Ch09 - Chapter 9 Perfectly Competitive Markets Solutions to Review Questions 1 The difference between accounting profit and economic profit is in

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Chapter 9 Perfectly Competitive Markets Solutions to Review Questions 1. The difference between accounting profit and economic profit is in how total cost is measured. With accounting profit, total cost is measured as total accounting cost while with economic profit, total cost is measured as total economic cost. Accounting cost measures the historical expenses the firm incurred to produce and sell its product while economic cost measured the opportunity cost of the resources that the firm uses to produce and sell its product. If a firm chose to produce and sell a product it could earn a positive accounting profit but negative economic profit. This would occur if the economic cost of the resources used was greater than the accounting cost of the resources used. For example, the firm might purchase resources for $1 million and use these to produce a product when instead the firm could have resold the resources for $2 million. In this case the economic cost exceeds the accounting cost and economic profit would be less than accounting profit. 2. The law of one price ensures that all transactions will take place at a single market price. A perfectly competitive firm cannot affect the market price by increasing or decreasing production. Therefore, for each unit produced and sold, the firm will receive the market price as revenue. Revenue will increase with each unit sold by the market price, implying the market price is equal to marginal revenue. 3. A perfectly competitive firm would not produce if the market price is below the minimum of its average variable cost. If the firm shuts down, the “bad news” is that it loses revenue. The “good news” is that the firm avoids non-sunk costs (including variable costs). If the market price is below the minimum of the firm’s average variable cost, the good news from shutting down outweighs the bad news. If the market price is below the minimum of the firm’s short-run average cost, the decision as to whether the firm should shut down depends on how much of the fixed costs are non-sunk (avoidable). Suppose first that all of the fixed costs are non-sunk. If the firm shuts down, the “bad news” is that it loses revenue. The “good news” is that the firm avoids variable costs, as well as all of the fixed costs. If the market price is below the minimum of the firm’s short-run average cost, the good news from shutting down outweighs the bad news. Now suppose that some of the fixed costs are sunk. Then for at least some levels of market price below the minimum of short-run average cost, the revenue lost Page 9 - 1
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may be greater than the costs that can be avoided if the firm shuts down. For such a market price, the firm would be better off continuing to operate in the short-run, because its losses from operating would be less than the losses it would sustain if it were to shut down. 4.
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This note was uploaded on 09/24/2008 for the course PAM 2000 taught by Professor Evans,t. during the Fall '07 term at Cornell University (Engineering School).

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Ch09 - Chapter 9 Perfectly Competitive Markets Solutions to Review Questions 1 The difference between accounting profit and economic profit is in

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