Competitive Markets: Questions & Answers Q10.1

Chapter 10
COMPETITIVE MARKETS
QUESTIONS & ANSWERS

Q10.1
Historically, the Regional Bell Operating Companies (RBOCs) had a monopoly on

the provision of local voice phone service. Regulation has now been eased to permit
competition from Competitive Local Exchange Carriers (CLECs), cable companies,
satellite operators and wireless competitors. Is the local phone service market likely
to become a vigorously competitive market?
Q10.1
ANSWER
The local voice phone service market is not one likely to support dozens of
competitors in each local market, but competition among the few can become
vigorous in this market. Market structure is described in terms of the complete array
of industry characteristics that directly affect the price/output decisions made by
firms. Primary elements of market structure include: the number and size
distribution of actual sellers and buyers as well as potential entrants, the degree of
product differentiation, the availability and cost of information regarding prices and
output quality, and conditions of entry and exit. All of these elements of market
structure can have important consequences for the vigor of competition in the local
voice phone service market, and for the price/output decisions made by firms. The
technology for voice phone service that is clear and reliable can be offered by many
firms. Thus, product quality is becoming homogenous. Brutal price competition is
sure to erupt in this market as voice over the Internet (VoIP) service becomes widely
available.
Q10.2
One way of inferring competitive conditions in a market is to consider the lifestyle

enjoyed by employees and owners. In vigorously competitive markets, employee
compensation tends to be meager and profits are apt to be slim. Describe the
perfectly competitive market structure and provide some examples.
Q10.2
ANSWER
Perfect competition is a market structure characterized by a large number of buyers
and sellers of an essentially identical product, where each market participant's
Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
- - 257 - -
transactions are so small that they have no influence on the market price of the
product. Individual buyers and sellers are price takers. This means that they take
market prices as given, and devise their production strategy accordingly. Free and
complete demand and supply information is available in a perfectly competitive
market, and no meaningful barriers to entry and exit are present. As a result,
vigorous price competition is prevalent, and only a normal rate of return on
investment is possible in the long-run. Excess profits are possible only in periods of
short-run disequilibrium before rivals are able to mount an effective competitive
response.
Examples of perfectly competitive markets include: agricultural markets for
corn, wheat, soybeans and other grains; commodity, stock and bond markets; and
unspecialized input markets (e.g., unskilled labor), among others. Many retail
markets, like gas stations, are also vigorously competitive.
Q10.3
Competitive firms are sometimes criticized for costly but superfluous product
differentiation. Is there an easy means for determining if such efforts are in fact
wasteful?
Q10.3
ANSWER
Yes. A simple market test is the most effective means available for determining if
customers value real or perceptual differences in the quality of goods and services.
Sources of valuable product differentiation include physical differences, such as
those due to superior research and development, plus any useful perceived
differences due to effective advertising and promotion. Price competition tends to be
most vigorous for homogenous products with few actual or perceived differences. If
firms spend money on superfluous product differentiation, these added costs will not
translate into added benefits for consumers, and consumers will not pay higher prices
to cover such costs.
Q10.4
The Worker Adjustment and Retraining Notification Act (WARN) requires employers
with 100 or more employees to provide notification 60 calendar days in advance of
plant closings and mass layoffs. Advance notice gives workers and their families
transition time to adjust to the prospective loss of employment, seek other jobs, or get
necessary training. Some employers complain that WARN reduces necessary
flexibility and makes them reluctant to open new production facilities. How are
barriers to entry and exit similar? How are they different?
Q10.4
ANSWER
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A barrier to entry is defined as any factor or industry characteristic that creates an

advantage for incumbents over new arrivals. Legal rights such as patents and local,
state, or federal licenses can present formidable barriers to new entry in
pharmaceutical, cable television, television and radio broadcasting, and other
industries. Additional factors that sometimes create barriers to entry include
substantial economies of scale, scope economies, large capital or skilled labor
requirements, and ties of customer loyalty created through advertising and other
means. Factors giving rise to a barrier to entry can sometimes result in compensating
advantages for consumers. Although patents can lead to monopoly profits for
inventing firms, they also spur valuable new product and process development. And,
although extremely efficient or innovative leading firms make entry and nonleading
firm growth difficult, they can have the favorable effect of lowering industry prices
and increasing product quality. Therefore, a complete evaluation of the economic
effects of entry barriers involves a consideration of both costs and benefits, if any.
Whereas barriers to entry have the potential to impede competition by making
entry or growth difficult, competitive forces can also be diminished through barriers
to exit. A barrier to exit is any restriction on the ability of incumbents to redeploy
assets from use in one industry or line of business to another. During the late 1980s,
for example, several state governments initiated legal proceedings in order to impede
plant closures by large employers in the steel, glass, automobile and other industries.
By imposing large fines, severance taxes, or requirements calling for substantial
expenditures for worker retraining, significant barriers to exit were created.
Like barriers to entry, barriers to exit can dramatically increase the costs of
entry or expansion in any given industry or locale. Barriers to exit impede the asset
redeployment that is typical of any vigorous competitive environment. By impeding
this process, barriers to exit can dramatically increase both the costs and risk of doing
business. Some differences in the competitive effects of barriers to entry and exit
may be noted in that barriers to entry have an immediate effect on potential entrants,
whereas barriers to exit have an immediate influence on industry incumbents. In the
short-run, particularly during a period of economic expansion, however, barriers to
exit can have minimal impact. In the long-run, barriers to exit become an important
consideration for industry incumbents and potential entrants, and like barriers to
entry can have an important effect limiting actual and potential competition.
Q10.5
A higher minimum wage means some low wage workers will get fired because there
will be less money available for labor costs. An international minimum wage, scaled
according to the working conditions and cost of living in a particular country, would
allow local workers to benefit without significant trade disruption. Discuss this
statement and explain why the demand curve is apt to be horizontal in the unskilled
labor market.
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Q10.5
ANSWER
In competitive markets, the demand curve tends to be horizontal because
homogeneous products are offered by several competitors. In product markets, firms
are price takers in perfectly competitive markets. This means that the activity level
of each firm is so small relative to that of the overall industry total that no influence
on industry prices is noted following a change in the firm's production decisions. All
of the firm's output can be sold at the industry's prevailing price. Price discounts are
unnecessary to sell even dramatically higher firm output. Moreover, the presence of
perfect substitutes means that buyers would immediately switch to alternate suppliers
following a price increase. Thus, prices above the industry norm are not feasible.
This gives rise to a horizontal firm demand curve.
A similar situation exists in the unskilled labor market. Not only are there lots
of part-time unskilled workers looking for jobs at any point in time, self-service labor
supplied by the customer is typically a perfect substitute for unskilled labor. This
makes consumers very reluctant to pay high wages for unskilled labor. This is the
basic problem faced by low-income workers, not competition from unskilled workers
in other countries, like India. The best way to improve incomes among the working
poor around the globe is to improve worker skills and productivity through better
education and training. Make low-income workers worth more, and they will get
paid more.
Q10.6
For smaller firms managed by their owners in competitive markets, profit

considerations are apt to dominate almost all decisions. However, managers of
giant corporations have little contact with stockholders, and often deviate from
profit-maximizing behavior. Get real. Look at Tyco, for Petes sake. Discuss this
statement.
Q10.6
ANSWER
This is, of course, a controversial subject. Most analysts concede that profit
maximization is a prime concern of owner-managers that run small businesses in
hotly competitive markets. In vigorously competitive markets, productive efficiency
is mandatory if the firm is to earn even a modest normal profit. Without close
attention to detail, smaller firms in competitive markets quickly find themselves
victimized by more efficient rivals. Faster, cheaper and better is not only the battle
cry of the successful competitive firm, it is the mantra of the long-term survivor.
However, some disagree with the contention that profit maximization is the
primary motivation of all competitive firms, large and small. Managers of giant
corporations are sometimes criticized for being motivated by empire building
(revenue maximization) or other forms of self-indulgent behavior. Surely, top
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managers at Tyco International, Enron, and WorldCom have been seen to deviate
markedly from the norms of profit-maximizing behavior. Still, it is worth pointing
out that these egregious examples of self-indulgent behavior were quickly rooted out,
the executives got fired, and in some cases, served time in prison for their
malfeasance. Vigorous competitors, unfriendly bidders, and the courts are all
enemies of inefficient managers. As a result, successful firms that have been in
business for long periods of time typically act in a manner consistent with profit
maximization.
Q10.7
If excess profits are rampant in the oil business, why arent the stockholders of
industry giants like Exxon Mobil, Chevron Texaco, and Royal Dutch Petroleum
making huge stock-market profits? Discuss this statement.
Q10.7
ANSWER
The stock market is a forward-looking device. If anticipated profits rise, stock prices
go up. If anticipated profits fall, stock prices go down. At any point in time, there
can be only a weak relationship between the amount of excess profits generated in a
business and stock-market returns because only unanticipated changes in excess
profits will affect stock prices. For example, if Exxon Mobil were making excess
profits, the stock price could perform in line with the overall market so long as no
earnings surprises came along. In the stock market, it is important to recognize that
while monopolies make excess profits, these advantages tend to get reflected in the
stock price at the time monopoly power is created. Investors in monopoly make only
a risk-adjusted fair return so long as there are no unanticipated changes in excess
profits.
All that being said, it is noteworthy that long-term investor rates of return to
investors in the energy sector have not been above average. If investor returns are
average to below-average in the energy business, and they are, it is difficult to argue
that excess profits are widespread in the sector. Critics of the oil industry allege that
the industry receives large and unwarranted government subsidies and that rival
technologies, such as those for ethanol, renewable energy, and energy efficiency,
deserve compensating government preferences. However, industry studies indicate
that, on balance, the oil industry is not a net beneficiary of government subsidies. In
fact, the oil industry may be more harmed than helped by government intervention in
energy markets. Special tax deductions, direct expenditures, net excise taxes, and
research and development expenditures are constantly targeted by oil critics.
However, those subsidies are a small share of oil revenues and far less generous than
the preferences and subsidies provided for rival businesses and technologies such as
mass transit and alternative fuels. Moreover, most energy subsidies are wealth
transfers that do not significantly distort energy prices or affect energy markets.
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Q10.8
Airline passenger service is a terrible high-fixed cost business featuring fierce price
competition. With uniform safety, customers pick the lowest airfare with the most
convenient departures. Except for pilots, nobody in the airline business makes any
money. Use the competitive firm short-run supply curve concept to explain entry
and exit in the airline passenger business. Why are pilots well paid?
Q10.8
ANSWER
An individual airline will supply output so long as it is profitable to do so. Profits are
maximized by setting MR = MC. Because P = MR in a competitive industry,
perfectly competitive firms maximize profits by setting P = MR = MC. This means
that the individual firm supply curve in a competitive industry is given by the
marginal cost curve, so long as marginal cost exceeds average variable cost, P = MC
> AVC. Given the U-shaped average cost curve that is typical of firms in perfectly
competitive industries, the MC and firm supply curve will tend to be upward sloping
over the range where MC > AVC. This means that individual airlines will increase
output as prices rise, and decrease output as prices fall.
In the airline business, any excess capacity is met by price cutting. Fare wars
are a permanent feature of the competitive landscape. The reason why pilots make
money in such a tough business is obvious: You cant fly a plane without them.
With enormous investment in highly technical aircraft, the airlines need highly
trained pilots, and pay them accordingly.
Q10.9
Suppose that a competitive firm long-run supply curve is given by the expression QF
= -500 + 10P. Does this mean that the firm will supply -500 units of output at a zero
price? If so, what does output of -500 units mean?
Q10.9
ANSWER
Taken literally, a competitive firm long-run supply curve given by the expression QF
= -500 + 10P means that the firm will supply -500 units of output at a zero price.
However, this is a nonsensical interpretation. There is no such thing as negative
production. Instead, there is a simple and economically appropriate interpretation of
the expression QF = -500 + 10P. This expression simply means that firm supply will
equals zero unless the market price exceeds $50. When P > $50, the firm will begin
to supply a positive amount of production. For market prices less than or equal to
$50, firm supply will equal zero.
Q10.10
The long-run supply curve for a given competitive firm can be written as QF = -250
+ 8P or P = $31.25 + $0.125QF. Explain why the amount supplied by 50 such
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competitors is determined by multiplying the first expression by 50 rather than by

multiplying the second expression by a similar amount.
Q10.10
ANSWER
The amount supplied in a competitive market is simply the sum of output produced
by all established competitors. In a market comprised of 50 firms with identical
costs, the long-run market supply 50 times the quantity indicated by the individual
firms long-run supply curve. In this case, 50 identical competitors would supply QM
= ( -250 + 8P) 50 = 12,500 + 400P, so long as the market price exceeds average
variable cost, each firms marginal cost curve is its supply curve. In general, the
market supply curve is derived by simply adding up the quantities supplied by all
competitors. If the competitive market is comprised of 50 firms with identical
marginal costs, market supply at every market price will total 50 times the quantity
supplied by a single firm.
Students must be careful not to multiply the expression P = $31.25 + $0.125QF
by 50 in an effort to derive the competitive market long-run supply curve. Such an
approach would suggest a marginal cost 50 times greater than the market cost curve
facing a single firm. Remember, to find aggregate supply, one must add up
individual firm supply. This is a horizontal summation of supply across all
competitors.
SELF-TEST PROBLEMS & SOLUTIONS

ST10.1
A.
Market Supply. In some markets, cutthroat competition can exist even when the
market is dominated by a small handful of competitors. This usually happens when
fixed costs are high, products are standardized, price information is readily
available, and excess capacity is present. Airline passenger service in large city-pair
markets, and electronic components manufacturing are good examples of industries
where price competition among the few can be vigorous. Consider three competitors
producing a standardized product (Q) with the following marginal cost
characteristics:
MC1 = $5 + $0.0004Q1
(Firm 1)
MC2 = $15 + $0.002Q2
(Firm 2)
MC3 = $1 + $0.0002Q3
(Firm 3)
Using each firms marginal cost curve, calculate the profit-maximizing short-run
supply from each firm at the competitive market prices indicated in the following
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table. For simplicity, assume price is greater than average variable cost in every
instance.
Market Supply is the Sum of Firm Supply Across all Competitors
Firm One
Supply
P = MC1=
$5 + $0.0004Q1
Price and
Q1 = -12,500 +
2,500P
$0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
75
80
Firm Two
Supply
P = MC2= $15 +
$0.002Q2 and
Q2 = -7,500 +
500P
Firm Three
Supply
P = MC3= $1 +
$0.0002Q3 and
Q3 = -5,000 +
5,000P
Market Supply
P = $3.125 +
$0.000125P and
QI = -25,000 +
8,000P (QI = Q1
+ Q2 + Q3)
B.
Use these data to plot short-run supply curves for each firm. Also plot the market
supply curve.
STP10.1
SOLUTION
A.
The marginal cost curve constitutes the short-run supply curve for firms in perfectly
competitive markets so long as price is greater than average variable cost.
Market Supply is the Sum of Firm Supply Across all
Competitors
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Firm One
Firm Two
Firm Three
Market Supply
Supply
Supply
Supply
P = MC1=
P = $3.125 +
P = MC2= $15 + P = MC3= $1 +
$5 + $0.0004Q1
$0.000125P and
$0.002Q2 and
$0.0002Q3 and
Price and
QI = -25,000 +
Q2 = -7,500 +
Q3 = -5,000 +
8,000P (QI = Q1
Q1 = -12,500 +
500P
5,000P
2,500P
+ Q2 + Q3)
$0
-12,500
-7,500
-5,000
-25,000
5
0
-5,000
20,000
15,000
10
12,500
-2,500
45,000
55,000
15
25,000
0
70,000
95,000
20
37,500
2,500
95,000
135,000
25
50,000
5,000
120,000
175,000
30
62,500
7,500
145,000
215,000
35
75,000
10,000
170,000
255,000
40
87,500
12,500
195,000
295,000
45
100,000
15,000
220,000
335,000
50
112,500
17,500
245,000
375,000
55
125,000
20,000
270,000
415,000
60
137,500
22,500
295,000
455,000
65
150,000
25,000
320,000
495,000
70
162,500
27,500
345,000
535,000
75
175,000
30,000
370,000
575,000
80
187,500
32,500
395,000
615,000
B.
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ST10.2
Competitive Market Equilibrium. Competitive market prices are determined by the

interplay of aggregate supply and demand; individual firms have no control over
price. Market demand reflects an aggregation of the quantities that customers will
buy at each price. Market supply reflects a summation of the quantities that
individual firms are willing to supply at different prices. The intersection of industry
demand and supply curves determines the equilibrium market price. To illustrate
this process, consider the following market demand curve where price is expressed
as a function of output:
P = $40 - $0.0001QD
(Market Demand)
or equivalently, when output is expressed as a function of price

QD = 400,000 - 10,000P
Assume market supply is provided by five competitors producing a standardized
product (Q). Firm supply schedules are as follows:
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Q1 = 18 +2P
(Firm 1)
Q2 = 12 + 6P
(Firm 2)
Q3 = 40 + 12P
(Firm 3)
Q4 = 20 + 12P
(Firm 4)
Q5 = 10 + 8P
(Firm 5)
Calculate optimal supply by each firm at the competitive market prices indicated in
the following table. Then, assume there are actually 1,000 firms just like each one
illustrated in the table. Use this information to complete the Partial Market Supply
and Total Market Supply columns.
A.
Quantity
Supplied by
Firm (000)
+ + + + = Partial Market Supply
Price 1 2 3 4 5
1,000
$1
2
3
4
5
6
7
8
= Total Market
Supply (000)
B.
Sum the individual firm supply curves to derive the market supply curve. Plot the
market demand and market supply curve with price as a function of output to
illustrate the equilibrium price and level of output. Verify that this is indeed the
market equilibrium price-output combination algebraically.
STP10.2
SOLUTION
A.
Quantity Supplied
by Firm (000)
Price
1+2 +3 +4 +5
= Partial Market Supply = Total Market

1,000
Supply (000)
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$1
2
3
4
5
6
7
8
20
22
24
26
28
30
32
34
18
24
30
36
42
48
54
60
52
64
76
88
100
112
124
136
32
44
56
68
80
92
104
116
18
26
34
42
50
58
66
74
140
180
220
260
300
340
380
420
140,000
180,000
220,000
260,000
300,000
340,000
380,000
420,000
The data in the Table illustrate the process by which an industry supply
curve is constructed. First, suppose that each of five firms in an industry is willing to
supply varying quantities at different prices. Summing the individual supply
quantities of these five firms at each price determines their combined supply
schedule, shown in the Partial Market Supply column. For example, at a price of $2,
the output supplied by the five firms are 22, 24, 64, 44, and 26 (thousand) units,
respectively, resulting in a combined supply of 180(000) units at that price. With a
competitive market price of $8, supply quantities would become 34, 60, 136, 116,
and 74, for a total supply by the five firms of 420(000) units, and so on.
Now assume that there are 1,000 firms just like each one illustrated in the table.
There are actually 5,000 firms in the industry, each with an individual supply
schedule identical to one of the five firms illustrated in the table. In that event, the
total quantity supplied at each price is 1,000 times that shown under the Partial
Market Supply schedule. Because the numbers shown for each firm are in thousands
of units, the total market supply column is in thousands of units. Therefore, the
number 140,000 at a price of $1 indicates 140 million units, the number 180,000 at a
price of $2 indicates 180 million units, and so on.
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B.
To find the market supply curve, simply sum each individual firms supply curve,
where quantity is expressed as a function of the market price:
QI = Q1 + Q2 + Q3 + Q4 + Q5
= 18 + 2P +12 +6P +40 + 12P +20 +12P +10 +8P
= 100 + 40P
(Market Supply)
Plotting the market demand curve and the market supply curve allows one to
determine the equilibrium market price of $6 and the equilibrium market quantity of
340,000(000), or 340 million units.
To find the market equilibrium levels for price and quantity algebraically,
simply set the market demand and market supply curves equal to one another so that
QD = QS. To find the market equilibrium price, equate the market demand and
market supply curves where quantity is expressed as a function of price:
Demand = Supply
400,000 - 10,000P = 100,000 + 40,000P
50,000P = 300,000
P = $6
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To find the market equilibrium quantity, set equal the market demand and
market supply curves where price is expressed as a function of quantity, and QD = QS:
Demand = Supply
$40 - $0.0001Q = -$2.5 + $0.000025Q
0.000125Q = 42.5
Q = 340,000(000)
Therefore, the equilibrium price-output combination is a market price of $6 with an
equilibrium output of 340,000(000), or 340 million units.
PROBLEMS & SOLUTIONS
P10.1
Competitive Markets Concepts. Indicate whether each of the following statements is

true or false, and explain why.
A.
In long-run equilibrium, every firm in a perfectly competitive industry earns

zero profit.
B.
Perfect competition exists in a market when all firms are price takers as
opposed to price makers.
C.
In competitive markets, P > MC at the profit-maximizing output level.
D.
Downward-sloping industry demand curves characterize perfectly competitive

markets.
E.
A firm might show accounting profits in a competitive market but be suffering

economic losses.
P10.1
SOLUTION
A.
False. In long-run equilibrium, every firm in a perfectly competitive industry earns

zero economic profit. For long-term viability, firms in competitive markets must
earn a normal rate of return on investment.
B.
True. Perfect competition exists in a market when individual customers and

individual firms have no influence over price. In such markets, both customers and
firms take prices as given.
C.
False. Profit maximization requires that a firm operate at the output level at which
marginal revenue and marginal cost are equal. With price constant, average revenue
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equals marginal revenue. Therefore, maximum profits result when market price is
set equal to marginal cost for firms in a perfectly competitive industry
D.
True. Downward sloping demand curves follow from the law of diminishing
marginal utility and characterize both competitive markets.
E.
True. Normal profit is defined as the rate of return necessary to retain and attract
needed capital investment. Economic profit represents an above-normal rate of
return. The firm incurs economic losses whenever it fails to earn a normal profit. A
firm might show a small accounting profit but be suffering economic losses because
these profits are insufficient to provide an adequate return to the firm's stockholders.
In such instances, firms are unable to replace plant and equipment and will exit the
industry in the long run.
P10.2
Short-run Firm Supply. Mankato Paper, Inc., produces uncoated paper used in a
wide variety of industrial applications. Newsprint, a major product, is sold in a
perfectly competitive market. The following relation exists between the firm's
newsprint output and total production costs:
Total Output
(tons)
0
1
2
3
4
5
6
7
P10.2
Total Cost
$25
75
135
205
285
375
475
600
A.
Construct a table showing Mankato's marginal cost of newsprint production.
B.
What is the minimum price necessary for Mankato to supply one ton of
newsprint?
C.
How much newsprint would Mankato supply at industry prices of $75 and $100
per ton?
SOLUTION
A.
- - 271 - -
Total
Output
0
1
2
3
4
5
6
7
Total
Cost
$25
75
135
205
285
375
475
600
Marginal
Cost
-$50
60
70
80
90
100
125
B.
The minimum marginal cost of newsprint is $50, so this also represents the minimum
price necessary to justify supplying a single unit of output.
C.
In a perfectly competitive market, P = MR. Therefore, Mankato will supply output

so long as price at least covers the marginal cost of production. At a price of $75, Q
= 3 units of output can be justified because P = $75 > MCQ=3 = $70. However,
production of a fourth unit is not warranted because P = $75 < MCQ=4 = $80.
Similarly, Q = 6 could be justified at a price of $100 because P = $100 = MCQ=6.
P10.3
Short-run Firm Supply. Florida is the biggest sugar-producing state, but Michigan
and Minnesota are home to thousands of sugar beet growers. Sugar prices in the
United States average about 20 per pound, or more than double the world-wide
average of less than 10 per pound given import quotas that restrict imports to about
15% of the U.S. market. Still, the industry is perfectly competitive for U.S. growers
who take the market price of 20 as fixed. Thus, P = MR = 20 in the U.S. sugar
market. Assume that a typical sugar grower has fixed costs of $30,000 per year.
Total variable cost (TVC), total cost (TC), and marginal cost (MC) relations are:
TVC = $15,000 + $0.02Q + $0.00000018Q2
TC = $45,000 + $0.02Q + $0.00000018Q2
MC = TC/Q = $0.02 + $0.00000036Q
where Q is pounds of sugar, total costs include a normal profit.
A.
Using the firms marginal cost curve, calculate the profit-maximizing short-run
supply from a typical grower.
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B.
Calculate the average variable cost curve for a typical grower, and verify that
average variable costs are less than price at this optimal activity level.
P10.3
SOLUTION
A.
competitive markets if price exceeds average variable cost. Because P = MR, the
price necessary to induce firm supply in the short run of a given amount is found by
setting P = MC, provided that P > AVC:
P
0.20
= 0.02 + 0.00000036Q
0.18
= 0.00000036Q
Q
B.
= $0.02 + $0.00000036Q
= 500,000
The average variable cost curve is determined by dividing total variable cost by
output:
AVC
= ($15,000 + $0.02Q + $0.00000018Q2)/Q

= $15,000/Q + $0.02 + $0.00000018Q
At the Q = 500,000 activity level, average variable cost is 14 and less than the
market price:
AVC
= $15,000/Q + $0.02 + $0.00000018Q

= $15,000/500,000 + $0.02 + $0.00000018(500,000)
= $0.14
Because P = MR = MC and P > AVC at the 500,000 pounds per year activity level,
this is an optimal amount of short-run supply from the typical sugar grower.
P10.4
Long-run Firm Supply. The retail market for unleaded gasoline is fiercely price
competitive. Consider the situation faced by a typical gasoline retailer when the
local market price for unleaded gasoline is $1.80 per gallon and total cost (TC) and
marginal cost (MC) relations are:
- - 273 - -
TC = $40,000 + $1.64Q + $0.0000001Q2

MC = TC/Q = $1.64 + $0.0000002Q
and Q is gallons of gasoline. Total costs include a normal profit.
A.
Using the firms marginal cost curve, calculate the profit-maximizing long-run
supply from a typical retailer
B.
Calculate the average total cost curve for a typical gasoline retailer, and verify
that average total costs are less than price at the optimal activity level.
P10.4
SOLUTION
A.
The marginal cost curve constitutes the long-run supply curve for firms in perfectly
competitive markets if price is greater than average total cost. Because P = MR, the
price necessary to induce firm supply in the long run of a given amount is found by
setting P = MC, provided that P > ATC:
P
= $1.64 + $0.0000002Q
1.80
= $1.64 + $0.0000002Q
0.16
= 0.0000002Q
Q
B.
= 800,000
The average total cost curve is determined by dividing total cost by output:
ATC
= ($40,000 + $1.64Q + $0.0000001Q2)/Q

= $40,000/Q + $1.64 + $0.0000001Q
At the Q = 800,000 activity level, average total cost is $1.77 and less than the market
price:
ATC
= $40,000/800,000 + $1.64 + $0.0000001(800,000)

= $1.77
- - 274 - -
P10.5
Because P = MR = MC and P > ATC at the 800,000 gallons per year activity level,
this is a sustainable amount of long-run supply from the typical gasoline retailer.
However, the economic profits being earned in the industry will attract entry until
prices fall or costs rise sufficiently to ensure that only a normal profit is earned by
each competitor in long-run equilibrium.
Short-run Firm Supply. Farm Fresh, Inc., supplies sweet peas to canneries located
throughout the Mississippi River Valley. Like many grain and commodity markets,
the market for sweet peas is perfectly competitive. With $250,000 in fixed costs, the
company's total and marginal costs per ton (Q) are:
TC = $250,000 + $200Q + $0.02Q2
MC = TC/Q = $200 + $0.04Q
A.
Calculate the industry price necessary to induce short-run firm supply of 5,000,
10,000, and 15,000 tons of sweet peas. Assume that MC > AVC at every point
along the firms marginal cost curve and that total costs include a normal
profit.
B.
Calculate short-run firm supply at industry prices of $200, $500, and $1,000
per ton.
P10.5
SOLUTION
A.
competitive industries provided price exceeds average variable cost. Because P =
MR, the price necessary to induce short-run firm supply of a given amount is found
by setting P = MC, assuming P > AVC. Here:
MC = TC/Q = $200 + $0.04Q
Therefore, at:
Q
= 5,000: P = MC = $200 + $0.04(5,000) = $400
= 10,000: P = MC = $200 + $0.04(10,000) = $600
= 15,000: P = MC = $200 + $0.04(15,000) = $800
(Note: Variable Cost = $200Q + $0.02Q2, and AVC = $200 + $0.02Q, so MC > AVC
at each point along the firms short-run supply curve.)
- - 275 - -
B.
When quantity is expressed as a function of price, the firms supply curve can be
written:
P = MC = $200 + $0.04Q
0.04Q = -200 + P
Q = -5,000 + 25P
Therefore, at:
P10.6
= $200: Q = -5,000 + 25($200) = 0
= $500: Q = -5,000 + 25($500) = 7,500
= $1,000: Q = -5,000 + 25($1,000) = 20,000
Short-run Market Supply. New England Textiles, Inc., is a medium-sized

manufacturer of blue denim that sells in a perfectly competitive market. Given
$25,000 in fixed costs, the total cost function for this product is described by:
TC = $25,000 + $1Q + $0.000008Q2
MC = TC/Q = $1 + $0.000016Q
where Q is square yards of blue denim produced per month. Assume that MC > AVC
at every point along the firms marginal cost curve, and that total costs include a
normal profit.
A.
P10.6
Derive the firm's supply curve, expressing quantity as a function of price.
B.
Derive the market supply curve if New England Textiles is one of 500
competitors.
C.
Calculate market supply per month at a market price of $2 per square yard.
SOLUTION
- - 276 - -
A.
The perfectly competitive firm will supply output so long as it is profitable to do so.
Because P = MR in perfectly competitive markets, the firm supply curve is given by
the relation:
P = MC = TC/Q = $1 + $0.000016Q
when quantity is expressed as a function of price, the firm supply curve is:
P = $1 + $0.000016Q
0.000016Q = -1 + P
QS = -62,500 + 62,500P
(Note: Variable Cost = $1Q + $0.000008Q2, and AVC = $1 + $0.000008Q, so
MC > AVC at each point along the firms short-run supply curve.)
B.
If the company is one of 500 such competitors, the industry supply curve is found by
simply multiplying the firm supply curve derived in part A by 500. This is
equivalent to a horizontal summation of all 500 individual firm supply curves. When
quantity is expressed as a function of price:
QS
= 500 (-62,500 + 62,500P)

= -31,250,000 + 31,250,000P
When price is expressed as a function of quantity:

QS
31,250,000P
P
C.
QS
= -31,250,000 + 31,250,000P
= 31,250,000 + QS
= $1 + $0.000000032QS
= -31,250,000 + 31,250,000P
= -31,250,000 + 31,250,000($2)
= 31,250,000
P10.7
Long-run Competitive Firm Supply. The Hair Stylist, Ltd., is a popular-priced

hairstyling salon in College Park, Maryland. Given the large number of competitors,
- - 277 - -
the fact that stylists routinely tailor services to meet customer needs, and the lack of
entry barriers, it is reasonable to assume that the market is perfectly competitive and
that the average $20 price equals marginal revenue, P = MR = $20. Furthermore,
assume that the firm's operating expenses are typical of the 100 firms in the local
market and can be expressed by the following total and marginal cost functions:
TC = $5,625 + $5Q + $0.01Q2
MC = $5 + $0.02Q
where TC is total cost per month including capital costs, MC is marginal cost, and Q
is the number of hairstylings provided. Total costs include a normal profit.
A.
B.
Calculate the firms profit-maximizing output level.
Calculate the firms economic profits at this activity level. Is this activity level
sustainable in the long run?
P10.7
SOLUTION
A.
The optimal output level can be determined by setting marginal revenue equal to
marginal cost and solving for Q:
MR = MC
$20 = $5 + $0.02Q
$0.02Q = $15
Q = 750 hairstylings per month.
B.
Because the cost of capital is already included in the total cost function, any excess
of revenues over total cost represents economic profits. At this output level,
maximum economic profits are
= TR - TC
= $20Q - $5,625 - $5Q - $0.01Q2
= $20(750) - $5,625 - $5(750) - $0.01(7502)
- - 278 - -
= $0.
The Q = 750 activity level results in zero economic profits. This means that the Hair
Stylist is just able to obtain a normal or risk-adjusted rate of return on investment
because capital costs are already included in the cost function. The Q = 750 output
level is also the point of minimum average production costs (ATC = MC = $20), and
thereby constitutes the firms long-run sustainable supply. Finally, with 100 identical
firms in the industry, industry output totals 75,000 hairstylings per month.
P10.8
Competitive Market Equilibrium. Dozens of Internet web sites offer quality auto
parts for the replacement market. Their appeal is obvious. Price-conscious
shoppers can often obtain up to 80% discounts from the prices charged by original
equipment manufacturers (OEMs) for such standard items as wiper blades, air filters,
oil filters, and so on. With a large selection offered by dozens of online merchants,
the market for standard replacement parts is vigorously competitive. Assume that
market demand and supply conditions for windshield wiper blades can be described
by the following relations:
(Market Demand)
QD = 100 - 10P
QS
= 15P
(Market Supply)
- - 279 - -
where Q is millions of replacement wiper blades and P is price per unit.
P10.8
A.
Graph the market demand and supply curves.
B.
Determine the market equilibrium price-output combination both graphically

and algebraically.
SOLUTION
A.
- - 280 - -
B.
From the graph, it is clear that QD = QS = 60 at a price of $4 per unit. Thus, P = $4

and Q = 60 is the equilibrium price-output combination.
Algebraically,
QD = QS
100 - 10P = 15P
25P = 100
P = $4
Both demand and supply equal 60 because:
Demand: QD = 100 - 10(4) = 60
Supply: QS = 15(4) = 60
P10.9
Dynamic Competitive Equilibrium. Big Apple Music, Inc., enjoys an exclusive

copyright on music written and produced by the Fab Four, a legendary British rock
group. Total and marginal revenues for the group's CDs are given by the following
relations:
TR = $20Q - $0.000006Q2
MR = TR/Q = $20 - $0.000012Q
Total costs (TC) and marginal costs (MC) for production and distribution are:
TC = $6,187,500 + $2.5Q + $0.00000275Q2
MC = TC/Q = $2.5 + $0.0000055Q
and Q is units (CDs). Total costs include a normal profit.
A.
Use the marginal revenue and marginal cost relations given above to calculate
Big Apple's CD output, CD price, and economic profits at the profitmaximizing activity level for the period during which the company enjoys an
exclusive copyright on the groups material.
- - 281 - -
B.
Calculate optimal output and profit levels in the period following expiration of
copyright protection based on the assumption that a competitive market where
P = MR = $10.75 would result. Is this a stable equilibrium?
P10.9
SOLUTION
A.
Set MR = MC to find the profit-maximizing activity level:

MR
$20 - $0.000012Q
0.0000175Q
= MC
= $2.5 + $0.0000055Q
= 17.5
= 1,000,000
= TR/Q
= ($20Q - $0.000006Q2)/Q
= $20 - $0.000006Q
= $20 - $0.000006(1,000,000)
= $14
= TR - TC
= $14(1,000,000) - $6,187,500 - $2.5(1,000,000)
- $0.00000275(1,000,0002)
= $2,562,500
B.
In a perfectly competitive industry, P = MR = MC in equilibrium. Thus, after

expiration of copyright protection, P = MC = $10.75 would result. Set P= MR = MC
to find the profit-maximizing activity level:
MR
$10.75
= MC
= $2.5 + $0.0000055Q
- - 282 - -
0.0000055Q
= 8.25
= 1,500,000
= TR - TC
= $10.75(1,500,000) - $6,187,500 -
$2.5(1,500,000)
- $0.00000275(1,500,0002)
= $0
Because only normal profits are being made, this is a stable equilibrium in the market
and there will be no incentive for entry nor exit.
P10.10
Stable Competitive Equilibrium. Bada Bing, Ltd., supplies standard 256 MB-RAM
chips to the U.S. computer and electronics industry. Like the output of its
competitors, Bada Bing's chips must meet strict size, shape, and speed specifications.
As a result, the chip-supply industry can be regarded as perfectly competitive. The
total cost and marginal cost functions for Bada Bing are:
TC
= $1,000,000 + $20Q + $0.0001Q2
MC
= TC/Q = $20 + $0.0002Q
where Q is the number of chips produced. Total costs include a normal profit.
A.
Calculate Bada Bing's optimal output and profits if chip prices are stable at
$60 each.
B.
Calculate Bada Bing's optimal output and profits if chip prices fall to $30 each.
C.
If Bada Bing is typical of firms in the industry, calculate the firm's long-run
equilibrium output, price, and economic profit levels.
P10.10
SOLUTION
A.
Because the industry is perfectly competitive, P = MR = $60. Set MR = MC to find

the profit-maximizing activity level. From the total cost function note:
- - 283 - -
TC
= $1,000,000 + $20Q + $0.0001Q2
MC
= TC/Q = $20 + $0.0002Q
MR
= MC
$60
= $20 + $0.0002Q
Therefore,
0.0002Q
= 40
= 200,000
= TR - TC
= $60(200,000) - $1,000,000 - $20(200,000)
- $0.0001(200,0002)
= $3,000,000
B.
After a fall in chip prices to $30, the optimal activity level falls to Q = 50,000
because:
MR
= MC
$30
= $20 + $0.0002Q
0.0002Q
= 10
= 50,000
= TR - TC
= $30(50,000) - $1,000,000 - $20(50,000)
- $0.0001(50,0002)
= -$750,000 (A loss)
- - 284 - -
C.
In equilibrium, P = AC and MR = MC at the point where average cost is minimized.

To find the point of minimum average costs set MC = AC, and solve for Q:
MC
$20 + $0.0002Q
20 + 0.0002Q
0.0001Q
Q2
Q
= AC = TC/Q
= ($1,000,000 + $20Q + $0.0001Q2)/Q
func {{1,000,000} over {Q}

~+~ 20 ~+~ 0.0001Q}
func
{{1,000,00
=
0}
func
{{1,000,00
=
0}
=
func {sqrt
{10 000 000 000
= 100,000
P
= AC
func {{$1,000,000} over {100,000} ~+~
$20 ~+~ $0.0001(100,000)}
= $40
= TR - TC
= $40(100,000) - $1,000,000 - $20(100,000)
- $0.0001(100,0002)
= $0
CASE STUDY FOR CHAPTER 10

Profitability Effects of Firm Size for DJIA Companies
- - 285 - -
Does large firm size, pure and simple, give rise to economic profits? This question has long
been a source of great interest in both business and government, and the basis for lively debate
over the years. Economic theory states that large relative firm size within a given economic
market gives rise to the potential for above-normal profits. However, economic theory makes no
prediction at all about a link between large firm size, pure and simple, and the potential for
above-normal profits. By itself, it is not clear what economic advantages are gained from large
firm size. Pecuniary or money-related economies of large size in the purchase of labor, raw
materials, or other inputs are sometimes suggested. For example, some argue that large firms
enjoy a comparative advantage in the acquisition of investment funds given their ready access to
organized capital markets, like the New York Stock Exchange. Others contend that capital
markets are themselves very efficient in the allocation of scarce capital resources and that all
firms, both large and small, must offer investors a competitive rate of return in order to grow
and prosper.
Still, without a doubt, the profitability effects of large firm size is a matter of significant
business and public policy interest. Ranking among the largest corporations in the United States
is a matter of significant corporate pride for employees, top executives, and stockholders. Sales
and profit levels achieved by such firms are widely reported and commented upon in the business
and popular press. At times, congressional leaders have called for legislation that would bar
mergers among giant companies on the premise that such combinations create monolithic giants
that impair competitive forces. Movements up and down lists of the largest corporations are
chronicled, studied, and commented upon. It is perhaps a little known fact that, given the
dynamic nature of change in the overall economy, few companies are able to maintain, let alone
enhance, their relative position among the largest corporations over a 5- to 10-year period.
With an annual attrition rate of 6% to 10% among the 500 largest corporations, it indeed
appears to be slippery at the top.
To evaluate the link, if any, between profitability and firm size, it is interesting to
consider the data contained in Table 1.1 on the corporate giants found within the Dow Jones
Industrial Average (DJIA). These are profit and size data on 30 of the largest and most
successful corporations in the world. Companies included in the DJIA are selected by and
reviewed by editors of The Wall Street Journal. For the sake of continuity, changes in the
composition of the DJIA are rare. Changes occur twice a decade, and only after corporate
acquisitions or other dramatic shifts in a component corporations core business. When events
necessitate a change in the DJIA, the entire index is reviewed and multiple component changes
are often implemented simultaneously. There are no hard and fast rules for component selection.
A major corporation is typically added to the DJIA only if it has an excellent reputation,
demonstrates sustained growth, is of interest to a large number of individual and institutional
investors. Most importantly, the overall makeup of the DJIA is structured so as to be
representative of the overall stock market. Despite its name, the DJIA is not limited to industrial
stocks, at least as stocks are traditionally defined. The DJIA serves as a measure of the entire
U.S. market, covering such diverse industries as financial services, technology, retail,
entertainment and consumer goods.
- - 286 - -
Table 1.1 shows profitability as measured by net income, and two standard measures of
firm size. Sales revenue is perhaps the most common measure of firm size. From an economic
perspective, sales is an attractive measure of firm size because it is not susceptible to accounting
manipulation or bias, nor is it influenced by the relative capital or labor intensity of the
enterprise. When size is measured by sales revenue, measurement problems tied to inflation,
replacement cost errors, and so on, are minimized. Another popular measure of firm size is net
worth, or the book value of stockholders' equity, defined in accounting terms as total assets
minus total liabilities. Stockholders equity is a useful measure of the total funds committed to
the enterprise by stockholders through paid in capital plus retained earnings.
The simplest means for studying the link between profitability and firm size is to compare
profits and firm size, when size is measured using sales and stockholders' equity. However, it is
important to remember that a link between profits and firm size may mean nothing at all in terms
of the effects of firm size on the rate of profitability. Big firms make big profits. Just because big
firms make lots of money there is no reason to fear large-firm exploitation in the economy. To
consider if firm size might be a contributor to the pace of profitability, it is necessary to compare
the profit margin on sales to sales (MGN), and the rate of return on stockholders equity (ROE)
on the size of stockholders equity. A significant link between the rate of profitability and firm
size is suggested to the extent that MGN and ROE tend to be highest among the very largest
companies.
The effects of firm size on profits and firm size on profit rates among the corporate giants
found among the DJIA are shown in Table 10.2.
Table 10.2 here
A.
Based upon the findings reported in Table 10.2, discuss the relation between firm
size and profitability, and the link, if any, between firm size and profit rates. In
general, does large firm size increase profitability?
B.
Using a spreadsheet, sort the DJIA according to profit rates and firm size. Use firmspecific information found on company web sites or investment portals, like Yahoo!
Finance or msn Money, to explain the superior profitability of these corporate giants.
C.
What other important factors might be included in a more detailed study of the
determinants of corporate profitability?
CASE STUDY SOLUTION

A.
Using a simple ordinary least squares regression approach to investigating the firm
size-profit rate relation, there is no apparent profit advantage to large firm size.
These results are perhaps surprising because it is commonly perceived that larger
firms enjoy revenue and cost advantages when compared with smaller companies.
- - 287 - -
Perhaps long-held notions of large firm advantages are no longer relevant in the
globally competitive twenty-first century.
A high degree of correlation between profitability and firm size is clearly
evident for corporate giants found within the DJIA. The statistically-significant size
coefficient in the profit = f (sales) relation suggest that unsurprising fact that profits
rise with sales revenue. Similarly, a statistically-significant size coefficient in the
profit = f (net worth) relation confirms that profits rise with the amount of capital
invested in the firm, measured by the book value of stockholders equity. It is
important to recognize that such relations do not mean that large firms have a
competitive advantage stemming from their large firm size. These linkages mean
only that big firms make big profits.
There is no high degree of correlation between profit rates and firm size for
corporate giants found within the DJIA. The lack of a statistically-significant size
coefficient in the profit margin (MGN) = f (sales) relation suggests that profit
margins do not rise with sales revenue. Similarly, the lack of a statisticallysignificant size coefficient in the return on equity (ROE) = f (stockholders equity)
relation confirms that profit rates are not systematically related to the amount of
capital invested in the firm. Big firms make big profits, but there is no evidence here
that big firms make big profit rates.
B.
Profits and profit rates vary on a year-by-year basis for the corporate giants found
within the DJIA. Wal-Mart, Exxon and GM are commonly found among the very
largest corporate giants when size is measured using sales. Notice that Wal-Marts
enviable rate of return on stockholders equity is despite very low profit margins, and
low markups over cost. It has become popular recently to criticize this retailing giant,
but the fact remains that millions of loyal shoppers crave the wide selection and low
prices feature in clean and convenient Wal-Mart stores. Despite its huge size,
integrated oil industry giant Exxon finds that its profit rates ride up and down with
the price of oil, and OPEC, not Exxon, sets oil prices. Over the last 50 years,
investors in Exxon have failed to keep up with the market averages. Still, the profit
rates earned by Exxon compare favorably with those recorded by GM, another
favorite target of corporate activists. Plain and simple, GM has not produced an
enviable rate of return for decades.
Among the DJIA companies with the highest profit rates, a handful stand out
year after year. Merck is known for producing effective and innovative drug
therapies. Proctor & Gamble continues to write the book on how to develop and
promote valuable consumer products, while Coca-Cola sets the standard for global
marketing of beverage products. Firms with the highest profit rates tend to have
records of outstanding customer service and product development.
- - 288 - -
C.
A number of other important factors might be considered in a more detailed study of

the determinants of profitability for corporate giants. For example, rapid firm growth
can be expected to give rise to profitability over time. Similarly, both advertising
and research and development (R&D) expenditures are made on the premise that
such spending gives rise to current and future profits. Each of these variables can be
expected to increase profitability. Profitability also varies widely from one industry
to another, so controlling for the number and size distribution of competitors, barriers
to entry, economies of scale and other such factors is likely to be worthwhile.
Likewise, it is worth considering the effects of effective tax rates, environmental and
other regulations, and so on.
- - 289 - -

Competitive Markets: Questions & Answers Q10.1

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Chapter 10

QUESTIONS & ANSWERS

Historically, the Regional Bell Operating Companies (RBOCs) had a monopoly on

One way of inferring competitive conditions in a market is to consider the lifestyle

A barrier to entry is defined as any factor or industry characteristic that creates an

For smaller firms managed by their owners in competitive markets, profit

competitors is determined by multiplying the first expression by 50 rather than by

SELF-TEST PROBLEMS & SOLUTIONS

MC2 = $15 + $0.002Q2

Competitive Market Equilibrium. Competitive market prices are determined by the

or equivalently, when output is expressed as a function of price

= Partial Market Supply = Total Market

Competitive Markets Concepts. Indicate whether each of the following statements is

In long-run equilibrium, every firm in a perfectly competitive industry earns

In competitive markets, P > MC at the profit-maximizing output level.

Downward-sloping industry demand curves characterize perfectly competitive

A firm might show accounting profits in a competitive market but be suffering

False. In long-run equilibrium, every firm in a perfectly competitive industry earns

True. Perfect competition exists in a market when individual customers and

Construct a table showing Mankato's marginal cost of newsprint production.

In a perfectly competitive market, P = MR. Therefore, Mankato will supply output

= ($15,000 + $0.02Q + $0.00000018Q2)/Q

= $15,000/Q + $0.02 + $0.00000018Q

TC = $40,000 + $1.64Q + $0.0000001Q2

= ($40,000 + $1.64Q + $0.0000001Q2)/Q

= $40,000/800,000 + $1.64 + $0.0000001(800,000)

= 5,000: P = MC = $200 + $0.04(5,000) = $400

= 10,000: P = MC = $200 + $0.04(10,000) = $600

= 15,000: P = MC = $200 + $0.04(15,000) = $800

= $200: Q = -5,000 + 25($200) = 0

= $500: Q = -5,000 + 25($500) = 7,500

= $1,000: Q = -5,000 + 25($1,000) = 20,000

Short-run Market Supply. New England Textiles, Inc., is a medium-sized

Derive the firm's supply curve, expressing quantity as a function of price.

= 500 (-62,500 + 62,500P)

When price is expressed as a function of quantity:

Long-run Competitive Firm Supply. The Hair Stylist, Ltd., is a popular-priced

Calculate the firms profit-maximizing output level.

where Q is millions of replacement wiper blades and P is price per unit.

Graph the market demand and supply curves.

Determine the market equilibrium price-output combination both graphically

From the graph, it is clear that QD = QS = 60 at a price of $4 per unit. Thus, P = $4

Dynamic Competitive Equilibrium. Big Apple Music, Inc., enjoys an exclusive

Set MR = MC to find the profit-maximizing activity level:

In a perfectly competitive industry, P = MR = MC in equilibrium. Thus, after

= $1,000,000 + $20Q + $0.0001Q2

= TC/Q = $20 + $0.0002Q

Because the industry is perfectly competitive, P = MR = $60. Set MR = MC to find

= $1,000,000 + $20Q + $0.0001Q2

= TC/Q = $20 + $0.0002Q

In equilibrium, P = AC and MR = MC at the point where average cost is minimized.

func {{1,000,000} over {Q}

CASE STUDY FOR CHAPTER 10

CASE STUDY SOLUTION

A number of other important factors might be considered in a more detailed study of

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