Perfect Competition in a Single Market Past Year Questions

2010 Zone A
1.Using the picture below, analyze the welfare effect of the policy of providing
government price supports for agricultural products to ensure a minimum in-
come level for farmers. Suggest a different policy that attains the same objective
but raises total welfare. (5 marks)

 
The question requires you to analyse the welfare
effect of a particular policy. It is important to be able to identify correctly
the net effect. In this case, the change in consumer surplus is −(F + G), the change in
producer surplus is +(F + G + H). Next, the cost to the
government is PS(Q2 − Q1). Adding these up, the net loss from the policy
is PS(Q2 − Q1) minus the triangle H.
More generally, this shows why income generation for farmers through
price support policies (the EU common agricultural policy is an important
example) is inefficient. The policy gets farmers to produce more (even
though demand is less at a higher price) and then spends government revenue
to buy up the unsold amount. This is, of course, a poor use of resources,
as the diagram clarifies.
A better solution is to simply give F + G + H amount of money to farmers
directly, and not interfere with the market. This avoids the unnecessary
excess production.  
 
2.Consider a competitive industry with several identical firms. You are given the
following information about this industry
QD = 100− 5P (Market demand)
QS = 20P (Market supply)
!!
C(q) = 2+ (Total cost function of a firm)
!
Here P is the market price and q denotes the output of the representative firm.

(a) Find the equilibrium market price and the output of the representative
firm. [5 marks]
Set QD = QS to get P = 4. The output
of the representative firm is obtained by setting marginal cost equal to
price. Here, marginal cost is q. Equate with price. So q = 4.

(b) Would you expect to see entry into or exit from this industry in the long
run? Explain your answer. [5 marks]

Profit is Pq − C(q) = 16 − 2 − 8 = 6. You should then explain that positive profit

attracts entry.

(c) What is the market price at which no further entry or exit would occur and
the industry would be in long-run equilibrium? [5 marks]

You should know what the long-run equilibrium

entails. No further entry or exit occurs when price equals the
minimum average cost. To find out this level, set MC = AC.

This gives

implying q = 2. Thus the long run equilibrium price is 2.

(d) Suppose a temporary shock reduces short-run price to some positive level
below the level identified in part (c). Would a firm continue to sell its out-
put at this new price or exit the industry? Does your answer depend on
how far the price falls in the short run? [5 marks]

To answer this, you need to know the exit

condition in the short run. The firm continues to operate in the short
run so long as the price is at least as large as AVC. For this to be true,
we need AVC to be at least as large as MC. Here AVC is q/2 which is
lower than MC q always. Therefore the firm would continue to sell at
any positive price.

2010 Zone B
3.Using suitable diagrams, evaluate the policy of rent control in terms of transfers
and deadweight losses when supply of housing is very inelastic. How would
your answer change if the housing supply becomes very elastic? (5 marks)

You have to understand the effect of a policy

such as rent control which places a price ceiling below the market equilibrium
price. Under such a ceiling, the short side of the market is the supply.
If supply is a lot lower under the ceiling, this causes a big deadweight loss:
while those who manage to find a property to rent are very happy, lots of
people would not be able to find a property. Therefore, the transfer aspect
of such a policy must be balanced against the potential deadweight loss.
Using this idea, you should explain that if supply is very inelastic, rent control
might be a good idea. There is a transfer from landlords to tenants
(which is presumably the social objective of rent control) and the cost, in
terms of deadweight loss, is small. However, if the supply is very elastic,
a similar drop in price would lead to a huge reduction in housing supply
(the deadweight loss is very large). In the figure below, the transfer from landlords to
tenants is the rectangle (P0 − PC)QC, and the shaded area is
the deadweight loss. Clearly, with an inelastic supply the transfer is large
and the loss is small, while the opposite is true for the case of elastic supply.

2011 Zone A
4.A competitive market is made up of 100 identical firms. The short-run total cost
function of each firm is given by
!!
C = 5q + + 100
!
where q denotes the output of the representative firm.
(a) Determine the short-run market supply curve. [10 marks]

This is a test of basic knowledge. This is also a good indicator of your preparedness for the
examination. If you are struggling to answer this question, your preparation is likely to be
significantly incomplete. The Examiner wants to see that you can (a) identify the short run
supply curve of an individual firm as the part of the marginal cost curve above the average
variable cost, and (b) you can sum across firms correctly to get the market supply curve.
Here, AV C = 5+q/ 4 and MC = 5+q/2. So MC is greater than AVC for any q > 0. Therefore a
firm's short run (inverse) supply curve is

i.e. q = 2P - 10. Let Q = 100q . The market supply curve is then given by
Q = 200P – 1000

A standard mistake that many candidates make is to multiply price by 100 and then say that
P = 500 + 50q is the market supply curve. Note that this is entirely meaningless. With 100
firms, the market price does not increase 100-fold. It is quantity that gets multiplied by 100. So
you must be careful to first write the supply curve of an individual firm in the form q = 2P - 10
and then multiply by 100 to get the market supply curve.

(b) Calculate the price at which market supply is 2000. [5 marks]

Once you have identified the market supply curve correctly, this is straightforward.
2000 = 200P -1000 implies P = 3000/200 = 15.

(c) Do you expect the long run equilibrium price in the market to be higher,
lower or the same as the price you calculated in part (b)? Explain. [5 marks]
In the long run equilibrium, firms operate at a price equal to the minimum AC. Set AC = MC
to find out this point. We get

which implies 𝑞 ! = 400, or q = 20. But then Q = 2000, implying that the price calculated in part
(b) is equal to the long run equilibrium price.

5(a) Suppose that the government wants to raise the price of a commodity on
the domestic market by reducing imports. Assume that the importing
country is a price taker in world markets. Compare the welfare effects
of an import tariff with an import quota. [8 marks]

Refer to Subject Guide

(b) To ensure a high enough income for farmers, the government wants to raise
the price of agricultural products. The policy adopted for this purpose
gives the farmers financial incentives to leave some of their land idle. The
policy is shown in the picture below. Without intervention, the market
price is P0 with associated quantity Q0. The government gives farmers
sufficient incentive to restrict output to Q1, making supply inelastic at Q1,
and raising price to the support price PS.

i. Using the picture, analyze the welfare effect of this policy. [6 marks]
  
The government gives farmers a financial incentive to restrict output. This reduces output to
Q1 (and makes supply completely inelastic at Q1 ). This raises price to PS from P0 . The
welfare gain and loss are as follows.
Consumer surplus changes by ∆CS = - F - G .
Producer surplus changes by ∆PS = F - D + Payments for not producing.
The cost to the government is equal to the payments for not producing.
Note that payments for not producing must be sufficient to stop farmers producing along the
original supply curve at PS . In other words, the payment must be equal to D + G + H
The net change in welfare is
∆W = ∆CS + ∆PS - Payments for not producing
From the above,
∆W = - G - D  
 
ii. Suggest a different policy that attains the same objective of ensuring
higher income for farmers, but raises total welfare. [6 marks]

A different policy would be as follows. We know that the change in producer surplus is given
by

∆PS = F - D + Payments for not producing

and we also know that the payments equal D + G + H . Therefore

∆PS = F - D + D + G + H = F + G + H

The government can just hand over this sum to the producers without intervening in the
market (i.e. the price and quantity in the market would be P0 and Q0 , respectively). The
producers would be indifferent between the policy above and this one. What is the net change
in welfare? In this case, the gain to producers is the same as the cost to the government.
Finally, since there is no market intervention, consumer surplus is unaffected. Therefore net
change in welfare is zero. This policy attains the same objective and achieves higher welfare.  
 
2011  Zone  B  
6.A perfectly competitive market implies a perfectly elastic demand curve, which
then implies that such a market produces no consumer surplus. Is this true or
false? Explain carefully. (5 marks)
The statement is false. This is testing whether you can differentiate between the market demand
curve and the demand curve facing each individual firm in a competitive market. This should
form part of your basic knowledge of markets, and if you are not familiar with the idea, your
preparation for the examination is likely to be deficient.
In a perfectly competitive market, each single agent is a price taker. This simply means that
each firm can sell any amount at the current price, but demand would be zero at any higher price
and demand would be infinite at any lower price. In other words, each individual firm chooses its
output based on the assumption that the market price will be unaffected by its choice of output.
This implies that the demand curve facing each firm is perfectly elastic.
However, the market demand curve is downward sloping as usual, and consumer surplus is
calculated from this curve. Therefore the fact that each firm faces a flat demand curve has no
implication for consumer surplus. You should draw a diagram to demonstrate this,.

7.Consider a competitive industry with several identical firms. The market demand
is given by
QD = 10− P
where P is the market price. The suppliers have a constant marginal cost of
production of 5, and no fixed costs.
(a) Find the equilibrium market price and quantity. [5 marks]
To answer this, you simply need to set price equal to marginal cost. Since marginal cost is 5,
supply is given by P = 5. Therefore equilibrium price is 5 and quantity is 10 - 5 = 5.

(b) The government grants a subsidy of 1 per unit to the suppliers. Calculate
the new equilibrium price and quantity in the market. [5 marks]
With a subsidy of s per unit, the new supply is P = 5 - s . Therefore equilibrium price is 5 - s
and quantity is 5 + s . With s = 1, price is 4 and quantity is 6.

(c) Show that the government expenditure used to pay for the subsidy program
exceeds the sum of the changes in producer and consumer surplus.
[10 marks]
With a flat supply curve, producer surplus is 0. Thus in what follows, consumer surplus is equal
to total surplus.
The consumer surplus without a subsidy is

With a subsidy of 1 per unit, consumer surplus is

Therefore consumer surplus rises by 11/ 2 = 5.5. Government spending on subsidy is given by 1
per unit on 6 units, adding up to 6. Therefore government spending exceeds the rise in consumer
surplus.
This can be seen also in Figure 4.
The original consumer surplus is the area FAC. After the subsidy of 1 per unit, price drops to 4
and quantity rises to 6, implying that the new consumer surplus is the area FBD. Clearly, the
gain is the area ABDC. However, with 6 units, the subsidy cost is the difference in price times 6,
which is the area ABDE. Clearly, the cost to the government is higher by the area of the triangle
DEC. This area is 1/2 , which is precisely the amount by which government spending on subsidy
exceeds the gain in surplus.

2012 Zone A
8.There is a competitive market for a good. The government announces a per unit
subsidy to be paid to producers of the good. Using a diagram, explain why this
policy creates a deadweight loss. (5 marks)
This is an easy question. If you are struggling with this, your preparation is unlikely to be
adequate. Note that without the subsidy, the competitive market equilibrium is efficient. A
subsidy then shifts the supply curve out, which in turn implies that output is now too high
relative to the social optimum. Be careful when drawing the picture. Many candidates correctly
draw the supply curve shift, but then do not correctly identify the triangular area that shows the
deadweight loss.
9.The inverse demand function for the product of a perfectly competitive industry
is given by
!
P = 160−
!
where P is the price per unit and Q is the total quantity. The short-run total cost
function of each firm is given by
C = 50+ 10q + 50𝑞!
where q denotes the output of the representative firm. There are 100 firms in the
industry.
(a) Derive the short-run supply curve of a firm. [5 marks]
The short-run supply curve of a firm is given by P = MC , so long as MC ≥ AVC . Here,
MC = 10 + 100q , and AVC = 10 + 50q . Therefore MC always exceeds AVC . Therefore
short-run supply curve is P = MC , which is P = 10 + 100q , or

q = P/100 – 1/10

(b) Derive the equilibrium price in the market. [5 marks]

The industry supply is Q = 100q , which is Q = P - 10, so P = 10 + Q . Equating demand
and supply
10+Q = 160 – Q/2
we get Q = 100 which implies P = 110.

A tax of 30 per unit sold is now imposed on every unit sold.

(c) Calculate the tax revenue raised. [5 marks]
The new supply function is P = 40 + Q . 40 + Q = 160 – Q/2
implies Q = 80. So the tax revenue is 80 x 30 = 2400.

(d) Calculate the deadweight loss from the tax. [5 marks]

(!""!!")  ×  !"
The deadweight loss, as shown in the picture, is = 300
!
2012 Zone B
10.In a perfectly competitive industry with constant input prices and constant returns
to scale, the burden of any tax will fall only on the consumers in the long
run. Is this true or false? Explain your answer. (5 marks)

This is true. You should realise that under the conditions specified in the question, the long run
industry supply curve is horizontal. Once you realise this, the answer is immediate as a
horizontal supply curve implies that price rises by the full extent of a tax, as shown in the
picture
2013 Zone A
11.Consider a competitive industry with several identical firms. The total cost
function of the representative firm is given by
!!
C(q) = q − 𝑞 ! +
!
where q denotes the output of the representative firm. Derive the supply function
of the representative firm, paying proper attention to the shut-down point. (5 marks)

The supply function is given by the MC curve above the average cost (which is here the same as
average variable cost) curve. Now, MC = 1 - 2q + 3𝑞 ! /2 , and AC = 1 - q + 𝑞 ! /2. Therefore
MC ≥  AC if

1 - 2q + 3𝑞 ! /2 ≥ 1 - q + 𝑞 ! /2

which implies

𝑞! ≥ q
This happens when q ≥ 1. Thus the (inverse) supply curve is given by
P = 1 - 2q + 3𝑞 ! /2 for q ≥ 1

12.If market demand is infinitely elastic and market supply elasticity is finite, a per
unit tax on suppliers creates no deadweight loss. Is this true or false? Explain
your answer. (5 marks)
This is false. There is no deadweight loss on consumers, but there is a deadweight loss in
producer surplus. The picture below shows the loss. You should be careful to correctly identify
the area of loss. Many candidates draw the right supply-demand picture, but then fail to
identify the correct area of deadweight loss.
2013 Zone B
13.Consider a competitive industry with several identical firms. You are given the
following information about this industry
QD = 320− 2P (Market demand)
C(q) = 50+ 10q + 50𝑞! (Total cost function of a firm)
Here P is the market price and q denotes the output of the representative firm.

(a) Derive the supply function of the representative firm, paying proper attention
to the shut-down point. [5 marks]
The supply function is the part of the marginal cost curve that is above the average variable
cost curve. The marginal cost is 10 + 100q which always exceeds the average variable cost
10 + 50q . Therefore the supply curve of a firm is simply P = MC for all q > 0. The supply
curve is therefore given by
P = 10 + 100q ,
or
!!!"
q=
!""
(b) Suppose there are 100 firms in the industry. Derive the market supply function
and equilibrium market price and quantity. [5 marks]
Market quantity is Q = 100q . Therefore market supply is given by Q = P - 10. Equilibrium
market price is given by equating demand and supply:
P -10 = 320 - 2P
which implies 3P = 330, i.e. P = 110. The equilibrium market quantity is therefore Q = 100.
(c) Suppose a tax of 30 per unit of output is imposed on sellers. Calculate the
deadweight loss from the tax. [5 marks]
The inverse market supply is P = 10 + Q . With a tax of 30 per unit, this becomes
P = 40 + Q or Q = P - 40. Equating with demand,
P - 40 = 320 - 2P
which implies P = 120 and Q = 80. Therefore the deadweight loss is
!
( 100 - 80) 30 = 300
!
(d) For the per-unit tax in part (c), calculate the burden of the tax on consumers,
and the burden of the tax on sellers. (5 marks)
Note that the total tax revenue is 80 x 30 = 2400.
The burden on consumers is ( 120 - 110) 80 = 800. The sellers get a net price per unit of
120 - 30 = 90. Therefore the burden on sellers is given by ( 110 - 90) 80 = 1600.

2014 Zone A
14.Identical firms in a competitive industry use capital (K ) and labour (L ) to produce
output (Q ).The labour supply curve is upward sloping, while the supply of capital is
infinitely elastic in the long run. It follows that the long run industry supply curve is
upward sloping. Is this true or false? Explain your answer. (5 marks)

This is true. While the cost of capital is constant, higher demand for labour implies a higher
wage rate. Therefore this is an increasing cost industry. It follows that the long run supply curve
is upward sloping. In the long run, the industry can produce higher output only at a higher
price, which is needed to compensate for the rise in unit labour costs.

15.You are advising the minister responsible for housing. The minister is concerned
that rents are too high and wants to reduce the rent payments by tenants without
causing too much inefficiency.
(a) Using appropriate diagrams explain the circumstances under which you would
advise the minister to impose rent control.(7 marks)
If supply is inelastic, rent control works well. As you can see from the picture, in this case
the deadweight loss is small.
(b) Using appropriate diagrams explain the circumstances under which you would
advise the minister to give a rent subsidy to tenants.(7 marks)

If supply is elastic and demand is not very elastic, any subsidy would mostly go to tenants
and the deadweight loss would be relatively small.
(c) Using appropriate diagrams describe a case in which issuing more building
permits would not be an effective policy.(6 marks)
If demand is very elastic (indicating consumers already have a lot of choice), raising supply
would not reduce rents much.

2014 Zone B
16.The short run supply function of a competitive firm is given by

where Q is the quantity supplied and P is the price of output. Derive the equation for
the firm’s marginal cost curve. (5 marks)
From the supply function:
!
P= + 10.
!  
Since the supply function is P = MC , the marginal cost is given by:
!
MC =   + 10.
!  

17.Consider an economy with two goods, 1 and 2. There is a competitive market for
the goods.
There are a100 identical firms in the competitive industry producing good 1, and the
cost of the representative firm producing q1 units of good 1 is given by

There are a100 identical consumers. The representative agent consuming q1 units of
good 1 and q2 units of good 2 obtains an utility
The price of good 1 is denoted by P and the price of good 2 is 1. Each consumer has
an income of 12.
(a) Derive the market supply function for good 1.
(5 marks)
Here MC = 1 + q1 , which always exceeds the AC (same as AVC) of 1 + q1 /2. Thus the
supply curve of an individual firm is given by P = 1 + q1 or:
q1 = P - 1.
The industry supply is given by 𝑄!! = 100q1 , which gives us:
𝑄!! = 100P - 100.
Be careful to add up the firm supply curves correctly. Far too many candidates lose points
because having found P = 1 + q1 for a firm, they then multiply the right hand side by 100.
But this is of course multiplying the price by 100, a meaningless exercise.

(b) Derive the market demand function for good 1.

(5 marks)
For any consumer with income M , q1 =M/2P
and q2 =M/2
Here M = 12, so q1 = 6/P and
q2 = 6. The market demand for 1 is 𝑄!! = 100q1 which is:
𝑄!! = 600/P
(c) Calculate the market equilibrium price and quantity of good 1.
(5 marks)
The equilibrium P is given by:
100P - 100 = 600/P
implying:
𝑃 ! - P - 6 = 0.

Solving:

Rejecting the negative solution, we get:

P= 3
Therefore the equilibrium quantity Q1 is:
Q1 = 200.

(d) Calculate the price elasticity of demand for good 1 at the market equilibrium.
(5 marks)
The elasticity of demand for 1 is given by:

at P = 3, Q1 = 200:

Note that the above calculations are not really necessary. Each individual simply spends
1/2 their income on each good – so you can directly conclude that demand is unit elastic at
all prices.

2015 Zone A
18. Consider a competitive industry with several identical firms. The long run average
cost of a firm producing q units of output is given by
AC(q) = 50 − 4q + 𝑞 !
Suppose market demand is
QD = 246 − P.
where P denotes market price. Determine the number of firms in the industry
in the long run equilibrium. (5 marks)
LRAC is minimised when - 4 + 2q = 0 or q = 2. At this level of output, LRMC = LRAC = 46. At
this price, 200 units are demanded. Since each firm produces 2 units in the long run, 100 firms
will operate in this industry.

2015 Zone B
19.Each firm in a perfectly competitive market faces a perfectly elastic demand
curve. This implies that the market generates no consumer surplus. (5 marks)
This is false. Firms are small relative to the market and face a notional flat demand curve,
essentially capturing the idea that firms are price-takers. The market demand curve can,
however, be downward sloping and therefore a consumer surplus can arise. You should draw a diagram
to illustrate this.

20.Consider a competitive industry with several identical firms. You are given the
following information about this industry
QD = 111− P (Market demand)
C(q) =  𝑞! − 10𝑞! + 36𝑞  (Total cost function of a firm)
Here P is the market price and q denotes the output of the representative firm.
(a) Derive the supply function of an individual firm. [5 marks]
The supply function is the part of the MC curve above the AC curve (here there are no fixed
costs, so AC and AVC are the same). MC crosses AC at the lowest point of AC. To find out
this point, we can either minimise AC or equate AC and MC.We have MC = 3𝑞 ! - 20q + 36
and AC = 𝑞 ! - 10q + 36.
Here, let us minimise AC. The first order condition for minimum is 2q - 10 = 0, from which
we get q = 5. Note that the second order condition for a minimum holds.
At q = 5, AC and MC are both equal to 11. Thus the supply function is P = MC for P ≥ 11.
Writing out MC, we have the (inverse) supply function of a firm as
P = 3𝑞 ! −20q + 36 for P ≥ 11.
This is shown in the picture below (the solid part of the MC curve).
Suppose the factor costs are constant for the industry and there is free entry and
exit.
(b) Write down the long run market supply function. [5 marks]
The LR supply function is flat at minimum AC, so the supply function is P = 11.

(c) Determine the number of firms in the industry in the long run equilibrium.
[5 marks]
The market equilibrium quantity is 111 - 11 = 100. Since each firm produces 5, there are 20
firms in the LR equilibrium.

(d) Calculate the total surplus (consumer surplus plus producer surplus) in
the long run market equilibrium. [5 marks]
The supply curve is flat, so there is no producer surplus. The consumer surplus is

21.a) Suppose that the government wants to raise the price of a commodity on
the domestic market by reducing imports. Assume that the importing
country is a price taker in world markets. Using a diagram, compare the
welfare effects of an import tariff with an import quota. [8 marks]

Refer to lecture notes.

(b) Under a price-support policy for agricultural products, the government

maintains a minimum market price in order to ensure a minimum income
level for farmers. To ensure that the price does not fall below the an-
nounced support price, the government buys us any excess supply at the
support price. The picture below shows the effect of such a policy.
i. What is the deadweight loss from the policy in the picture above?
[6 marks]
Refer to lecture notes

ii. Suggest a different policy that attains the same objective of raising the
income level for farmers, but has a smaller deadweight loss compared
to the price-support policy. [6 marks]

Refer to lecture notes