Solution Manual for Microeconomics, 16th Canadian

Edition, Christopher T.S. Ragan, Christopher Ragan

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Solution Manual for Microeconomics, 16th Canadian Edition, Christopher T.S. Ragan, Christoph

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Part Four

Market Structure and Efficiency

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The four chapters in this Part of the book cover the core theory of markets, to which we have
always given a balanced treatment of theory, applications, and policy. Chapters 9 and 10 on perfect
competition and monopoly include some brief discussions of efficiency that anticipate the more
detailed discussion in Chapter 12. In addition to covering the basic theory of monopoly, Chapter 10
addresses the economics of cartels and price discrimination by any firm with market power.
Chapter 11 examines the intermediate forms of imperfect competition—monopolistic competition
and oligopoly. The first part of Chapter 12 continues to give the standard welfare case in favour of
perfect competition (and against monopoly). We also discuss the relationship between productive
efficiency, allocative efficiency, and the production possibilities boundary. The second part, on
economic regulation and competition policy, updates the policy discussion and addresses the trade-
off that mergers often create between reduced competition and reduced costs.

***

The four chapters are arranged so that the instructor who must leave out some of the material can
do so with relative ease. Chapters 9 and 10 are the basic theories of perfect competition and
monopoly, respectively. Instructors usually assign these two chapters in their entirety. Chapter 11
covers both monopolistic competition and oligopoly, and most instructors will want to cover at
least the core sections; there are many side issues that might successfully be left to students to read
on their own. Some simple but useful game theory is introduced in this chapter, and it is shown
how this way of thinking can help us examine the nature of firm interaction.

The first half of Chapter 12 introduces the important distinction between productive and
allocative efficiency and then examines the relationship between market structure and allocative
efficiency. It relates allocative efficiency to the concepts of consumer surplus and producer surplus.
It also discusses how the allocatively efficient point on the production possibilities boundary is
determined, using a diagram that links the production possibilities boundary to two supply-and-
demand diagrams representing the underlying competitive markets. Having discussed allocative
efficiency in some detail, the concept of a market failure is then briefly introduced. This provides
the student with some motivation for the study of policy that follows, and provides a hint of what is
to come in Part 6 of the textbook. The remainder of Chapter 12 examines regulation and
competition policy.

***

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Chapter 9: Competitive Markets

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The first section of this chapter deals with the often-confusing distinction between competitive
market structure and competitive firm behaviour. We hope our discussion resolves the apparent
paradox that there can be a great deal of competitive behaviour in market structures that are
oligopolistic, while there is no competitive behaviour whatsoever in market structures that
economists call perfectly competitive.

In the second section, we develop the theory of perfect competition around four key structural
assumptions:
• a homogeneous product;
• well-informed customers;
• each firm is small relative to the overall size of the industry; and
• the industry has freedom of entry and exit.
Though these structural assumptions are sufficient, but not necessary, for price-taking behaviour,
our experience shows that students find it easier to come to terms with the abstract model of
perfect competition if it is erected on the structural assumptions that help to make price taking
seem reasonable. Students who wish to argue that these are unrealistic assumptions can be directed
to look at the great commodity exchanges where well-informed buyers purchase grains, meats,
minerals and energy products under conditions that closely resemble perfect competition.

We treat the competitive firm’s infinitely (perfectly) elastic demand curve as an empirical
approximation rather than as an extreme assumption. We hope this helps to make the model more
relevant to students. The detailed calculation of a firm’s demand elasticity given the industry’s
demand elasticity is examined in a box. The wheat data used in this box are real. Note that they
yield a virtually horizontal demand curve for the firm producing a commodity whose market
demand is nonetheless quite inelastic.
The third section examines the behaviour of perfectly competitive firms, and derives their
supply curves from first principles. Here is where the rules for profit maximization appear. The
possibility that firms may earn negative profits and remain in business (price less than ATC but
greater than AVC) leads to a box on the parable of the seaside inn. We have a discussion and
table to illustrate the firm’s shut-down decision.

Having dealt with the short-run determination of price under perfect competition, the
chapter then turns to a full discussion of long-run industry equilibrium. We examine entry-
attracting prices as well as exit-inducing prices, and how such changes in the number of firms lead
to shifts in the industry supply curve. We use two-part diagrams for these analyses that allow
students to see what is happening for individual firms as well as for the industry as a whole. The
examples of declining industries and changes in technology provide students with excellent
applications of the basic theory. These examples should give students some feeling for the
importance and relevance of long-run market analysis.

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Answers to Study Exercises

Fill-in-the-Blank Questions

Question 1
a) homogeneous
b) price
c) small
d) entry; exit

Question 2
a) perfectly elastic (horizontal)
b) marginal revenue; average revenue
c) price; quantity; total revenue; output; the change in total revenue; the change in output
d) total fixed cost

Question 3
a) average variable costs
b) produce no output (“shut down”)
c) reduce or decrease
d) increase
e) equal; maximized
f) greater than; increase

Question 4
a) AVC
b) ATC; AVC
c) ATC; enter

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 Chapter 9: Competitive Markets 103

Question 5
a) enter; right; fall (decrease)
b) exit; left; rise (increase)
c) zero; minimum; ATC; minimum; average cost

Review Questions

Question 6
a) Let the equilibrium market price be p* (which equals $3 in Figure 9-1). Any firm that tried to
charge a higher price would make no sales whatsoever, since consumers would simply make their
purchases from other (lower-price) sellers.
b) Each (small) firm is able to sell as much as it wants to supply to the market at the price p*. Thus,
selling at a lower price would not increase sales but would reduce profits. So, no firm has the
incentive to charge any price below p*.
c) Each individual firm is very small relative to the market (check Figure 9-1 again and compare
the units on the quantity axes in the two parts of the figure). Thus, for any change in output that is
realistic for the firm, there would be no significant or noticeable effect on the industry level of
output and thus no significant effect on the market price. Thus, each firm sees that it can sell any
reasonable amount at the given market price. (Read Applying Economic Concepts 9-1 to see an
application—we show that even though the market demand for wheat is quite inelastic, the demand
for any individual farmer’s wheat is almost perfectly elastic.)

Question 7

This is a good question to help students understand which real-world observations about markets
are consistent with perfect competition. It also helps to reinforce the important distinction
between a competitive market and competitive behaviour.

Fact (a) is consistent with perfect competition, since different methods will always be found
when embodied changes in technological knowledge are occurring.

Fact (b) is also consistent since it is the industry association’s attempt to shift the market demand
curve rather than an individual firm’s attempt to shift its own demand curve.

Fact (c) is plainly inconsistent, since price takers would not advertise their own brand because
they do not have a brand – their product is identical to that of other firms.

Fact (d) is not necessarily inconsistent since it is quite possible that 24 firms selling a
homogeneous product could each act as if they were price takers.

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104 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

Fact (e) is probably inconsistent since the two largest firms will have significant market power.
However, if the products really are identical and MES is large, then this industry could still be
competitive.

Fact (f) is consistent with perfect competition since large profits may merely mean that an
increase in demand has left existing firms earning profits in an industry that is not yet in long-run
equilibrium (when entry will eventually eliminate the profits).

Question 8

a) In order to be able to earn positive economic profits, there must be some level of output for
which the price exceeds average total cost. This is impossible for both Firm 1 and Firm 4 since in
both cases the ATC curve is always above the price line. Firm 2 could, at best, break even (and
earn zero profit). Positive economic profits are only possible for Firm 3.

b) Firm 4 is the only firm that will produce positive output while earning negative profits
(losses). To see this, note that the combined rules from the chapter imply that price-taking firms
should produce at the level of output where price equals marginal cost, so long as price is no less
than average variable cost. The firms that will optimally choose to produce positive levels of
output (at p = MC) are Firm 2, Firm 3 and Firm 4 (Firm 1 will shut down since price is less than
the minimum of AVC). Firm 2 will break even and will continue producing. Firm 3 will earn a
positive profit and will continue producing. Firm 4 will earn negative profits (losses) but is just
covering its variable costs; it will remain producing as long as price falls no further.

c) Firm 1 will not produce at the current price because it cannot even cover the variable costs of
production. All other firms will produce at the current price.

Question 9

a) Entry is probably restricted although it is possible (if unlikely) that demand has continued to rise
at a rate that has been unanticipated over the last two decades. It could also mean that because of
exceptional risk in the industry, accounting profits are high although economic profits are zero.

b) This tells us nothing about ease of entry or exit. The absence of entry for 20 years is consistent
with a perfectly competitive industry in which technological change is increasing the capacity of
existing firms at the same rate that demand is growing (which includes the special case of zero
change). Students might find it instructive to draw the case in which cost changes offset a demand
shift so that the number of firms in the industry in long-run equilibrium does not change.

c) The young average age of firms suggests that there has been quite a bit of new entry in recent
years.

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 Chapter 9: Competitive Markets 105

d) If existing plants are using equipment of very different vintages, it suggests heavy capital, long
useful life, and possibly low variable costs. It also suggests that firms are able to expand their
operations (new equipment) and in this sense there is relatively easy entry.

e) This plainly suggests slow exit, possibly for the same reasons as in (d), but it says nothing about
ease of entry.

Question 10

a) The diagrams are shown below. The left-hand diagram shows the initial industry equilibrium
at price p0 and quantity Q0.

b) The right-hand diagram below shows a typical firm when the industry is in long-run
equilibrium. The typical firm is producing q0 units of output. It is not only earning zero economic
profits in the short run (p = SRATC), but it also has no unexploited economies of scale — that is,
it is at the minimum of its LRAC curve.

c) The increase in demand for barley shifts the demand curve to D and raises the short-run
equilibrium price to p1. The increase in market price causes each firm to increase its own output
along its MC curve, to output q1 for the typical firm shown. Short-run profits for each firm at this
new high price are shown by the shaded area.
d) The positive profit in part (c) leads other firms to enter this industry. As new barley farmers
enter the industry, the industry supply curve shifts to the right and reduces the equilibrium
market price. Entry continues until existing firms are not making any economic profits. As long
as technology has not changed, firms’ cost curves do not shift and so supply shifts eventually to
S, where the market price has returned to p0. At this point, the typical firms are again making
zero economic profits. Note that in the new long-run equilibrium, industry output has increased

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106 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

(because of the entry of new firms) but each of the “old” firms is producing the same amount as
it did in the initial long-run equilibrium.

Problems

Question 11

a) The completed table is shown below. Recall that total revenue is equal to price times quantity.

Price ($) Quantity Total Average Marginal

Revenue ($) Revenue ($) Revenue ($)
2 150 300 300/150 = 2
2 175 350 350/175 = 2 50/25 = 2
2 200 400 400/200 = 2 50/25 = 2
2 225 450 450/225 = 2 50/25 = 2
2 250 500 500/250 = 2 50/25 = 2

b) See the table above. Average revenue is equal to total revenue divided by quantity. Marginal
revenue is equal to the change in total revenue divided by the change in quantity; it is computed
using the change from one row to the next.

c) A perfectly competitive firm is a price taker. It can sell any amount at the given market price,
which in this case is $2. Since every unit it sells is sold at the price of $2, it follows that its average
revenue is $2 but also its marginal revenue is $2.

d) See the figure below. Note that the vertical scales on the two diagrams are different, though both
are measured in dollars. The slope of the TR curve is the change in total revenue divided by the
change in quantity, TR/Q. This is marginal revenue and is equal to 2.

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 Chapter 9: Competitive Markets 107

Question 12

a) The completed table is shown below. The firm’s supply curve is given by the section of its MC
curve above the minimum of the AVC curve. Profits are determined by the difference between
price and average total cost, ATC. For the first row in the table, price ($3) is below ATC and AVC
for any possible output level, as can be seen in the diagram, and so the firm chooses not to produce
at all (and so there are no profits).

Price ($) Firm’s Output Is price > ATC? Is Price > AVC? Profits positive?
3 Do not produce No No No profits
4 130 units No No (Price = AVC) Negative profits
5 145 units No Yes Negative profits
6 155 units No Yes Negative profits
7 165 units Yes Yes Positive profits
8 175 units Yes Yes Positive profits
9 185 units Yes Yes Positive profits
10 195 units Yes Yes Positive profits

b) The firm shuts down when the market price falls below the minimum of the AVC curve. In this
case, when the price falls below $4, the firm will shut down. The reason is that when price < AVC,
the firm cannot cover even its variable costs, and so the firm is better off to close down rather than
continue to produce and increase its losses.

c) The firm’s supply curve is its MC curve above the minimum point of AVC. There will be no
production when price < AVC, for the reason given in part (b). For prices above AVC, profit
maximization requires the firm to produce until marginal revenue (which equals market price) is
equal to marginal cost. Thus, the MC curve above the AVC curve is the firm’s supply curve.

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108 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

Question 13

a) Total industry supply at each price is simply equal to the sum of the quantities supplied by all of
the individual firms. The completed table is shown below.

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 Chapter 9: Competitive Markets 109

Market Industry Quantity

price ($) Supplied
2.50 100 + 0 + 0 = 100
3.00 125 + 0 + 0 = 125
3.50 150 + 100 + 0 = 250
4.00 175 + 150 + 0 = 325
4.50 200 + 200 + 100 = 500
5.00 225 + 250 + 175 = 650
5.50 250 + 300 + 250 = 800
6.00 275 + 350 + 325 = 950

b) The scale diagrams are shown below. Note that the vertical scales are the same in all four
figures, but the horizontal axis for the Industry figure is different from the other three figures.

c) Firm B produces no output at prices of $3.00 or below because those prices do not cover Firm
B’s average variable costs. Similarly, for Firm C and prices at or below $4.00.

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110 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

Question 14
a) The table below shows the correct cost data. Output is in units and all costs are in dollars.

Output TVC TFC TC MC ATC AVC

0 0 100 100
100 40 100 140 0.40 1.4 0.40
200 70 100 170 0.30 0.85 0.35
300 120 100 220 0.50 0.73 0.40
400 180 100 280 0.60 0.70 0.45
500 250 100 350 0.70 0.70 0.50
600 330 100 430 0.80 0.72 0.55
700 420 100 520 0.90 0.74 0.60
800 520 100 620 1.00 0.78 0.65
900 630 100 730 1.10 0.81 0.70

b) The figure below shows the AVC, MC and ATC curves.

c) The firm should optimally choose to produce zero units of output when the price falls below
the minimum of the AVC curve – in this case, a price of $0.35.

d) At a price of $0.80 per napkin, the profit-maximizing level of output is given by the MC curve
at that price. In this case, the answer is approximately 550 napkins (in the middle of the range
500-600 napkins). At a price of $0.60 per napkin, the optimal output is in the range 300-400
napkins. At a price of $1.00 per napkin, the optimal output is in the range 700-800 napkins.

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Solution Manual for Microeconomics, 16th Canadian Edition, Christopher T.S. Ragan, Christoph

Chapter 9: Competitive Markets 111

e) Consider the above diagram to answer this question. At a market price of $0.70 per napkin, the
profit-maximizing level of output is (approximately) 450 napkins per day. In this situation, the
firm’s total revenue is $315 per day. Average total cost is $0.70 per napkin. So total (economic)
profit for the firm is zero, and profit per unit is zero. The firm is just covering its economic cost.

Question 15
For this question, compare market price to AVC to see if the firm should produce at all. Then
compare the firm’s marginal cost at its current level of output to the market price. If p > MC, the
firm should produce more; if p < MC, the firm should produce less.

a) Price is $64 and AVC is $48, so producing is OK. Since marginal cost is $67, the firm should
reduce its output.

b) Price is $64 and AVC is $66, so firm should not produce at all.

c) Price is $64 and AVC is $58, so producing is OK. Since MC is $60, less than price, the firm
should increase output.

d) Price is $64 and AVC is $62, so producing is OK. Since MC equals price, the firm should not
change its output level.
e) Price is $10 and AVC is $11 (= $66,000/6000 units), so firm should not produce at all.

f) Price is $4 and AVC is $3 (=$30,000/10000 units), so producing is OK. Since MC equals

price, the firm should not change its output.

*****

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