FB 2400 Economics I

Tutorial Exercises 7: Perfect Competition

Essential readings: Chapter 7.

1. Consider the short-run equilibrium of a perfectly competitive market. The market demand schedule
for a particular product is shown as follows:

Price (dollars per unit) Quantity demanded (units per week)

0.75 440,000
1.75 430,000
2.75 420,000
3.75 410,000
4.75 400,000
5.75 390,000
6.75 380,000
7.75 370,000
8.75 360,000
9.75 350,000
10.75 340,000
11.75 330,000
12.75 320,000

The market is perfectly competitive and there are 1000 firms in the industry. Each firm has the
same cost structure described by the following table:

Output Marginal cost Average variable cost Average total cost

(units per week) (dollars) (dollars) (dollars)
150 4.82 8.80 15.47
200 4.09 7.69 12.69
250 4.63 7.00 11.00
300 6.75 6.75 10.07
350 9.75 6.91 9.75
400 13.95 7.50 10.00
450 19.62 8.52 10.74
500 26.57 9.97 11.97

(a) What is the industry price and quantity traded?

(b) What is the output of each firm?
(c) What is the economic profit of each firm?
(d) What is the shutdown price?

2. The Silk Street attracts approximately 20,000 visitors daily (from 9am to 9pm) on weekdays and
between 50,000 and 60,000 on weekends as of 2006. Many of the stalls have over the years gained
local and international reputation for selling counterfeit luxury designer brands at relatively low
prices.

In an opinion piece published in The Wall Street Journal on 17 June, 2008, Chinese Vice-Premier
Wang Qishan mentioned that Beijing’s Silk Market has gone “through rectification and has since
become a distribution centre of famous brands”. But in reality, many stalls have carried on selling
counterfeit luxury designer brands despite growing pressures from the Chinese government and
famous brand name companies.

According to the article, the problem persists because of weak enforcement of the intellectual
property law. “In reality the cost of proving a criminal charge is very high,” said National
Copyright Administration deputy director – general Xu Chao. “It’s very difficult, hence the limited
number of criminal arrests.” (Source: SCMP, July 7, 2008)

(a) Consider the counterfeiters industry, which is highly competitive. Suppose the government
runs a confiscation program to arrest the counterfeiters from time to time. The program

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can only arrest limited number of counterfeiters. What would happen to the profits and
prices of the remaining firms, which were not arrested in short run?

(b) What would be the long run adjustment in the market after the confiscation program? Is
this kind confiscation program an effective way to deal with the piracy problem?

(c) Many people suggested other measures to be more effective, e.g. educating the youngsters
about the importance of protecting the intellectual property rights were more effective
ways to deal with piracy in long run. Do you agree?

3. A report published in Hong Kong Economics Times on 11 June 2008 concerns the fishing market in
Hong Kong. It is reported that the diesel price increased by 2.4 times in a year, which raised the
cost of fishing significantly. How would this regulation affect the market and individual fishermen
in the short run and long run?

4. Suppose the book-printing industry is competitive and begins in a long-run equilibrium.

(a) Hi-Tech Printing Company employs an extra-ordinary manager that sharply reduces the
cost of administrative costs (i.e. fixed cost in the short run). What happens to Hi-Tech’s
profits and the price of books in short run? Will it attract new firms to enter the market in
long run?

(b) Suppose you were the owner of Hi-Tech. What is the maximum amount that you would
offer to keep the extra-ordinary manager to your own firm?

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Suggested (Not Restrictive) Answers

1. (a) Equilibrium price = $9.75; Equilibrium quantity = 350,000

Market
P
30 SS
25
20
15
10
5 D
0
200,000 250,000 300,000 350,000 400,000 450,000 500,000 550,000
Q

(b) To maximizing profit, the firm’s output level is 350 units

Market Individual Firm

P P
30 30
SS SMC
25 25

20 20

15 15
SAC
AVC
10 10 d = MR = P

5 5

D
0
0
200,000 250,000 300,000 350,000 400,000 450,000 500,000
Q
550,000 0 100 200 300 400 500 600q

(c) Economic profit = (P – SAC) x q

In this case, it’s zero as P = SAC = $9.75.

(d) Shutdown price = $6.75 that is the lowest level of AVC.

In short run, a firm in perfect competition has to decide “Produce or not (Shutdown)”

Case 1 Not produce (Shutdown) Case 3 ATC > P > AVC

Economic Loss = TFC ATCxq > Pxq > AVCxq
TC > TR > TVC
Economic Loss = TC – TR < TC – TVC (= TFC)
Case 2 When P > ATC
P x q > ATC x q Case 4 When ATC > AVC > P
TR > TC ATCxq > AVCxq > Pxq
Economic Profit = TR – TC TC > TVC > TR
Economic Loss = TC – TR > TC – TVC (=TFC)3
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2.
(a) Short run effect on remaining firms after confiscation program (Fig 1):

o Initially, in long run equilibrium: P = LAC = LMC = SAC = SMC: Zero equilibrium profit.
o Confiscation program decreases the supply of counterfeit goods, shifting the market supply curve
from S1 to S2, resulting in higher market price (P2).
o Although market quantity drops, the profit maximizing output level of each remaining firm
increases to the corresponding output level where MC1 = MR2.
o At the new output level, each remaining firm is making economic profit.

(b) Long run effect on remaining firms after confiscation program (Fig 1):

o In short run equilibrium: Positive equilibrium profit

o Long-run adjustment: The profit earned by the existing firms attracts potential entrants. Free Entry
increases the supply of counterfeit goods until the price drops back to its original level (S2 to S1) so
that there is no profit incentive for potential entrants to enter the market.
o The market price (P0) is lowered.
o Although market quantity rises, the profit maximizing output level of each individual firm
decreases to the corresponding output level where LMC = SMC = MR1.
o At this output level, each firm is making zero economic profit again.
o This policy is ineffective at all as the market quantity goes back to the original level in long run.

(c) Effect on remaining firms if consumers change their preference due to education (Fig 2 & Fig 3):

o Initially, in long run equilibrium: P = LAC = LMC = SAC = SMC: Zero equilibrium profit.
o Education successfully lowers the demand for counterfeit goods shifting the market demand curve
from D1 to D2, lowering the market price (P2).
o Both the market quantity and the profit maximizing output level of each remaining firm drops,
resulting in an economic loss in short run.
o Long-run adjustment: Some of the existing exit the market due to the economic loss. It reduces
supply from S2 to S1. It stops when price goes back to its original level (P1).
o The individual firm is making zero economic profit again.
o Although market quantity drops, the profit maximizing output level of each individual firm
decreases to the corresponding output level where LMC = SMC = MR1.

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Market Individual Firm

P S2 S1 P ($)
SMC
LMC

LAC
SAC
P2
MR2

P1
MR1

D
Q2 Q1 Q q1 q2 q

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Figure 1: Short-run equilibrium: Decrease of Supply.

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Market Individual Firm

P S1 P ($)
SMC

LAC
SAC

P1
MR1
P2
MR2

D
D2
Q2 Q1 Q q2 q1 q

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Figure 2: Short-run equilibrium: Decrease in Demand

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Market S2 Individual Firm

P S1 P ($)
SMC
LMC

LAC
SAC

P1
MR1
P2
MR2

D2 D1

Q3 Q2 Q1 Q q2 q1 q

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Figure 3: Adjustment to long-run equilibrium: Exit of Existing Firms

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3.
The increase in diesel price increases both the variable cost in the short run. In the long-run, the total cost
will increase.

(a) Short run effect of the increase in diesel price on fishing industry in HK (Fig 4):

o Initially, in long run equilibrium: P = LAC = LMC = SAC1 = SMC1: Zero equilibrium profit.
o The increase in diesel price increases the firms’ marginal cost. Shifts SMC1 to SMC2 and SAC1 to
SAC2.
o The market supply curve shifts up by the same vertical amount as the MC (why?) from S1 to S2.,
resulting in a higher market price (P2).
o Both the market quantity and the profit maximizing output level of each firm drops.
o At the new output level, each firm is making economic loss.
o Depending on its AVC, some firms may shutdown if p < AVC.

(b) Long run effect of the increase in diesel price on fishing industry in HK (Fig 5)
o In short run equilibrium: Economic Loss.
o Long-run adjustment: The loss incurred by the existing firms induces some firms to exit the
market. Exit decreases the supply of electronic equipment until the price increases to P3 so that
there is economic profit is zero again.
o Although market quantity drops, the profit maximizing output level of a remaining firm increases
at which LMC2 = SMC2 = MR3.
o At this output level, each firm is making zero economic profit again.

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Market Individual Firm

P P ($)

S2
S1
SMC2
SMC1
SAC2 LAC2

SAC1 LAC1
P2
MR2
P1 MR1

Q2 Q1 Q q2 q1 q

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Figure 4: Short-run Equilibrium: An increase in marginal costs.

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Market Individual Firm

P P ($)

S3
S2
S1
SMC2
SMC1
SAC2 LAC2

P3 LAC1
P2 SAC1
MR2
P1 MR1

Q3 Q2 Q1 Q q2 q3 q1 q

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Figure 4: Adjustment to Long-run Equilibrium: Exit of Existing Firms

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4.
(a) Figure 4 shows the Hi-Tech’s initial situation, with long-run average cost LAC1, long-run marginal
cost LMC, and price P1. The short-run cost curves are not shown in the diagram to avoid too many
lines in the diagram. The extra-ordinary manager reduces Hi-Tech’s average cost to LAC2, but the
price remains at P1 since other firms can’t use the new process. It is because Hi-Tech is a very
small firm and cannot affect the market price. Thus Hi-Tech remains producing at q1 where LMC
= MR and earns positive economic profits. It will not attract new firms to enter the market in long
run since new firms cannot make profit without the extra-ordinary manager. Hi-Tech’s economic
profit will not be driven away by new entrants and therefore can exist even in the long run.

(b) In part (a), your economic profit (say $50, 000) will not be driven away even in long run, but your
long run economic profit is zero in part (b). Therefore, other firms will try getting your technology
so as to make profit. To keep it for your exclusive use, the maximum amount you are willing to
spend should be the economic profit (the $50,000) that you can enjoy in part (a), which is the
benefit of having such special technology. Even if you want to pay less, other firms will try to get
this resource from you and competition will drive the cost of keeping it for exclusive use to
$50,000. In economics, we call this economic rent. This is the economic surplus that is attributable
to an extraordinarily productive input or technology whose supply is limited. It is often confused
with economic profit. Therefore, in long run, Hi Tech’s economic profit is still zero, because the
part of economic rent is in fact the opportunity cost that you have to pay so as to keep the
extraordinarily productive input or technology.

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Market Hi-Tech
P S P ($)

SMC

SAC1
SAC2

P1
MR1

D
Q1 Q q1 q

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Figure 5: The cost-saving technology is exclusively used by Hi-Tech only.

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