Lecture 11: Perfect Competition (I)
Suggested questions and exercises (Pindyck and Rubinfeld, Ch.8).
Questions: 1, 2, 5, 8, 9,10
Exercises: 4, 5, 6, 7, 8
Why would a firm that incurs losses choose to produce rather than shut down?
Losses occur when revenues do not cover total costs.
Revenues could be greater
than variable costs, but not total costs, in which case the firm is better off
producing in the short run rather than shutting down, even though they are
incurring a loss.
The firm should compare the level of loss with no production to
the level of loss with positive production, and pick the option that results in the
In the short run, losses will be minimized as long as the firm
covers its variable costs.
In the long run, all costs are variable, and thus, all
costs must be covered if the firm is to remain in business.
2. Explain why the industry supply curve is not the long-run industry marginal
In the short run, a change in the market price induces the profit-maximizing
firm to change its optimal level of output.
This optimal output occurs when
price is equal to marginal cost, as long as marginal cost exceeds average
Therefore, the supply curve of the firm is its marginal cost curve,
above average variable cost.
(When the price falls below average variable cost,
the firm will shut down.)
In the long run, the firm adjusts its inputs so that its long-run marginal cost is
equal to the market price.
At this level of output, it is operating on a short-run
marginal cost curve where short-run marginal cost is equal to price.
long-run price changes, the firm gradually changes its mix of inputs to minimize
Thus, the long-run supply response is this adjustment from one set of
short-run marginal cost curves to another.
Note also that in the long run there will be entry and the firm will earn zero
profit, so that any level of output where MC>AC is not possible.
Why do firms enter an industry when they know that in the long run economic
profit will be zero?
Firms enter an industry when they expect to earn economic profit.
run profits are enough to encourage entry.
Zero economic profits in the long run
returns to the factors of production, including the labor and
capital of the owners of firms.
For example, the owner of a small business
might experience positive accounting profits before the foregone wages from
running the business are subtracted from these profits.
If the revenue minus
other costs is just equal to what could be earned elsewhere, then the owner is
indifferent to staying in business or exiting.
An increase in the demand for video films also increases the salaries of actors and
Is the long-run supply curve for films likely to be horizontal or upward