Quiz 9: Businesses and the Costs of Production
The key characteristic of a purely competitive industry is that there is zero economic profit in the long run, because other firms will want to enter that industry to capture a higher profit. The normal rate of profit, which is given to be 5 percent, is what a "normal" firm should earn in this economy. Firms in an industry have an economic profit if their profit is higher than the normal profit of 5 percent. We see that the firm we are interested in is making $5.50 on every $50 invested, which means that it has a profit of , or 11 percent. This is higher than the normal profit of 5 percent, and so the firm is earning an economic profit of 6 percent (11 percent - 5 percent). Firms in other industries will see that there is an industry in the market that is earning 6 percent higher than the normal profit, and thus will want to move into this industry. Perhaps a good example is if there are only two industries in the market, the burger industry and the hot dog industry, and the burger industry's profit is 6 percent higher than that of the hot dog industry, then we would expect to see many firms in the hot dog industry to move into the burger industry. This is exactly the same as what will happen in the economy that we are looking at - when an industry has a positive economic profit, firms will want to move into that industry and leave the industry that they were in. In the long run - which means after any firms that want to enter had entered and after any firms that want to leave had left - there will be zero economic profit. If there was a positive economic profit, that means that the industry is still enjoying profits higher than that of the normal profit, and firms will want to be entering. The only way that we will reach a long run equilibrium when no firms are entering is when the economic profit is zero, which means that the industry is earning the normal profit of 5 percent.
The short run or long run does not really refer to a specific time period in the case of pure competition, but it refers to what kinds of cost the firms are facing. In the short run, a firm that is purely competitive will face both fixed costs and variable costs. Fixed costs are costs that must be paid regardless of how much the firm is producing - such as rent for the factory, or if there are labor contracts. As an example for a fixed cost, a firm that needs to pay $100,000 to rent a factory for a year must pay that $100,000 regardless of how much production is. If they decide to make nothing, the $100,000 is still paid, and if they decide to make 1 million units, the $100,000 is paid then as well. Variable costs are costs that changes as the quantity produced changes. If the firm makes zero units, then they will not need to pay any variable cost, since variable costs are usually things like costs for material or paying wages to worker (non-contractual). If the firm doesn't want to make a single unit, then it will not need to pay for someone to work the machines or for materials. However, if the firm decides to produce some amount of the good, then, it must pay for the costs from materials and labor. If the firm decides to increase production, then, they must pay more for more materials and more labor, which shows that the variable cost changes with quantity produced. These are two kinds of costs that the firm will face in the short run, one that it cannot change and one that can change. So, the short run is defined by the firm facing both fixed and variable costs. In the long run, all the costs of a firm are variable costs. As mentioned earlier, the long run is not a specific time period, but rather however long it takes for all the costs of a firm to become variable costs. Costs that used to be fixed, such as rent on a factory or contracts for workers, can be adjusted in the long run. If the firm wants to move out of the current factory, in the long run, then, they can make the decision to do so. On the other hand, in the short run, the firm cannot make a decision to leave the factory because they are "locked-in" to the factory until their contract is up. Also, if the firm wants to expand and ramp up production, then they will probably need to produce out of a larger factory, making that a variable cost as well. So, in the long run, all the costs of the firm are variable, meaning they can be changed and they change with the quantity produced.
Forces of demand and supply together determine the market price in a competitive industry. A typical firm produces a profit-maximizing level of output by keeping the market determined price equal to the marginal cost function. There can be zero economic profits, positive economic profits or negative economic profits, depending upon the average total cost of producing that level of output. Marginal cost function is usually U-shaped indicating that it decreases for initial levels of output and then starts increasing after reaching a minimum level. This is also applicable for the average total cost function which is also U-shaped. However, this is unrelated to the price taking behaviour by a competitive firm. This is because the price is set by the market and has nothing to do with the cost of production of a single firm. Also note that marginal cost and average total cost are not equal to each other at all profit maximizing levels of output. Even when they do, at the minimum of average total cost, they are unable to influence the market price which is established by market forces. Hence options are incorrect. Price taking behaviour by a competitive firm indicates that it will be charging a same price for every unit sold. This suggests that marginal revenue for each additional unit sold will be equal to price. Now that price is unchanged and marginal revenue is equal to price, the marginal revenue function will be flat parallel to the quantity axis. Hence, is correct.