EC2066 Microeconomics: Chapter 6: Perfect Competition in A Single Market - Sample Examination Questions

EC2066 Microeconomics
Chapter 6: Perfect competition in a single market – Sample
examination questions
Question 1
An industry comprises of n identical firms. The short-run cost function of a

price-taking firm is given by C(q) = 4q 2 + 100. The market demand curve is
Q = 600 − 10P .
(a) Find the market equilibrium price and quantity.

(b) Will there be entry or exit from this industry in the long run?
(a) Firm supply: MC = 8q > 4q = AVC. Therefore, there is no shut-down at any positive price.
Firm supply is P = MC, which is P = 8q or q = P/8.
Industry supply is Q = nP/8.
Market equilibrium: 600 − 10P = nP/8 implies 4800 = (n + 80)P or P = 4800/(n + 80). The
market quantity is 600n/(n + 80).
(b) The profit of a firm is Π(q, P ) = P q − 4q 2 − 100, where q = 600/(n + 80).

Using the values of P and q, we have:
1440000
Π= − 100.
(80 + n)2
Solving Π = 0, we get n = 40.

Therefore, if n < 40, entry takes place and, if n > 40, exit takes place. The long-run equilibrium
number of firms is 40.
Question 2
In the short run, the demand for cigarettes is totally inelastic. In the long run,
suppose that it is perfectly elastic. What is the impact of a cigarette tax on the
price that consumers pay in the short run and in the long run?
In the short run, the full incidence of tax is on the consumers. Therefore, price goes up by the
full amount of any tax in the short run. In the long run, there is zero incidence on consumers –
the sellers bear all the tax.
Question 3
Suppose the market demand curve is infinitely elastic. In a diagram, show the
deadweight loss from a subsidy. What is the incidence of any subsidy?
Since demand is infinitely elastic (i.e. horizontal), the market price is unaffected by any tax or
subsidy. So the incidence of any tax or subsidy is 100% on the suppliers. The figure below shows
the deadweight loss from a subsidy. Note that the loss arises because after the subsidy,
1
Chapter 6: Perfect competition in a single market – Sample examination questions
production extends to levels where the marginal benefit (given by the demand curve) is lower
than the marginal cost (given by the supply curve).
Question 4
Suppose the government sets a price ceiling below the unregulated competitive
equilibrium price. Show the effect on the market equilibrium, consumer surplus,
producer surplus and total welfare.
See the subject guide for an exposition.
Question 5
Consider an agricultural price support policy where the government announces the
support price PS . Farmers then choose how much to produce, and sell everything to
consumers at the price at which everything can be sold. Let this price be P ∗ . The
government then pays farmers a deficiency payment equal to (PS − P ∗ ) per unit on
the entire quantity produced.
Suppose the demand curve for wheat is Q = 100 − 10P and the supply curve is
Q = 10P . Suppose the government announces a support price of PS = 6 using a
deficiency payment programme.
(a) Calculate the quantity supplied, the price at which output is sold and the deficiency
payment.
(b) Calculate the effect on consumer surplus, producer surplus and total welfare.
In the figure below, the initial equilibrium is E, where P = 5 and Q = 50. At a support price of
6, the total supply is 60. 60 can be sold in the market at a price of 4. Therefore, consumers get a
price of 4, while the sellers get a price of 6 (the government pays 2 per unit to sellers over the
quantity 60).
Note that this is exactly like a subsidy of 2 given to sellers.
Before the policy, the CS is (10 − 5) × 50/2 = 125 and the PS is 5 × 50/2 = 125. Total surplus is
250 and there is no deadweight loss.
2
After the policy, the CS is the triangle ABC, which has an area of (10 − 4) × 60/2 = 180. The PS
is the triangle FGH, which has an area of 6 × 60/2 = 180. The spending on deficiency payment is
60 × 2 = 120, which is the rectangle GBCH.
The shaded triangle EHC is the deadweight loss. The area is 10 × 2/2 = 10.
Another way to calculate the deadweight loss is to compare the total surplus (TS) before and
after the policy. Before the policy, the TS is 250. After the policy, the TS is
180 + 180 − 120 = 240. Therefore, the deadweight loss is the difference, i.e. 10.

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EC2066 Microeconomics

An industry comprises of n identical firms. The short-run cost function of a

(a) Find the market equilibrium price and quantity.

(b) The profit of a firm is Π(q, P ) = P q − 4q 2 − 100, where q = 600/(n + 80).

Solving Π = 0, we get n = 40.

See the subject guide for an exposition.

Note that this is exactly like a subsidy of 2 given to sellers.

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