oh. perfect. (Chapter 8 Q & A)

11/12/2012 § Leave a comment

#1. 25 marks.

a) Using a suitable diagram, explain the difference between short-run equilibrium and long-run equilibrium in perfect competition.

In the short run, firms are allowed to make supernormal or abnormal profits and can get away with it. However, when their price is greater than the cost it takes to make the product (hence, their revenue is quite large, giving them a big profit), the message the market will be getting is that more than enough of the product is needed, therefore the market will adjust itself so that the firms’ production costs will equal the price (P = MC). In the meantime, a perfectly competitive firm will find that its costs and revenue will look like the graph below. Of course, in the immediate short run (like, as soon as the firm starts its business), the costs will be much higher since the firm needs to start off the business and overcome the barriers of entry first. However, the rest of the short run involves abnormal profit wherein the firm can produce at an output where the price is greater than the cost, earning them supernormal profit.

The long run has to do with what happened during the short run. The abnormal profit gained in the short run will have attracted other firms to the market, and because the barriers of entry are so little (it’s so easy to start a business in a perfect competition), many more firms will be able to produce the same product. This will increase the supply of that product, lowering the equilibrium price in the process. The lower price brings the firm’s MR down, and the new point where MC = MR (the optimal level of production) has a lower quantity of production. Now, normal profits are the only profits being made. Therefore, the main difference is that in the short run, abnormal profits can be made while in the long run, only normal profits will be made because of the entry of new firms in the market.

b) To what extent is the perfectly competitive market likely to exist in the real world?

Perfectly competitive markets are not likely to exist in the real world. This is because these are the markets in which there is an incredibly large amount of firms competing with one another, they all produce the same product, or the same type of product, and there are essentially no barriers of entry or exit. Some of the markets that do exist and are perfectly competitive include low-tech manufactured goods, low-skilled labour, specific agricultural commodities, and basically any market where lots and lots of firms are producing practically the same thing. These conditions are not common in the real world, but the ones that do exist display how competition affects the efficiency of a firm in both the short run and the long run.

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