MCD2020 Microeconomics

Tutorial 8: Firms in competitive markets

Chapter 14

Tutorial this week will focus on the learning objectives of Topic 7, which are:

1. Identify the characteristics that make a market competitive.

2. Explain why a perfect competitor faces a horizontal demand curve
3. Explain how a perfect competitor decides how much to produce
4. Use graphs to show the competitive firm’s profit or loss
5. Explain why firms may shut down temporarily
6. Explain how entry and exit ensure that firms earn zero economic profit in the long run
7. Explain how perfect competition leads to economic efficiency

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Q.1 Marginal analysis

a) Complete the following table for a firm operating under perfect competition
(Competitive market)

Output Price TR AR MR TC AC MC
0 14 0 - - 20 - -
1 14 14 14 14 21 21 1
2 14 28 14 14 23 11.5 2
3 14 42 14 14 27 9 4
4 14 56 14 14 36 9 9
5 14 70 14 14 50 10 14
6 14 84 14 14 72 12 22

b) What is the profit maximising level of output of the firm?

The profit maximising output is 5 units.
c) Explain why any other output level is not maximising profit. Use marginal analysis
in your answer.

Output levels below 5 show that the marginal cost is less than the current price
(MR) of $14. Therefore, every additional unit adds to the total profit. After
output level 5 marginal cost increases above MR, and every additional unit
reduces the total profit.

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 Q.2 Profit maximisation - Calculate and graph

Assume a competitive market for t-shirts with the market price of $20 per t-shirt. Eco-
Friendly is one of the many companies producing t-shirts. The table below shows Eco-
Friendly’s cost of producing t-shirts.

a) Calculate the missing values and fill in the correct columns in the table:
Quantity Total revenue Total Cost Profit Marginal Marginal
(Q) (TR) (TC) (TR-TC) Revenue Cost
(t-shirts ($) ($) ($ ) ($) (MC)
per day)
0 0 10 -10 0
1 20 14 6 20 4
2 40 22 18 20 8
3 60 34 26 20 12
4 80 50 30 20 16
5 100 70 30 20 20
6 120 94 26 20 24
7 140 120 20 20 26
8 160 152 8 20 32

Draw a sketch diagram showing MR and MC and the level of profit maximising output for
Eco-Friendly:

b) Fill in the correct words or values to complete the sentences below:

Eco-Friendly will maximise its profit when the level of output produced is
determined by the marginal revenue is equal to marginal cost, or Q= 5 t-shirts per day.

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 Q.3 Profit maximising decisions - 1

A small pharmaceutical company in a perfectly competitive market developed a new

medicine that lets people lose 6kg in one month. So far, the company has sold 200 doses
of the new medicine and faces the following average total cost schedule.

Q Average total cost

199 $199
200 $200
201 $201

a) If the market price=$400, what is the profit maximising level of output, 199, 200 or
201 doses of the new medicine? Show your workings.

Profit maximising output is where marginal revenue is equal to marginal cost. In perfect
competition price is equal to marginal revenue. Price is $400; therefore, the marginal
revenue is $400. To find the marginal cost we need to find the total cost first, and use the
formula MC = ∆TC/∆Q
Q Average total cost Total cost Marginal cost
199 $ 199 $39,601
200 $ 200 $40,000 $399
201 $ 201 $ 40401 $401

Profit maximising output is 200

b) If the market price=$400 should the company produce more output if they want to
maximize the profit? Explain your answer.
Company should not produce more than the profit maximising output of 200 doses because
if 201 doses are produced marginal cost exceeds marginal revenue, and it will reduce the
total profit

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Q.4 Profit maximising decisions - 2

Jason is operating a commercial fishing business in a competitive market. Every

week he catches 200 kilograms of fish, and sells them at the market price of $10 per
kilogram. At the current level of operations, his marginal cost is $8.
a) Draw a sketch graph to illustrate the current operations of Jason’s business

b) Advise Jason as to how he can improve his profits, using marginal analysis and
your graph
The graph shows that the profit maximising output (PMQ) for Jason is higher than his
current output of 200 kilograms of fish. At PMQ, MR is equal to MC, but Jason’s MC
at current output level is $8, which is less than the current market price (MR) of $10.
If one more unit is produced his profits will increase, because marginal cost of the
next unit is less than its marginal revenue. Therefore, using marginal analysis it can
be said that Jason needs to increase his output until MC = MR to maximise his profits

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Q.5 Decrease in supply - Short-run profits –– back to long-run
equilibrium

Assume that the market for pizza in Melbourne is competitive, with 100 pizza
restaurants.
a) Illustrate and explain the long run equilibrium on the market, using graphs for the
entire market and for an individual restaurant.

b) The supply curve, S1, intersects the demand curve at price P1. Each restaurant bakes
quantity q1 pizzas, so the total quantity of pizzas produced is 100 × q1. Pizza restaurants
earn zero profit, since price equals average total cost.

c) Now assume that the council passed a law which limits the number of restaurants serving
pizza to 80. Show the effect of this law on graphs in part (a) and finish the paragraph.

If the city council restricts the number of restaurants to 80, the market supply curve shifts
to S2. The market price rises to P2, and individual restaurants produce output q2. Market
output is now 80 × q2, and the price exceeds average total cost, so each firm is making a
positive profit. Without restrictions on the market, this would induce other restaurants to
enter the market, but they can’t, since the council has limited the number of licences.

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Challenging
d) Suppose that the council wants to impose a license fee on the 80 restaurants serving
pizza. How will this affect the number of pizzas sold by an individual restaurant and its
profit? The council wants to make as much revenue as possible but at the same time the
council wants all 80 restaurants to stay in business. At what level should the council `set
the license fee? Show it on your diagram.

The council could charge a licence fee which is a lump-sum fee. Therefore, the licence fee
will be a fixed cost because it is not based on the quantity of sales. A fixed cost will increase
the total cost and average total cost but has no effect on marginal cost. Therefore, it will shift
the ATC curve up but will not affect the firm’s profit maximising output. As the total costs
have increased the licence fee will reduce the firm’s profits.
The licence fee that brings the most money to the council is to charge each restaurant the
amount
(P2 – ATC2) x q2. In other words, all the economic profit can be paid as the licence fee and
the firm will be earning zero economic profits. As long as the firm is left with zero economic
profit, it will have no incentive to leave the pizza market because its return is still equal to the
return from its next best alternative. So as the council wishes all 80 restaurants will continue
to operate.

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Q.6 Increase in demand - Short-run profits –– back to long-run equilibrium

Assume that the cut-flower industry is competitive. Flowers are considered a cherished gift
for all types of celebrations. Suppose that New Year festive season caused a surge in the
demand for flowers.

a) Using diagrams, explain what happens in the short run to the cut flower market and to
the representative individual firm.

Market:
The increase in demand shifts the demand curve to the right to D1. In the short run, price
rises to P2, industry output rises to Q2.

Representative firm:
The firm being a price taker, takes the higher market price. The firm’s
output rises to Q2. Since price now exceeds average total cost per unit,
P2>ATC, the representative firm earns positive economic profits.

b) If the demand for flowers remains high over time what would
happen to the price,quantity and the output over time in the long
run? (Diagram not required)

Market:
Since the firms in the cut-flower industry are earning positive economic profits, over time
more firms will enter the industry (no barriers to entry). This will shift supply curve to the
right, reducing the price increasing the quantity.
Individual firm:
For firms, the fall in market price returns them to their original price P1,
producing original quantity Q1, and earning zero economic profits. Individual firm level of
output at MR (P1) =MC will be equal to the minimum of ATC again (efficient level of output).

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 Q.7 Decrease in Demand - Short-run Losses – Back to Long-run equilibrium

Assume that the smartphones are sold in a competitive market. Smartphones are considered
essential gadgets for communication and entertainment. However, due to a new
technological innovation that significantly reduces the need for traditional smartphones, there
is a sharp decline in demand for smartphones.

a) Using diagrams, explain what happens in the short run to the smartphone market and to
the representative individual firm.

Market:
The decrease in demand shifts the demand curve to the left to D2. In the short run, price
decreases to P2, industry output decreases to Q2

Representative firm:
The firm being a price taker can only sell at the market price. The individual firm’s price
decreases to P2, and output decreases to Q2. Since price is below average total cost, P2<C2,
the representative firm earns economic losses (negative economic profits).

b) If the demand for smartphones remains low over time, what would happen to the price,
quantity, and the output in the long run? (Diagram not required)

Market:
Since the firms are earning negative economic profits (economic losses), some firms will exit
the industry (no barriers to entry and exit) as the price of the smart phone does not cover the
average total cost of selling a phone. This will shift supply curve to the left, increasing the
price and decreasing the quantity.

Individual firm:
The increase in price returns the firm to its original price P1, producing original quantity Q1,
and earning zero economic profits. Individual firm’s level of
output at MR1 (P1) = MC will be equal to the minimum ATC again (efficient level of output).

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Q.8 – Practice what you know (Homework)
Your aunt wants to start a fishing business. Her cost is:
• the cost of the fishing rod (which is $15 dollars),
• the cost of a bait (which is $1 per fish caught), and
• the opportunity cost of her time (which is $10 per hour).
The following table shows the relationship between hours spent and number of fish caught.
Calculate the missing values and fill in the table below:

10
 Hours 1 2 3 4 5
Number of 10 18 24 28 30
fish caught
Marginal 10 18-10=8 24-18=6 28-24=4 30-28=2
product
Fixed cost 15 15 15 15 15
Variable cost ($1x10)+($10 (2x$10)+(18 (3x$10)+(24 (4x10)+(28 (5x10)+(30
x1)=20 x$1)=38 x$1)=54 x1)=68 x1)=80
Total cost 35 53 69 83 95
Average 35/10=3.5 53/18=2.94 69/24=2.88 83/28=2.96 95/30=3.17
total cost
Marginal (35-15)/10 - (53-35)/ 8 = (69-53)/6 = (83-69)/4 = (95-83)/2 = 6
Cost 2.0 2.25 2.67 3.5
Total 10x5=50 18x5=90 24x5=120 28x5=140 30x5=150
revenue if
price = $5
Total profit 50-35=15 90-53=37 120-69=51 140-83=57 150-95=55
Total 10x2.1=21 18x2.1=37.8 24x2.1=50.4 28x2.1=58. 30x2.1=63
revenue if 0 0 80
price = $2.10
Total profit 21-35=-14 3 37.80-53= - 50.4-69= - 58.80-83= - 63-95= -33
15.20 18.60 24.20

Complete the following paragraphs by circling or filling the correct word:

a) The marginal product of each hour spent fishing decreases as the number of fish
caught increases. Because of the diminishing marginal product, the fish get
progressively harder to catch as more fish have already been caught.
b) The average cost curve has a U- shape. Average fixed cost decreases as output
rises because the fixed cost is spread over a larger number of fish. Average
variable cost typically increases as output increases, because of diminishing
marginal product. As such, at low levels of output and very high levels of output,
average total cost is high.
c) Marginal cost rises with the quantity of output produced, reflecting the property of
diminishing marginal product.
d) Assume that your aunt can sell fish for $5 each, to maximise profit she will need
to catch 28 fish. This will give her profits of $ 57.
e) Assume that the market price of fish drops to $2.10. At profit maximising/loss minimising

output she would catch 28 fish and make a loss of $14

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