Review Questions

1. Economists categorize an industry by three criteria: the number of firms in the industry, the type of product sold, and barriers to entry. Using these three criteria, describe a perfectly competitive industry.

   A perfectly competitive industry has no barriers to entry, and features many firms selling identical products.

2. Why does a perfectly competitive firm face a horizontal demand curve?

   Perfectly competitive firms are price takers. As a result, the demand curve facing a perfectly competitive firm is horizontal; no matter what quantity the firm produces, the market price at which the firm sells its product stays constant.

3. Define a firm’s profit.

   A firm’s profit is the difference between its revenue and its total cost.

4. What is the relationship between the market price and marginal cost when a perfectly competitive firm is maximizing its profit?

   At its profit-maximizing output, the perfectly competitive firm’s marginal cost equals the market price.

5. A firm operating at a loss will decide whether to shut down based on the relationship between the market price and the firm’s average variable cost. When will a firm choose to operate? Why does a firm ignore its fixed cost when making this decision?

   A firm will stay in operation so long as the market price is at least as large as the firm’s average variable cost at its profit-maximizing level. In the short run, fixed costs need to be paid whether the firm stays in operation or not; because of this, the firm’s fixed costs will not enter into its operating decisions.

6. What is a perfectly competitive firm’s short-run supply curve?

   The portion of the short-run marginal cost curve above the minimum average variable cost is the perfectly competitive firm’s supply curve. At any price below the minimum average variable price, the firm shuts down, and supply goes to zero.

7. How do we use firms’ short-run supply curves to create the industry short-run supply curve?

   The short-run industry supply is the horizontal sum of the short-run supply curve of all individual firms in the industry. This industry supply curve represents the combined decisions of all firms in the industry.

8. What happens to short-run industry supply when firms’ fixed costs change?

   In the short run, fixed costs do not affect firms’ operating decisions, and any changes in fixed costs do not affect the short-run industry supply.

9. Define producer surplus. What is the relationship between profit, producer surplus, and fixed costs?

   Producer surplus is the aggregation of price-marginal cost markups across every unit of output that the firm makes, or the revenue a firm makes above and beyond its variable cost. A firm’s profit is its producer surplus minus its fixed cost.

10. Perfectly competitive industries have free entry and exit in the long run. When will firms decide to enter an industry? When will a firm exit an industry?

    Firms enter a perfectly competitive industry when the market price is above minimum long-run average total cost, or when firms in the industry earn positive economic profits. Conversely, a firm exits the industry when the market price is below minimum long-run average total cost, or when the firm earns negative economic profits.

11. When do economists say that a market is in a long-run competitive equilibrium?

    Long-run competitive equilibrium occurs when price is equal to the firm’s minimum average total cost. In other words, in the long run, there is no entry or exit into the industry, and firms earn zero economic profits.

12. Economic rents are returns to scarce inputs above what firms paid for them. When will a firm earn economic rents?

    A firm earns economic rents when it has lower costs than other firms in its industry.

13. Perfectly competitive firms earn zero economic profits in the long run. How can a firm earn zero economic profits and still yield positive economic rents?

    Economic profits incorporate a firm’s opportunity costs. Once opportunity costs are included, all firms—even those earning positive economic rents—earn zero economic profits in perfect competition.