ps9ans - UNIVERSITY OF WISCONSIN Economics 101 Fall 2005...

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UNIVERSITY OF WISCONSIN Economics 101 – Fall 2005 Wei Zhang Problem Set 9 – ANSWER KEY Perfect Competition (Chapter 14): Short Run and Long Run 1) Begin by looking at the long run equilibrium (LRE). Notice that it must be true in LRE that profit = 0. This means that P = ATC (since one way of writing profit is π = TR – TC = (P-ATC)*q). But since firms always maximize profits by producing where MR = MC , and since MR = P* in perfect competition , it must be true in LRE, that MR = P* = MC = ATC. Thus, you can always find the long run equilibrium price by looking at the intersection of MC and ATC . Below, this gives us q* and P* from the firm’s picture. This equilibrium price must be the industry price as well – which means D and S intersect at P* and Q* in the industry picture. Notice that you can figure out the number of firms in long run equilibrium by dividing Q*, the total quantity supply in the industry, by q*, the quantity produced be each firm. That is, the number of firms, n = (Q*/q*). You may be wondering how we can guarantee that in the LRE, supply and demand will intersect right at the P* that insures P = MC = ATC. The answer: the supply curve will adjust to make this true, via firm entry and exit. To see this better, let’s work through an example. Page 1 of 6 q $ MC ATC P* Firm Q P P* Industry Demand MR = P* = Firm’s demand Market Supply Q* q*
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Example: Suppose firms are making profit in the short run. If firms are making profit in the short run, this must mean that P* > ATC. Again, since firms maximize profit by setting MR = MC, and since MR = P* in perfect competition, we see that P* = MR = MC > ATC. Graphically, we can use this profit maximization condition (MR = P* = MC) to see that each firm will produce q* in the short run. Note that profit can be seen as the shaded area below, where π = TR – TC = (P-ATC)*q. In the short run, that’s the end of the story; every firm produces q* (above), there are n = Q*/q* firms in the market, profits are positive, and everyone is happy. BUT – since there are positive profits to be had, other folks want to enter the
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This note was uploaded on 07/28/2010 for the course ECON 101 taught by Professor Hansen during the Fall '07 term at Wisconsin.

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ps9ans - UNIVERSITY OF WISCONSIN Economics 101 Fall 2005...

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