Macroeconomics Principles, Problems and Policies

McConnell 20th Edition Solutions Manual

To download the complete and accurate content document, go to:

https://testbankbell.com/download/macroeconomics-principles-problems-and-policies-
mcconnell-20th-edition-solutions-manual/
Macroeconomics Principles, Problems and Policies McConnell 20th Edition Solutions Manual

Chapter 11 - Pure Competition in the Long Run

Chapter 11 - Pure Competition in the Long Run

McConnell Brue Flynn 20e

DISCUSSION QUESTIONS

1. Explain how the long run differs from the short run in pure competition. LO1

Answer: The entry and exit of firms in our market models can only take place in the long
run. In the short run, the industry is composed of a specific number of firms, each with a
plant size that is fixed and unalterable in the short run. Firms may shut down in the sense
that they can produce zero units of output in the short run, but they do not have sufficient
time to liquidate their assets and go out of business.
In the long run, by contrast, the firms already in an industry have sufficient time to either
expand or contract their capacities. More important, the number of firms in the industry
may either increase or decrease as new firms enter or existing firms leave.

2. Relate opportunity costs to why profits encourage entry into purely competitive industries and
how losses encourage exit from purely competitive industries. L02

Answer: Remember that normal profit is our measure of opportunity cost. Entry or exit
will continue until the market price generates a normal profit for firms in the industry.
With firms earning a normal profit, there will be no incentive to either enter or exit the
industry. This situation constitutes long-run equilibrium in a purely competitive industry.

3. How do the entry and exit of firms in a purely competitive industry affect resource flows and
long-run profits and losses? LO2

Answer: Entry and exit help to improve resource allocation. Firms that exit an industry
due to low profits release their resources to be used more profitably in other industries.
Firms that enter an industry chasing higher profits bring with them resources that were
less profitably used in other industries. Both processes increase allocative efficiency.
In the long run, the market price of a product will equal the minimum average total cost
of production. Thus, long run economic profits are zero.

4. In long-run equilibrium, P = minimum ATC = MC. Of what significance for economic

efficiency is the equality of P and minimum ATC? The equality of P and MC? Distinguish
between productive efficiency and allocative efficiency in your answer. LO4

11-1
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.

Visit TestBankBell.com to get complete for all chapters

Chapter 11 - Pure Competition in the Long Run

Answer: The equality of P and minimum ATC means the firms is achieving productive
efficiency; it is using the most efficient technology and employing the least costly
combination of resources. The equality of P and MC means the firms is achieving
allocative efficiency; the industry is producing the right product in the right amount based
on society’s valuation of that product and other products.

5. The basic model of pure competition reviewed in this chapter finds that in the long run all
firms in a purely competitive industry will earn normal profits. If all firms will only earn a normal
profit in the long run, why would any firms bother to develop new products or lower-cost
production methods? Explain. LO5

Answer: Competition involves the never-ending attempts by entrepreneurs and managers

to earn above-normal profits by either creating new products or developing lower-cost
production methods for existing products. These efforts cause creative destruction, the
financial undoing of the market positions of firms committed to existing products and old
ways of doing business by new firms with new products and innovative ways of doing
business. That is, if firms can innovate they can earn economic profit in the short run.

6. “Ninety percent of new products fail within two years—so you shouldn’t be so eager to
innovate.” Do you agree? Explain why or why not. LO5

Answer: If your firm happens to be one of the 10% that succeed you can capture short
run economic profits. You may even qualify for a patent on your product which allows
you to act as a monopolist for a given amount of time. So, if you can capture enough
expected economic profit in the short run to cover your initial investment then it is
worthwhile to innovate. (This argument ignores risk. If you add risk to the investment
story then you will need to receive additional expected economic profit to undertake the
investment to innovate.)

7. LAST WORD How can patents speed up the process of creative destruction? How can
patents slow down the process of creative destruction? How do differences in manufacturing
costs affect which industries would be most likely to be affected by the removal of patents?

Answer: Patents create a very large profit incentive. This incentive encourages firms to
constantly innovate and come up with something new. This increased innovation speeds
up the process of creative destruction.
Patents also eliminate the threat of competition for the life of the patent. This may make
the firm less eager to research and innovate, slowing down the process of creative
destruction. They also prevent other firms from copying the patent holder. This means
the other companies cannot come out with their version of the patented product, and
thereby slowing the process of creative destruction.
Industries with high costs need the high profit incentive that a patent supplies to give
them an opportunity to recover those costs. These industries would be greatly affected by
the removal of patents, as the company’s profit would be greatly reduced if they faced
competition right away.

11-2
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 11 - Pure Competition in the Long Run

REVIEW QUESTIONS

1. When discussing pure competition, the term long run refers to a period of time long enough to
allow: LO1
a. Firms already in an industry to either expand or contract their capacities.
b. New firms to enter or existing firms to leave.
c. Both a and b.
d. None of the above.

Answer: c. Both a and b.

When discussing pure competition, the term long run refers to a period of time long
enough for existing firms to expand or contract their capacities AND for the overall
number of firms to increase or decrease as new firms enter or existing firms exit.
For intuition, note that the long run is the amount of time necessary for both existing and
potential firms to react to profit incentives. High profits will tend to cause existing firms
to expand capacity while also attracting new firms to enter the industry. Low profits or
losses will tend to cause existing firms to reduce capacity or exit the industry. They will
also discourage any new firms from entering the industry.

2. Suppose that the pen-making industry is perfectly competitive. Also suppose that each current
firm and any potential firms that might enter the industry all have identical cost curves, with
minimum ATC = $1.25 per pen. If the market equilibrium price of pens is currently $1.50, what
would you expect it to be in the long run? LO2
a. $0.25.
b. $1.00.
c. $1.25.
d. $1.50.

Answer: c, $1.25.
We would expect the long-run market equilibrium price of pens to be equal to the
minimum ATC of $1.25 per pen.
To understand why, note that the current market equilibrium price of $1.50 is higher than
minimum ATC. This implies that each firm in the industry will be making a positive
economic profit because the $1.50 price at which a firm can sell a pen exceeds the
average total cost of producing that pen.
These positive economic profits will attract new firms to enter the industry. As each new
firm enters, it will increase the total supply of pens. That increase in supply decreases the
market equilibrium price of pens and, consequently, the profits earned by each firm in the
industry.
Firms will continue to enter the industry as long as profits are positive. Thus, they will
continue to enter as long as the market is greater than the minimum ATC of $1.25 per
pen. Entry will only stop once the number of firms has increased industry supply so
much that the market equilibrium price drops down to the minimum ATC of $1.25 per
pen. Thus, in the long run, we would expect the market price of pens to be $1.25.

11-3
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 11 - Pure Competition in the Long Run

3. Suppose that as the output of mobile phones increases, the cost of touch screens and other
component parts decreases. If the mobile phone industry features pure competition, we would
expect the long-run supply curve for mobile phones to be: LO3
a. Upward sloping.
b. Downward sloping.
c. Horizontal.
d. U-shaped.

Answer: b. Downward sloping.

This is a decreasing-cost industry because the cost of mobile-phone components declines
as output increases. These decreases in input costs will lower the ATC curves of every
firm in the industry. The result will be that as output increases, the equilibrium price of
mobile phones will decrease. This implies that the industry’s long-run supply curve will
be downward sloping as increases in output lead to decreases in price.

4. Using diagrams for both the industry and a representative firm, illustrate competitive long-run
equilibrium. Assuming constant costs, employ these diagrams to show how (a) an increase and
(b) a decrease in market demand will upset that long-run equilibrium. Trace graphically and
describe verbally the adjustment processes by which long-run equilibrium is restored. Now
rework your analysis for increasing- and decreasing-cost industries and compare the three long-
run supply curves. LO3

Answer: See figures 11.1 and 11.2 and their legends for the answers to (a) and (b) above.
See figure 9.4 for the supply curve for an increasing cost industry and figure 11.5 for the
supply curve for a decreasing cost industry.

11-4
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 11 - Pure Competition in the Long Run

11-5
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 11 - Pure Competition in the Long Run

5. Suppose that purely competitive firms producing cashews discover that P exceeds MC. Will
their combined output of cashews be too little, too much, or just right to achieve allocative
efficiency? In the long run, what will happen to the supply of cashews and the price of cashews?
Use a supply and demand diagram to show how that response will change the combined amount
of consumer surplus and producer surplus in the market for cashews. LO4

Answer: The combined output is too little to achieve allocative efficiency. The marginal
benefit of producing more cashews (as measured by P) exceeds the cost of the resources
necessary to produce them.
In the long run, the supply will increase as firms enter (or expand) to capture the
economic profits being earned. The increase in supply will reduce the price of cashews.
The increase in supply will unambiguously increase the combined area under the demand
curve and above the supply curve (consumer surplus and producer surplus, respectively).
See figure 11.6b for reference.

11-6
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 11 - Pure Competition in the Long Run

PROBLEMS

1. A firm in a purely competitive industry has a typical cost structure. The normal rate of profit in
the economy is 5 percent. This firm is earning $5.50 on every $50 invested by its founders. What
is its percentage rate of return? Is the firm earning an economic profit? If so, how large? Will this
industry see entry or exit? What will be the rate of return earned by firms in this industry once the
industry reaches long-run equilibrium? LO2

Answers: Percentage rate of return is 11 percent (= $5.50/$50); Yes, it is earning an

economic profit; It’s economic profit is 6 percent (= 11 percent – 5 percent); This
industry will see entry; Once the industry reaches equilibrium, firms in the industry
will earn the economy’s normal rate of profit, 5 percent.

Feedback: Since the firm is earning $5.50 on every $50 invested, the percentage rate of
return is 11% (= ($5.50 / $50) x 100).
Yes, the firm is earning an economic profit of 6%, which equals the difference between
the actual percentage rate of return and the normal rate of profit in the economy (=11%-
5%).
This industry will see entry because the rate of return is greater than the normal rate of
profit (economic profit is positive) resources could earn on average in other industries.
In the long run firms in this industry will earn the normal rate of profit. This is when
entry of new firms stops.

2. A firm in a purely competitive industry is currently producing 1,000 units per day at a total cost
of $450. If the firm produced 800 units per day, its total cost would be $300, and if it produced
500 units per day, its total cost would be $275. What are the firm’s ATC per unit at these three
levels of production? If every firm in this industry has the same cost structure, is the industry in
long-run competitive equilibrium? From what you know about these firms’ cost structures, what
is the highest possible price per unit that could exist as the market price in long-run equilibrium?
If that price ends up being the market price and if the normal rate of profit is 10 percent, then how
big will each firm’s accounting profit per unit be? LO4

Answers: The firms’ ATC per unit at 1,000 units per day is $0.45 (= $450/1,000); at
800 units per day it is $0.38 (= $300/800); and at 500 units per day it is $0.55 =
($275/500). This industry is not in long-run equilibrium because the firms in the
industry are not producing at the minimum point on their ATC curves—they are
producing at an output level higher than minimum ATC. From what we know of
these three output levels, the highest that the long-run equilibrium price could be is
$0.38 since that is the lowest of the three ATC per unit that we know and in long-
run equilibrium firms must be producing at the lowest possible ATC per unit. If
$0.38 ends up being the market equilibrium price in the long run and if the normal
profit rate that must hold in long-run equilibrium is 10%, then the firm must be
earning a normal profit of 3.8 cents per unit (= 10% * $0.38).

11-7
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Macroeconomics Principles, Problems and Policies McConnell 20th Edition Solutions Manual

Chapter 11 - Pure Competition in the Long Run

Feedback: The average total cost (ATC) is found by dividing total cost by the number of
units being produced. ATC for 1,000 units is $0.45 (=$450 / 1,000). ATC for 800 units
is $0.375 (=$300 / 800). ATC for 500 units is $0.55 (=$250 / 550).
If every firm in this industry has the same cost structure, is the industry in long-run
competitive equilibrium? No, because the firm is producing 1,000 (as stated in the
question) this industry cannot be in long-run equilibrium because it is not producing at
the lowest ATC (ATC at 1,000 units is greater than ATC at 800 units).
The highest possible price that could be supported in the long-run is the lowest ATC in
the industry. Given the information above this is $0.375 or $0.38 after rounding.
Since the normal rate of profit is 10% and the firm will charge $0.38 for each unit in the
long run, the accounting profit will be $0.038 (3.8 cents per unit). This is 10% of the
price (=.10 x $0.38).

3. There are 300 purely competitive farms in the local dairy market. Of the 300 dairy farms, 298
have a cost structure that generates profits of $24 for every $300 invested. What is their
percentage rate of return? The other two dairies have a cost structure that generates profits of $22
for every $200 invested. What is their percentage rate of return? Assuming that the normal rate of
profit in the economy is 10 percent; will there be entry or exit? Will the change in the number of
firms affect the two that earn $22 for every $200 invested? What will be the rate of return earned
by most firms in the industry in long-run equilibrium? If firms can copy each other’s technology,
what will be the rate of return eventually earned by all firms? LO4

Answers: The 298 dairies earn an 8 percent (= $24/$300) rate of return while the
two other dairies earn an 11 percent (= $22/$200) rate of return. Because the normal
rate of return of 10% is higher than the 8 percent earned by the 298 dairies, there
will be exit. The exit will not affect the two dairies that are earning 11 percent
returns because they are earning above-normal returns and thus do not have any
incentive to exit. In long-run equilibrium, most firms (the ones that remain from the
original 298) will earn the normal 10% rate of return. If firms can copy the
technology used by the two more efficient firms, then all firms will end up earning
the normal 10% rate of return after all firms have copied the better technology and
expanded output until the increase in market supply brings down the market price
low enough that all firms in the industry are earning the normal profit.

Feedback: The percentage rate of return for the firms is found by dividing profits by the
amount invested. This is multiplied by 100 to convert into percentage form. The
percentage rate of return for the 298 firms is 8% (= ($24 / $300) x 100). The percentage
rate of return for the 2 firms is 11% (= ($22 / $200) x 100).
There will be exit in this industry because the normal rate of profit is 10% and the 298
firms are only earning a return of 8%. That is, firms will exit this industry and invest their
resources in other industries which, on average, are earning 10%. This will not affect the
2 firms that are earning an 11% rate of return on their investment.
To stop the exit of firms from this industry, the firms will need to earn a 10% rate of
return. This equals the normal rate of profit in the economy.
If firms can copy the technology used by the two more efficient firms, then all firms will
end up earning the normal 10% rate of return after all firms have copied the better
technology and expanded output until the increase in market supply brings down the
market price low enough that all firms in the industry are earning the normal profit.

11-8
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.

Visit TestBankBell.com to get complete for all chapters