Perfect Competition

What is the definition of perfect competition?

• All firms are price takers on both output and input sides.

• All firms have the optimal levels of labor and capital.

• All firms maximize profits.

• There is at least one firm producing the good of interest.

Answer explanation

All firms maximize profits and have optimal levels of labor and capital in perfect competition, but this does not define perfect competition; even firms that are monopolists or oligopolists will maximize profits and set the optimal levels of labor and capital. It is necessary for at least one firm to be producing the good of interest in perfect competition, but not sufficient.

Consider the market for shoes. If one of the following statements is true, we can conclude that it is not perfectly competitive. Which statement, if true, is evidence against perfect competition?

• Demand for a given firm's output is perfectly elastic.

• Entry into the shoe market is restricted because a government permit is required.

• Supply of a given firm's inputs is perfectly elastic.

• There are low transaction costs in searching for the lowest shoe price.

Answer explanation

If entry and exit into a market is restricted, then this is a violation of perfect competition. The other three answers define perfect competition, rather than being in violation of it.

In a competitive market, the marginal revenue for selling an additional good is, by definition, equal to what quantity?

• None of these.

• The price of the good being sold.

• The price of the primary input.

• The wage.

Answer explanation

In a competitive market, every firm is a price-taker, and its decisions about how much to produce do not affect the price. Accordingly, if it sells one more unit, the marginal revenue is the prevailing price.

A firm should shut down if what condition holds?

• Price is below average total cost, but greater than average variable cost.

• Price is below average variable cost.

• Price is greater than average total cost.

• Price is greater than average variable cost.

Answer explanation

If price is below average total cost, but greater than average variable cost, then the firm has negative profits. However, it is still optimal to continue operating to avoid forgoing the fixed costs already paid.

What is true about the individual firm demand curve that each firm faces in a competitive market?

• It is downward-sloping.

• It is horizontal.

• It is upward-sloping.

• It is vertical.

Answer explanation

The individual firm demand curve in a perfectly competitive market is perfectly elastic, or horizontal. Since the firm is a price-taker, it can sell as many units of the output good as it wants to at that price.

In the long run, firms should decide to shut down if what condition holds?

• Price is less than total cost.

• Price is less than average fixed cost.

• Price is less than the marginal cost.

• Price is less than average cost.

Answer explanation

In the long run, all costs are variable, and thus average variable cost and average cost are equivalent. The firm will shut down if price is less than average cost. Average fixed cost is not a relevant concept in the long-run, because all costs are considered to be variable.

In the long run, what cost measure is minimized?

• Average cost.

• Labor supply costs.

• Marginal cost.

• Total cost.

Answer explanation

In the long-run, average cost is minimized and the equilibrium is found where price equals minimum average costs.

In recent years, the American automobile manufacturing industry has struggled; assume that some companies are earning negative profits (i.e., they are losing money). In the long-run, what changes will we expect to see in this market?

• A shift toward using more capital than labor.

• A shift toward using more labor than capital.

• Firm entry.

• Firm exit.

Answer explanation

If profits are negative, firms should exit.

In a perfectly competitive market with constant long run marginal cost, the tax burden will be borne by:

• The Consumer

• The Producer

• Both

• Cannot tell from the above information

Answer explanation

This is because the supply curve is a flat line, no matter what the demand is, supply is inelastic.

In a perfectly competitive market, firms take the market price as a given, which implies that:

• Market demand is perfectly inelastic

• Market demand is somewhat inelastic

• Market demand is perfectly elastic

• Market demand is somewhat elastic

Answer explanation

In a competitive market, firms are assumed to be very small, therefore they are assumed to have no influence on the market price – like if they faced an infinitely elastic demand at the market price level.