UMI2 Suggested Answers C9

Chapter 9: Market structure 1: overview and perfect
competition
REVIEW QUESTIONS
1. List seven requirements for perfect competition to exist.
 Large number of buyers and sellers.
 No collusion.
 Product must be homogeneous (identical).
 Freedom of entry and exit.
 All participants must have perfect knowledge.
 No government intervention.
 Complete factor mobility.
2. What is the essential difference between perfect competition and monopolistic competition?
If one or more of the conditions listed in Question 1 is/are not met, competition is imperfect. For perfect
competition, all the conditions have to be satisfied.
3. What are the main differences between monopoly and oligopoly?
In the case of monopoly there is only one supplier, while an oligopoly refers to a situation where there are a
few large suppliers (but more than one). Monopoly also requires perfect knowledge, while oligopoly is
characterised by imperfect knowledge.
4. Give three examples of oligopolistic markets in South Africa.
The banking sector, the retail sector (supermarkets), the cellular phone industry, the motor industry, the
cement industry, the fuel industry and many more.
5. Explain why any firm maximises profit, or minimises losses, when marginal cost is equal to marginal revenue.
If marginal revenue (MR) is greater than marginal cost (MC), it implies that the last unit adds to total profit.
Conversely, if MC is greater than MR the last unit reduces the total profit (because a loss is made on the last
unit).
As long as MR > MC, it pays to expand production. As long as MC > MR, it pays to reduce production. Where
MR = MC maximum total profit (or minimum total loss) is achieved and there is no incentive to expand or
contract production.
6. Explain, with the aid of a diagram, the equilibrium of the firm under perfect competition. Show the economic profit
(or loss) and clearly indicate what equilibrium means in this context.
As explained in the answer to Question 5, maximum profit (or minimum loss) is achieved when marginal
revenue (MR) is equal to marginal cost (MC). This is where equilibrium occurs. If profit is maximised (or loss
minimised), there is no incentive for the firm to change the volume (quantity) of output. This is illustrated in the
diagram below.
In the diagram the price is at P0. This is also the firm’s MR and AR. MR = MC at point E, which indicates the
equilibrium (maximum profit in this case), corresponding to an output Q0. To the left of E, MR > MC; therefore
total profit can be increased by producing more units of output. To the right of E, MC > MR; therefore total
profit can be increased by reducing the level of output. The profit per unit of output is the difference between
AR and AC. At Q0 ,this difference is ED, which is equal to P0C. The firm’s total profit is given by the profit per
unit multiplied by the number of units produced. In the diagram this is indicated by the shaded area P0CDE.
7. Explain, with the aid of diagrams, why perfectly competitive firms earn normal profits only when the industry is in
equilibrium.
Answer:
The short answer is as follows: If firms are earning economic profits, these profits will attract new entrants to
the industry. This will increase the supply of the product, causing the price to drop. This process will continue
until all economic profit has been eliminated and only normal profit will be earned.
If firms are suffering economic losses, some will leave the industry. The supply of the product will thus
decrease and this will cause the price to increase. As the price increases, the losses will decrease and this
process will continue until normal profit is earned.
When normal profit is earned, there will be no incentive for existing firms to leave the industry, or for new firms
to enter the industry and equilibrium will thus exist.
8. What is the point of studying perfect competition if it does not exist, or exists only very rarely in the real world?
Four reasons are provided in the textbook. These reasons may be summarised as follows:
 We may apply our knowledge to markets where many of the requirements for perfect competition are
met.
 It is a useful starting point for analysing markets.
 It serves as a basis or standard against which other markets may be compared.
 If we know how perfectly competitive markets work, we can use that knowledge to analyse other
markets.
9. “A perfectly competitive firm maximises profit by producing at a level of output where marginal cost is lower than the
market price of the good.” Do you agree? Substantiate your answer.
No. We know that profit is maximised where marginal cost is equal to marginal revenue, which, in the case of
perfectly competitive markets, is equal to the price. This means that there should be no economic profit or
loss earned or suffered on the last unit produced. If marginal cost is lower than the market price, total profit
may be increased by producing more units of the product.
10. Explain the relationship, under conditions of perfect competition, between (a) total revenue and marginal revenue,
(b) total revenue and average revenue, and (c) average revenue and marginal revenue.
(a) Total revenue is the cumulative sum of the marginal revenues, or marginal revenue is the change in total
revenue.
(b) Average revenue = total revenue divided by the quantity produced/sold.
OR Total revenue = average revenue multiplied by the quantity produced/sold.
(c) Average revenue = marginal revenue = price of the product.

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Chapter 9: Market structure 1: overview and perfect

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