a total cost of $450. If the firm produced 800 units per day, its total cost would be $300, and if it produced 500 units per day, its total cost would be $275.

What are the firm’s ATC per unit at these three levels of production? The average total cost (ATC) is found by dividing total cost by the number of units being produced. ATC for 1000 units is $0.45 (=$450 / 1000). ATC for 800 units is $0.375 (=$300 / 800). ATC for 500 units is $0.55 (=$250 / 550).


If every firm in this industry has the same cost structure, is the industry in longrun competitive equilibrium? No, because the firm is producing 1000 (as stated in the question) this industry cannot be in long-run equilibrium because it is not producing at the lowest ATC (ATC at 1000 units is greater than ATC at 800 units).


From what you know about these firms’ cost structures, what is the highest possible price per unit that could exist as the market price in longrun equilibrium? The highest possible price that could be supported in the long-run is the lowest ATC in the industry. Given the information above this is $0.375 or $0.38 after rounding.


Given that the long-run market price is $0.38 and if the normal rate of profit is 10 percent, then how big will each firm’s accounting profit per unit be? Since the normal rate of profit is 10% and the firm will charge $0.38 for each unit in the long run, the accounting profit will be $0.038 (3.8 cents per unit). This is 10% of the price (=.10 x $0.38).



3. There are 300 purely competitive farms in the local dairy market. Of the 300 dairy farms, 298 have a cost structure that generates profits of $24 for every $300 invested. What is their percentage rate of return? The other two dairies have a cost structure that generates profits of $22 for every $200 invested. What is their percentage rate of return? Assuming that the normal rate of profit in the economy is 10 percent, will there be entry or exit? Will the change in the number of firms affect the two that earn $22 for every $200 invested? What will be the rate of return earned by most firms in the industry in longrun equilibrium? If firms can copy each other’s technology, what will be the rate of return eventually earned by all firms? LO5


Answers: The 298 dairies earn an 8 percent (= $24/$300) rate of return while the two other dairies earn an 11 percent (= $22/$200) rate of return. Because the normal rate of return of 10% is higher than the 8 percent earned by the 298 dairies, there will be exit. The exit will not affect the two dairies that are earning 11 percent returns because they are earning above-normal returns and thus do not have any incentive to exit. In long-run equilibrium, most firms (the ones that remain from the original 298) will earn the normal 10% rate of return. If firms can copy the technology used by the two more efficient firms, then all firms will end up earning the normal 10% rate of return after all firms have copied the better technology and expanded output until the increase in market supply brings down the market price low enough that all firms in the industry are earning the normal profit.


Feedback: Consider the following example. There are 300 purely competitive farms in the local dairy market. Of the 300 dairy farms, 298 have a cost structure that generates profits of $24 for every $300 invested. The other two dairies have a cost structure that generates profits of $22 for every $200 invested. Also, assume that the normal rate of profit in the economy is 10 percent.

The percentage rate of return for the firms is found by dividing profits by the amount invested. This is multiplied by 100 to convert into percentage form. The percentage rate of return for the 298 firms is 8% (= ($24 / $300) x 100). The percentage rate of return for the 2 firms is 11% (= ($22 / $200) x 100).


Will there be entry or exit in this industry? There will be exit in this industry because the normal rate of profit is 10% and the 298 firms are only earning a return of 8%. That is, firms will exit this industry and invest their resources in other industries which are on average are earning 10%. This will not affect the 2 firms that are earning an 11% rate of return on their investment.


What will be the rate of return earned by most firms in the industry in longrun equilibrium? To stop the exit of firms from this industry, the firms will need to earn a 10% rate of return. This equals the normal rate of profit in the economy.


If firms can copy each other’s technology, what will be the rate of return eventually earned by all firms? If firms can copy the technology used by the two more efficient firms, then all firms will end up earning the normal 10% rate of return after all firms have copied the better technology and expanded output until the increase in market supply brings down the market price low enough that all firms in the industry are earning the normal profit.


9-7

© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


CONFIGURING USER STATE MANAGEMENT FEATURES 73 CHAPTER 7 IMPLEMENTING
INTERPOLATION 41 CHAPTER 5 INTERPOLATION THIS CHAPTER SUMMARIZES POLYNOMIAL
PREPARING FOR PRODUCTION DEPLOYMENT 219 CHAPTER 4 DESIGNING A


Tags: chapter 09, this chapter, competition, chapter