Economics 247 Assignment 2 Version A

Economics 247 Assignment 2 Version A
This assignment has a maximum total of 100 marks and is worth 10% of your total grade for this course. You should complete it after completing your course work for Units 6 through 10. Answer each question clearly and concisely. 1. In perfect competition, one result of the model was that there were no economic profits in the long run. In a monopoly, the firm typically earns a positive economic profit. Why is there this difference? The lack of barriers to entry will allow competitors to enter the market unil economic profit is zero. These firms are price takers, and they cannot affect prices because their demand curve is horizontal.(4 marks)

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2. Assume that a single firm in a pure competitive industry has a fixed cost of \$6500 and variable costs as indicated in the table below.

a. Calculate the TC, AFC, AVC, ATC, and MC columns for this firm. (5 marks)

Total Output
TVC
TC
AFC
AVC
ATC
MC
00
0

600
70,000

1000
76000

1400
81000

1800
87000

2200
90000

2600
93000

2800
96000

3000
100000

3100
110000

b.
Explain the concepts of economies and diseconomies of scale, and describe the underlying reasons why both occur. (4 marks)

3. At its current level of production, a profit-maximizing firm in a competitive market receives \$12.50 for each unit it produces, and it faces an average total cost of \$10. At the market price of \$12.50 per unit, the firm’s marginal cost curve crosses the marginal revenue curve at an output level of 1000 units. What is the firm’s current profit? What is likely to occur in this market and why?(4 marks) P=12.5

TR=P*Q = 12.5 * 1’000 = 12’500
TC=ATC*Q = 10 * 1’000 = 10’000
Profit=TR-TC = 12’500 – 10’000 = +2’500

Profit is positive, but for perfectly competitive markets there will be no profits at all in the long-run, so in this markets new firms will enter market attracted by profits thus increasing market supply and reducing equilibrium price till it reaches close to P=\$10, consequently leading to zero economic profits in long-run. For lower price this firm will be pressed to reduce output a bit for new P=MR=MC equilibrium.

4. a.Why would a firm in a perfectly competitive market always choose to set its price equal to the current market price? If a firm set its price below the current market price, what effect would this have on the market? (4 marks) The assumptions of perfect competition that matter here are that in perfect competition 1 every firm is so small compared to the market so as to have no effect on market price 2 everyone is aware of everybody’s price. Now if you set a price lower than the market, you are only cutting your nose to spite your face since you would sell as much as a higher price. (Remember, how much you produce is determined by your MC and the output level you produce at is the minimum MC). Cutting the price to sell more also costs more to produce; you are worse off.

If you set a price higher than market, noone will buy from you.

Explain how a firm in a competitive market identifies the profit-maximizing level of production. When should the firm raise production, and when should the firm lower production?

In a perfectly competitive market, all firms are assumed to be very small compared to the market.

Now the price is set at the market level, and as a small firm you take it as given; you couldn’t sell at a higher price since nobody would buy from you. Now in the long run, you should be at the minimum point of your cost curve, ensuring you make just normal profits. The price is your MR and at the minimum point of your AC curve your MC cuts it: MC=MR and AC=AR.

If the market price is higher than this, new entrants will sniff the opportunity created by super normal profits and the market supply curve shifts right/up, reducing price until there are no more super ormal profits to be earned.

If market price is lower, then firms are making losses, some exit and supply curve shifts left driving price up.

In equilibrium, each firm is producing at the minmum point of the AC, where MC=MR=P.

Hence the firm temporarily raises production when P>min AC and makes supernormal profits until new entrants drive price back down; or lowers production temporarily when P