Analysis of Markets and Public Policy
Analysis of Markets and Public Policy
Chapter 8
Questions for Review
1. Why would a firm that incurs losses choose to produce rather than shut down?
Losses occur when revenues do not cover total costs. If revenues are greater than variable costs, but not total costs, the firm is better off producing in the short run rather than shutting down, even though it is incurring a loss. The reason is that the firm will be stuck will all its fixed cost and have no revenue if it shuts down, so its loss will equal its fixed cost. If it continues to produce, however, and revenue is greater than variable costs, the firm can pay for some of its fixed cost, so its loss is less than it would be if it shut down. In the long run, all costs are variable, and thus all costs must be covered if the firm is to remain in business.
3. In long-run equilibrium, all firms in the industry earn zero economic profit. Why is this true?
The theory of perfect competition explicitly assumes that there are no entry or exit barriers to new participants in an industry. With free entry, positive economic profits induce new entrants. As these firms enter, the supply curve shifts to the right, causing a fall in the equilibrium price of the product. Entry will stop, and equilibrium will be achieved, when economic profits have fallen to zero.
11. What assumptions are necessary for a market to be perfectly competitive? In light of what you have learned in this chapter, why is each of these assumptions important?
The three primary assumptions of perfect competition are (1) all firms in the industry are price takers, (2) all firms produce identical products, and (3) there is free entry and exit of firms to and from the market. The first two assumptions are important because they imply that no firm has any market power and that each faces a horizontal demand curve. As a result, firms produce where price equals marginal cost, which defines their supply curves. With free entry and exit,
Chapter 8
Questions for Review
1. Why would a firm that incurs losses choose to produce rather than shut down?
Losses occur when revenues do not cover total costs. If revenues are greater than variable costs, but not total costs, the firm is better off producing in the short run rather than shutting down, even though it is incurring a loss. The reason is that the firm will be stuck will all its fixed cost and have no revenue if it shuts down, so its loss will equal its fixed cost. If it continues to produce, however, and revenue is greater than variable costs, the firm can pay for some of its fixed cost, so its loss is less than it would be if it shut down. In the long run, all costs are variable, and thus all costs must be covered if the firm is to remain in business.
3. In long-run equilibrium, all firms in the industry earn zero economic profit. Why is this true?
The theory of perfect competition explicitly assumes that there are no entry or exit barriers to new participants in an industry. With free entry, positive economic profits induce new entrants. As these firms enter, the supply curve shifts to the right, causing a fall in the equilibrium price of the product. Entry will stop, and equilibrium will be achieved, when economic profits have fallen to zero.
11. What assumptions are necessary for a market to be perfectly competitive? In light of what you have learned in this chapter, why is each of these assumptions important?
The three primary assumptions of perfect competition are (1) all firms in the industry are price takers, (2) all firms produce identical products, and (3) there is free entry and exit of firms to and from the market. The first two assumptions are important because they imply that no firm has any market power and that each faces a horizontal demand curve. As a result, firms produce where price equals marginal cost, which defines their supply curves. With free entry and exit,