Quiz 8: Pricing and Output Decisions: Perfect Competition and Monopoly

Yes, this is good idea for the firm to be in the market. In the given case, AC P AVC A perfectly competitive firm will continue to produce in the short run if its price is above the average variable cost. Although AC P which means the firm is making losses, but since P AVC, it means the firm is still able to cover its variable costs and can thus continue producing, only in the short run. Due to short run losses, many firms will start exiting the market. This will reduce the number of producers in the market and thus shift the supply curve to the left. This will lead to an increase in prices and the firms will now be able to make profits and the market will reach equilibrium.

A price-taking seller or buyer is one who does not have the ability to control the price of its product. Under perfect competition both sellers and buyers are price-takers. For example, buyers and sellers can increase or decrease the output without significantly affecting the price of the product. Perfect competition is based on the four assumptions. First, there are many sellers and buyers. Second, sellers sell a homogeneous good. Third, buyers and sellers have all relevant information. Fourth, entry into and exit from the market are easy. Since, a buyer or seller is a small part of the market and it produces or buys homogeneous good where buyers and sellers have all relevant information. Thus first, second and third characteristics are the main causes of the buyers and sellers to be price takers.

a) False, perfectly competitive firm should not immediately cease operations. Perfectly competitive firm will continue to produce in the short run if price is lower than average total cost but above the average variable cost. If firm shuts down the production in this condition then it will increase losses. Firm will shut down the production when price is below the average variable cost. b) False, monopoly does not have the power set its price at any level it desires. The reason is that monopolist can to some degree control the price of the product it sells. Demand curve for the monopolist firm is the market demand curve, which is downward sloping. Downward-sloping demand curve shows an inverse relationship between price and quantity of product. More quantity of good is sold at lower prices, ceteris paribus. c) True, perfectly competitive firms and monopolistic competitive firms earn normal profit in the long run. Long-run competitive equilibrium cannot exist if firms have positive economy profit and losses. If firms earn positive economic profit then it will attract new firms to enter the industry. Ultimately economic profit is zero. If firms incur losses, then some firms will leave the industry. Since, all firms in the industry earn zero economy profit or normal profit. d) True, a firm that wants to maximize its revenue will charge a lower price than a firm that wants to maximize its profit. The condition of revenue maximizing is that marginal revenue should be zero. While the condition of profit maximizing is that difference between total revenue and total cost is highest or marginal revenue is equal to marginal cost. If firm wants to sell more quantity of good he has to lower the price from the profit maximization price because of price-setting firm faces downward sloping demand curve. e) False, if it means that price is greater than average variable cost. It also indicates positive contribution margin. Contribution margin is the amount of revenue that a firm earns above its total variable cost. A firm incur loss may continue operating in the short run if it has a positive contribution margin f) False, firm always sets its price where marginal revenue is equal to marginal cost rather than less than its marginal revenue. g) False, monopoly does not set any price that it wants to. Monopolist can to some degree control the price of the product it sells. Demand curve for the monopolist firm is the market demand curve, which is downward sloping. Downward-sloping demand curve shows an inverse relationship between price and quantity of product. More quantity of good is sold at lower prices, ceteris paribus.