OM, Copenhagen Business School (01.04.

2022 / Week 13)

Workshop #4: Perfect Competition

Instructor: Rosa Klöser and Franz Buchmann Course: Managerial Economics, SEM 2022

Reminder: Download problems and data from canvas.cbs.dk prior to the start of the Workshop.
If you are asked to draw a graph, the x-axis values are given in the Excel file ”Workshop 4 Data”.
The Workshop will take place in person, please refer to the CBS calendar for the exact location
and time.

Problem 4.1: Perfect Competition

We will start the exercise class with some short questions highlighting some of the most important
concepts in perfectly competitive markets.

(a) Which conditions lead to individuals being price takers and perfect competition?

Solution: The conditions required for individuals being price takers are:

• Large numbers of buyers and sellers: Each firm produces a small part of the industry and
each customer only buys a small part of the total.

• Product homogeneity: There is no product differentiation meaning that the output of every
company in the market is basically the same.

• Free entry and exit: Companies are not restricted from entering or leaving the industry.

• Perfect information: Cost, price and product quality information is available and known by
all buyers and all sellers.

• Normal profits in the long-run equilibrium: Ruthless competition keeps P = M C and P =

AR = AT C.

(b) What is the long-run price in perfect competition? Explain why this is a stable equilibrium.
What is the affiliated long-run economic profit in perfectly competitive markets?

Solution: In the long-run equilibrium the market price will be defined as P = M C = M R =

AR = AT C and will be equal to the minimum point on each firm’s ATC curve. If the market price
fulfills this condition it is a stable equilibrium because,

• If P would be lower: Firms would not earn normal profits and would exit the market. The
lower supply leads to an increase in the market price P .

1
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 2

• If P would be higher: Firms would earn an economic profit and new firms would enter the
market. The increased supply lowers the market price P .

Hence, the long-run equilibrium is reached when all firms in the market earn normal profits and
zero economic profits.

(c) If 20.000 identical consumers each have the (inverse) demand function P = 100 − 20Q, what is
then the market demand function?

Solution: The intercept of the market demand function is the same but the slope has to be
divided by the number of customers

P = 100 − 0, 001QM D .

(d) If 1.000 identical companies each have M C = 40+1Q, what is then the market supply function?

Solution: The intercept of the market supply function stays the same but the slope has to be
divided by the number of producers

P = 40 + 0, 001QM S .

(e) Given your answers in (c) and (d), what is the price/quantity equilibrium?

Solution: To find the market equilibrium quantity, set equal the market supply and market
demand curves where price is expressed as a function of quantity, and QM S = QM D :

Supply = Demand
40 + 0, 001Q = 100 − 0, 001Q
0, 002Q = 60
Q = 30.000

To find the corresponding market price, plug Q into either the market demand or market supply
function. Hence,

P = QM D
= 100 − 0, 001(30.000)
= 70.

Therefore, the equilibrium price-output combination is a market price of $70 with an equilibrium
output of 30.000 units.
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 3

(f ) What is the consumer surplus (CS) and the producer surplus (PS)?

Solution: The total consumer surplus in this case is the triangle bounded by the market price
P , market demand curve QM D and the optimal quantity,

1
CS = [(100 − 70) · 30.000]
2
= 15 · 30.000
= 450.000

Similiarly, the producer surplus is the triangle bounded by the market price P , the market supply
curve QM S and the the optimal quantity,

1
P S = [(70 − 40) · 30.000]
2
= 15 · 30.000
= 450.000

Hence, both CS and PS are 450.000 in this example (Note: Keep in mind that normally consumer
and producer surplus are different and are only the same because of the specific functional form of
market supply and market demand curves in this example).

(g) Suppose the equilibrium in (e) is the long-run equilibrium, what are the fixed costs for each
producer then?

Solution: Remember that the total producer surplus was 450.000 in (f) and therefore the
producer surplus of every individual producer is given as

450.000
P Si = = 450.
1.000

Remember that in the long-run equilibrium no surplus above a normal profit is possible. Hence
the fixed costs have to be 450 for every individual producer.

(h) Give three examples of industries/markets where perfect competition best describes the market
structure.

Solution: Three examples could be:

• Agricultural commodities and commodities in general (Cotton, steel, potatoes).

• Unskilled Labour market in metropolitan regions.

• Discount retailers (especially low-end food and fashion retailers).

Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 4

Problem 4.2 Long-Run Competitive Equilibrium

Sun Charge, Ltd., supplies standard (CPU) processors to the U.S. computer and electronics indus-
try. Like the output of its competitors, Sun Charge’s processors must meet strict capacity, shape,
and speed specifications. As a result, the processor-supply industry can be regarded as perfectly
competitive. The total cost function for Sun Charge is::

T C = $2.000.000 + $80Q + 0, 0002Q2

where Q is the number of processors produced. Total costs include a normal profit.

(a) Calculate the marginal cost function for Sun Charge. Briefly explain the difference between
normal profits and economic profits.

Solution: The marginal cost curve of Sun Charge is given as

δT C
MC = = 80 + 0, 0004Q.
δQ

Normal Profit is the rate of return required to attract and retain capital investments in the com-
pany and is normally included in the total costs (as part of financing costs). Economic profit is just
defined as an above-normal rate of return. A negative economic profit is also defined as economic
losses meaning that the company is unable to provide an adequate return to their stakeholders.

(b) Calculate Sun Charge’s optimal output if chip prices are stable at $240 each. Do they earn an
economic profit?

Solution: the industry is perfectly competitive, P = M R = $240. Set MR = MC to find the

profit-maximizing activity level. From (a) we know the marginal cost function of Sun Charge.
Therefore,

MR = MC
240 = 80 + 0, 0004Q
0, 0004Q = 160
Q = 400.000,

and profits are,

Π = TR − TC
= 240(400.000) − 2.000.000 − 80(400.000) − 0, 0002(400.0002 )
= 30.000.000.
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 5

So yes, Sun Charge earns an economic profit of $30.000.000 since a normal profit is already included
in the total costs.

(c) Calculate Sun Charge’s optimal output if processor prices are stable at $100 each. Do they
earn an economic profit?

Solution: The strategy to solve this question is the same as in (b). If processor prices fall to
$100, the optimal activity level falls to Q = 50.000 because:

MR = MC
100 = 80 + 0, 0004Q
0, 0004Q = 20
Q = 50.000

Hence, economic profits are,

Π = TR − TC
= 100(50.000) − 2.000.000 − 80(50.000) − 0, 0002(50.0002 )
= −1.500.000.

In this case, Sun Charge earns an economic loss of $1.500.000.

(d) If Sun Charge is typical of firms in the industry, calculate the firm’s long-run equilibrium out-
put, price, and economic profit levels.

Solution: In the long-run equilibrium, P = AT C and M R = M C at the point where average

totals costs are minimized. To find the point of minimum average costs set M C = AC, and solve
for Q:

TC
M C = AT C =
Q
2.000.000 + 80Q + 0, 0002Q2
80 + 0, 0004Q =
Q
2.000.000
80 + 0, 0004Q = + 80 + 0, 0002Q
Q
2.000.000
0, 0002Q =
Q
2.000.000
Q2 =
0, 0002
√
Q = 10.000.000.000
Q = 100.000.
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 6

Afterwards, derive the long-run equlibrium price given the quantity,

P = AT C
2.000.000
= + 80 + 0, 0002(100.000)
100.000
= 120.

As a last step we are now able to solve for the long-run economic profits. The result should be no
surprise to you,

Π = TR − TC
= 120(100.000) − 2.000.000 − 80(100.000) − 0, 0002(100.0002 )
= 0.

In the long-run equilibrium there are no economic profits in perfectly competitive markets and
every company just earns normal profits.

Problem 4.3 Profit Maximization in Competitive Markets

Suppose a friend of yours is producing local craft beer here in Copenhagen. The competition
in the craft beer market is fierce and hence he has to act as a price taker. The market price for
craft beer is 50 DKK per bottle in Copenhagen. His yearly fixed costs covering rent, salaries etc.
are 500.000 DKK. Furthermore, his total variable cost function is given as

T V C = 50.000 + 10Q + 0, 0002Q2 ,

where Q is the number of beer bottles produced by him. Since he knows that you are having the
course Managerial Economics, he asks you for help to get an overview over his costs, revenue and
profit in this market.

(a) Fill out the table in the Excel file ”Workshop 4 data” to get an overview over his finances
(Hint: Fill out the table from left to right).

Solution: Please see the Excel file ”Workshop 4 Solutions” for the filled out table.

(b) By looking at the table you derived in (a), how many bottle of beers should he produce to
maximize profits? What is his economic profit at this point? Is the second-order condition for
profit maximization fulfilled?
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 7

Solution: Remember that the condition for profit maximization is

M Π = M R − M C = 0.

Hence, the point where M R = M C in the table is for 100.000 units (green marked row in the Excel
file). Furthermore, the second order condition is fulfilled since marginal profits are decreasing after
the equilibrium point.

(c) Calculate the output at which his average variable costs (AVC) are minimized. Afterwards,
calculate the output at which his average total costs (ATC) are minimized.
Solution: The point where AVC are minimized is the point where M C = AV C holds, yielding

M C = AV C
50.000 + 10Q + 0, 0002Q2
10 + 0, 0004Q =
Q
10Q + 0, 0004Q2 = 50.000 + 10Q + 0, 0002Q2
0, 0002Q2 = 50.000
Q ≈ 15.811

Similarly, the point where ATC are minimized is the point where M C = AT C holds. The reason
for this can be explained by the U-shape of the ATC curve. In the beginning, it tends to fall since
the fix costs are spread across an increasing amount of Q, but then tend to rise again due to the
marginal costs.

M C = AT C
550.000 + 10Q + 0, 0002Q2
10 + 0, 0004Q =
Q
10Q + 0, 0004Q2 = 550.000 + 10Q + 0, 0002Q2
0, 0002Q2 = 550.000
Q ≈ 52.440

(d) Your friend is unsure how much beer he should supply to the Copenhagen market in case the
price changes and asks again for your advice. Draw a graph including the MR, MC, ATC and AVC
with Q on the x-axis in Excel. Describe to him on the graph his competitive short and long-run
supply curve.

Solution: In the short-run, the marginal cost curve is the supply curve as long as the market
price P is higher than the AV C (P > AV C). This is the case until an output slightly below 200.000
in this example.
In the long-run, the marginal cost curve is the supply curve as long as the market price P is higher
than the AT C (P > AT C). This is the case between an output of roughly 15.000 and 185.000 in
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 8

this example.

(e) Assume that your friend owns a typical microbrewery in Copenhagen. Is the current price/quantity
combination a stable long-run equilibrium for the craft beer market in Copenhagen? If not, will
microbreweries enter or exit the market and what will the long-run equilibrium price per bottle of
craft beer be?

Solution: No, it is not a stable long-run equilibrium since your friend makes an economic
profit. Hence, other microbreweries will enter the market and ruthless price competition will drive
the market price down. The long-run equilibrium price will be at the minimum point of each
microbrewery’s ATC curve. In (c) we have seen that this happens at a quantity of roughly 52.440.
Hence, the market price P will be

P = AT C
550.000 + 10(52.440) + 0, 0002(52.4402 )
=
52.440
= 30, 91.

Hence the long-run equilibrium market price per bottle of craft beer will be 30,91 DKK.

Problem 4.4 Demand vs Supply Subsidy

In Africa, the polio epidemic has been the most difficult to control. Besides the lack of infras-
tructure and political instability, low incomes make paying for the vaccine a real problem among
the poor. As a possible measure to make the oral polio vaccine more affordable, either consumer
purchases (demand) or production (supply) can be subsidized. We are interested in investigating
the economic effects of these two subsidies on (effective) prices and outputs. Consider the following
market demand and market supply curves for a generic oral polio vaccine

QD = 12.000 − 800P
QS = −1.000 + 500P

where Q is output measured in doses of oral vaccine (in thousands), and P is the market price
in dollars.

(a) Vouchers have a demand-increasing effect. Calculate the equilibrium price/output solution
before and after the institution of a voucher system whereby consumers can use a $3,25 voucher to
supplement cash payments.

Solution: The market demand curve is given by the equation

QD = 12.000 − 800P
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 9

or, solving for price,

800P = 12.000 − QD
P = 15 − 0, 00125QD

The market supply curve is given by the equation

QS = −1.000 + 500P

or, solving for price,

500P = 1.000 + QS
P = 2 + 0, 002QS

To find the market equilibrium levels for price and quantity, simply set the market supply and
market demand curves equal to one another so that QS = QD . To find the market equilibrium
price, equate the market demand and market supply curves where quantity is expressed as a function
of price:

Supply = Demand
−1.000 + 500P = 12.000 − 800P
1.300P = 13.000
P = 10

To find the market equilibrium quantity, set equal the market supply and market demand curves
where price is expressed as a function of quantity, and QS = QD :

Supply = Demand
2 + 0, 002Q = 15 − 0, 00125Q
0, 00325Q = 13
Q = 4.000

Therefore, the equilibrium price-output combination is a market price of $10 with an equilibrium
output of 4.000 (000) units. Following the institution of a $3,25 per unit demand voucher, the new
voucher-aided market demand curve is given by the equation

P = 15 − 0, 00125QD + voucher
= 15 − 0, 00125QD + 3, 25
= 18, 25 − 0, 00125QD
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 10

or, solving for quantity,

P = 18, 25 − 0.00125QD
0.00125QD = 18, 25 − P
QD = 14.600 − 800P

To find the new market equilibrium price, equate the new voucher-aided market demand and market
supply curves where quantity is expressed as a function of price and QS = QD :

Supply = Demand
−1.000 + 500P = 14.600 − 800P
1.300P = 15.600
P = 12

To find the market equilibrium quantity, set equal the market supply and market demand curves
where price is expressed as a function of quantity, and QS = QD :

Supply = Demand
2 + 0, 002Q = 18, 25 − 0, 00125Q
0, 00325Q = 16, 25
Q = 5.000

Therefore, the equilibrium price-output combination with a $3,25 per unit voucher is a market
price of $12 with an equilibrium output of 5.000 (000) units.

(b) Graph your results from question (a) in Excel.

Solution: Please see the Excel file ”Workshop 4 Solutions” for the graph.

(c) Per-unit producer subsidies have a marginal cost-decreasing effect. Show and calculate the
equilibrium price/output solution after the institution of a $3,25 per unit subsidy for providers of
the oral polio vaccine.

Solution: Following the institution of a $3,25 per unit producer subsidy, the new subsidy-aided
market supply curve is given by the equation

P = 2 + 0, 002QS − subsidy
= 2 + 0, 002QS − 3, 25
= −1, 25 + 0, 002QS
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 11

or, solving for quantity,

P = −1, 25 + 0, 002QS
0, 002QS = 1, 25 + P
QS = 625 + 500P

To find the new market equilibrium price, equate the market demand and subsidy-aided market
supply curves where quantity is expressed as a function of price and QS = QD :

Supply = Demand
625 + 500P = 12.000 − 800P
1.300P = 11.375
P = 8, 75

To find the market equilibrium quantity, set equal the market supply and market demand curves
where price is expressed as a function of quantity, and QS = QD :

Supply = Demand
−1, 25 + 0, 002Q = 15 − 0, 00125Q
0, 00325Q = 16, 25
Q = 5.000

Therefore, the equilibrium price-output combination with a $3,25 per-unit subsidy is a market price
of $8,75 with an equilibrium output of 5.000 (000) units.

(d) Discuss any differences between answers to questions (a) and (c).

Solution: Notice that the exact same level of output is achieved in (a) and (c). Also notice that
the market price of $12 in (a) results in an effective price to consumers of $8,75 (= $12 − $3, 25),
the exact same price as (c). Holding demand and supply elasticities constant, there is no economic
difference between an identical per unit subsidy (or tax) for buyers or seller.

Problem 4.5: Import Controls and Deadweight Loss

In 2019, the total U.S. goods deficit, the difference between imported and exported goods, in-
creased temporarily to $891.3 billion, the highest level ever recorded. Meanwhile, the overall trade
deficit with the rest of the world jumped 12,5 percent to $621 billion as both imports and ex-
ports rose to their highest levels ever. The White House still has a negative view towards trade
imbalances and hence wants to restrict foreign imports to reduce the deficit. Suppose you are a
consultant for the administration of Joe Biden and are responsible to investigate the effects of an
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 12

important ban on foreign footwear. Assume market supply and demand conditions for shoes are

QU S = −50 + 2, 5P Supply from US Producers

QF = −25 + 2, 5P Supply from Foreign Producers
QD = 375 − 2, 5P Market Demand

where Q is output (in millions), and P is the market price per unit.

(a) Calculate the equilibrium price/output solution assuming there are no import restrictions.

Solution: In the absence of import bans, the market supply curve is determined by adding
supply from domestic and foreign producers,

QS = QU S + QF
= −50 + 2, 5P − 25 + 2, 5P
= −75 + 5P

or, solving for price,

5P = 75 + QS
P = 15 + 0, 2QS .

The market demand curve is given by the equation

QD = 375 − 2, 5P

or solving for price,

2, 5P = 375 − QD
P = 150 − 0, 4QD .

To find the market equilibrium levels for price and quantity, simply set the market supply and
market demand curves equal to one another so that QS = QD . To find the market equilibrium
price, equate the market demand and market supply curves where quantity is expressed as a function
of price:

Supply = Demand
−75 + 5P = 375 − 2, 5P
7, 5P = 450
P = 60

To find the market equilibrium quantity, set equal the market supply and market demand curves
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 13

where price is expressed as a function of quantity, and QS = QD :

Supply = Demand
15 + 0, 2Q = 150 − 0, 4Q
0, 6Q = 135
Q = 225

Therefore, the equilibrium price-output combination is a market price of $60 with an equilibrium
output of 225 (million) units.

(b) Calculate the equilibrium price/output solution under the assumption that imports from for-
eign producers are prohibited.

Solution: If foreign goods are kept off the market, the domestic producer supply curve becomes
the market supply curve

QS = −50 + 2, 5P

or, solving for price,

2, 5P = 50 + QS
P = 20 + 0, 4QS

To find the market equilibrium levels for price and quantity in the face of import supply restrictions,
simply set the market supply and market demand curves equal to one another so that QS = QD .
To find the market equilibrium price, equate the market demand and market supply curves where
quantity is expressed as a function of price:

Supply = Demand
−50 + 2, 5P = 375 − 2, 5P
5P = 425
P = 85

To find the market equilibrium quantity, set equal the market supply and market demand curves
where price is expressed as a function of quantity, and QS = QD :

Supply = Demand
20 + 0, 4Q = 150 − 0, 4Q
0, 8Q = 130
Q = 162, 5

Therefore, the equilibrium price-output combination with import supply restriction is a market
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 14

price of $85 with an equilibrium output of 162,5 (million).

(c) Draw your results from question (a) and (b) in one graph in Excel.

Solution: Please see the Excel file ”Workshop 4 Solutions” for the graph.

(d) Use this graph to help you algebraically determine the amount of consumer surplus transferred
to producer surplus and the deadweight loss in consumer surplus due to a ban on foreign imports.
Would you recommend the import ban when considering the impact on social welfare in the United
States?

Solution: In a free market, the value of consumer surplus is equal to the region under the
market demand curve that lies above the market equilibrium price of $60. Because the area of such
a triangle is one-half the value of the base times the height, the value of consumer surplus equals:

1
CSU S+F = [225 · (150 − 60)]
2
= 10.125

With a ban on foreign goods, the value of consumer surplus is equal to the region under the market
demand curve that lies above the market price of $85. Because the area of such a triangle is one-half
the value of the base times the height, the value of consumer surplus equals:

1
CSU S = [162, 5 · (150 − 85)]
2
= 5.281, 25

Therefore, the loss in consumer surplus caused by foreign supply restriction is:

∆CS = CSU S+F − CSU S

= 10.125 − 5.281, 25
= 4.843, 75

The $4.843,75 (million) loss in consumer surplus due to the foreign supply restriction has two
components. First, there is a transfer of consumer surplus to producer surplus:

Transfer to PS = 162, 5 · (85 − 60)

= 4.062, 5

Second, there is a deadweight loss of consumer surplus. Because the area of such a triangle is
Managerial Economics, SEM 2022 – Workshop #4: Perfect Competition 15

one-half the value of the base times the height, the value of consumer surplus equals:

1
DW L = [(225 − 162, 5) · (85 − 60)]
2
= 781, 25

(e) A smart colleague of yours argues that instead of banning foreign imports the US should just
impose a tax on every imported pair of footwear to avoid negative effects on social welfare. Do you
agree with him (Hint: No calculations are needed here)?

Solution: No, the main point here is that a tax on imported footwear will increase prices.
Hence, there will still be consumer surplus transferred to producer surplus and a deadweight loss
of consumer surplus. So social welfare is still not maximized as it is under perfect competition.
Also, note that it does not matter if the tax is imposed on the consumer or producer side as seen
in problem 4.4.