Module 6 – Economic Efficiency Flashcards Preview

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Flashcards in Module 6 – Economic Efficiency Deck (56):
1

A competitive firm will maximize profits by

...producing at that level of output at which Pa = MCa (Price = Marginal Cost).

1

Adam Smith in the 18th century came up with the following conclusions:

  • Utility seeking and profit maximizing behaviors tend to lead to an efficient solution to the problem posed by limited resources and unlimited wants
  • Market forces by themselves would not gurantee economic efficiency under all circumstances, collective action and planning would be necessary in certain areas of economic activity

1

A consumer will maximize utility from a given income when,

...that income is allocated to goods and services so that:

1

A competitive market economy tends to be economically efficient as well as:

Technically efficient

1

A fish farm was established and the owner installed the necessary set of tanks and filtration plants to help keep the sea water in and around the fish tanks pure. The expected life of the tanks and filtration plants was 10 years and their purchase price was £500 000; the accountant depreciates the plants (straight line) at £50 000 per year. The annual variable costs associated with the fish farm were also £50 000 per year. Annual fish sales of £120 000 per annum were anticipated. Immediately after the installation of the equipment, which once installed cannot be removed, has no alternative use and no scrap value, the price of fish dropped dramatically, because of the availability of foreign fish. Annual revenues from sales of fish decreased to £80 000 and it is expected the £80 000 annual revenue figure will remain for the foreseeable future. The accountant has advised the fish farm owners to cease operations immediately. He stated, ‘With annual revenues of £80 000 and annual costs of £100 000 it does not need an MBA graduate to tell you that staying in business is throwing good money after bad.’

 

Should the owner of the fish farm follow the accountant’s advice? Why or why not?

The owner should not follow the advice of the accountant: If the farm is closed down the owner will lose the £500 000 start up cost or £50 000 per annum for 10 years. He will however incur no variable cost. If the farm remains in business for 10 years, the expected life of the equipment, there will be generated each year a surplus of £30 000 over the variable costs, i.e. £80 000 in total revenues minus £50 000 in variable cost, to set against the fixed cost of £50 000. Thus the loss will be only £20 000 instead of £50 000. Thus in the short run i.e. 10 years the farm should remain in business. When it comes time to replace the capital equipment, i.e. at the end of 10 years the marginal benefit for remaining in business i.e. £80 000 is less than the annual marginal cost, i.e. £100 000; thus in the long run the farm should close.

1

A fish farm was established and the owner installed the necessary set of tanks and filtration plants to help keep the sea water in and around the fish tanks pure. The expected life of the tanks and filtration plants was 10 years and their purchase price was £500 000; the accountant depreciates the plants (straight line) at £50 000 per year. The annual variable costs associated with the fish farm were also £50 000 per year. Annual fish sales of £120 000 per annum were anticipated. Immediately after the installation of the equipment, which once installed cannot be removed, has no alternative use and no scrap value, the price of fish dropped dramatically, because of the availability of foreign fish. Annual revenues from sales of fish decreased to £80 000 and it is expected the £80 000 annual revenue figure will remain for the foreseeable future. The accountant has advised the fish farm owners to cease operations immediately. He stated, ‘With annual revenues of £80 000 and annual costs of £100 000 it does not need an MBA graduate to tell you that staying in business is throwing good money after bad.’

Would you have advised the establishment of a fish farm if there were no fish imports? Why or why not?

The farm was set up on the expectation of an annual return of £20 000, i.e. revenue of £120 000 minus total costs of £100 000, £50 000 for depreciation and £50 000 of variable cost. The £50 000 annual depreciation is the £500 000 initial investment spread evenly over 10 years. But what was the opportunity cost of the £500 000? An interest rate of 4% earns £20 000 in the bank and thus any rate higher than 4% says ‘no fishing’ assuming any working capital faces the same opportunity cost.

2

As a nation we wish to obtain from our limited resources the maximum benefit at minimum cost. The market mechanism guarantees such economic efficiency. Do you agree with the statement about the efficiency of the market mechanism? Why or why not?

The Question Asked

As a nation we wish to obtain from our limited resources the maximum benefit at minimum cost. The market mechanism guarantees such economic efficiency. Do you agree with the statement about the efficiency of the market mechanism? Why or why not?

Suggested Answer

Under certain conditions it is possible, theoretically, for a nation to achieve maximum benefit from its limited resources; to do so goods and services must be produced at minimum cost.

Economic efficiency conditions are captured in the marginal equivalency conditions (MEC).

One necessary condition is that consumers maximise utility from the way they allocate their incomes. This occurs when

MUa/Pa = MUb/P= ... = MUn/Pn

Another necessary condition is that goods and services are produced using minimum resources. A firm will maximise profit by producing that level of output where MR = MC; under conditions of perfect competition price equals MC of production.

Thus

Pa = MCa, Pb = MCb, Pn = MCn

Substitution the MCs for Ps yields the MEC.

MUa/MCa = MUb/MC= ... = MUn/MCn

In the dynamic real world many forces are at work which prevent MEC being achieved. They include:

 

  1. introduction of new goods and services

  2. changes in factor supplies/prices

  3. technological change

Second there are areas where competitive market forces will not lead to economic efficiency; they are known as market failures. These areas involve:

  1. imperfect markets

  2. externalities

  3. public goods

  1. An imperfect market exists if the characteristics of a market are not the same as those for a perfect market:

    • Many buyers and sellers

    • Perfect information

    • Freedom of entry and exit

    • Homogeneous product

    If all of the above characteristics do not exist then a market is said to be an imperfect market and as a consequence the profit maximising output supplied will be lower than the output at which price is equal to marginal costs, i.e. lower than the optimal output level determined in perfect competition. This means it is not possible to substitute marginal costs for price in the MEC since P > MC.

  2. Externalities are those costs/benefits that result from an act of production or consumption but are not taken into account by the economic agent making the decision. If externalities exist it implies that either the costs of production or consumption are understated or that the benefits of either or both are understated.

    If external benefits exist in the consumption of good A then the value of MUa in the MEC will understate the societal MUa. Similarly if the societal costs of producing goods B exceed a firm’s private cost then will be higher than the rates of other goods.

  3. Public goods or services have two characteristics, which distinguish them from private goods and services; they are

    • non-excludability and

    • non-rivalry

    The latter characteristic implies that the consumption of the good by one consumer does not preclude the consumption of it by another consumer. This creates a problem as to how to determine the optimum level of supply. However, it is the first characteristic, which implies that consumers can consume a good or service without paying for it, i.e. they can be free riders, that creates the market failure; this is because no firm would be prepared to supply a good or service for which it cannot extract a price.

4

Division of labour permits
I. specialisation
II. increased total output
III. a larger labour force


Which of the following is correct?

A. I only
B. II only
C. I and II only
D. I, II and III

C

If each member of the labour force specialises in producing those goods/services in which he/she is most skilled there will result a larger total output than the individual performing a multitude of tasks. Thus II is true. If members of a labour force indulge in specialisation they are performing a division of labour. Thus I is true. Division of labour permits a more efficient use of an existing labour force but does not increase the size of the labour force. Thus III is wrong.

5

A

For the economy to be in long run equilibrium not only will the ratios of MUa/MC(longrun)a be equal but firms will be earning normal returns producing where price = MClongrun; this means the optimally sized firm, i.e. the firm with the lowest average total cost. It follows that price must also equal the MC of this optimally sized firm which is of course MCshortrun. Thus A is true.

In the utility maximising equation it is MUa/Pa which must equal MUb/Pb and not MUa=MUb or Pa=Pb. Thus B and C are wrong. Similarly it is MCa=Paand MCb=Pb which must hold for firms to be in equilibrium, not MCa=MCb. Thus D is wrong.

5

Which of the following limits how much division of labour can occur in a capitalist society? The size of the

A. labour force
B. capital stock
C. market
D. total output

C

While the size of the labour force, capital stock, market and total output may be highly correlated it is the size of the market which sets a limit on the extent of division of labour. As Adam Smith pointed out if the size of the market for pins is large enough people start to specialise in pin making, e.g. shaping the point, making the head, etc.

6

In small villages in some countries the only medical doctor is also the local dentist and the village general store serves also as the post office. Which of the following explains the dual nature of these suppliers?

A. The demand for dental services is price elastic
B. The demand for postal services is price inelastic
C. Specialisation is determined by the size of markets
D. People have healthier diets outside of cities and require fewer dentists and villagers do not write many letters

C

Division of labour is limited by the extent of the market. In major cities there may be enough business to attract a heart surgeon – in a small village the services of a heart surgeon may be sought only once in fifty years. Specialisation is determined by demand which in turn is determined by the size of the market; the bigger the market the greater the degree of specialisation.

6

For an economy to be economically efficient

I. it must produce that bundle of goods and services where no individual could be made better off

II. each firm must produce the maximum amount of output it possibly could

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

D

Economic efficiency requires that the bundle of goods and services produced must be produced using the minimum amount of resources and the bundle produced must satisfy society’s wants as fully as possible. It is always possible however to make one individual better off by transferring goods and services from other members of society. Thus I is wrong. No profit maximising firm producing in an engineering efficient fashion will produce beyond that point at which marginal revenue equals marginal cost; it would cost more than the firm would receive in revenue for any production beyond that point; thus to be efficient firms will not produce the maximum amount of output possible. Thus II is wrong.

7

A consumer is maximising utility by allocating income so that

MUa/Pa = MUb/Pb = ... = MUn/Pn

Which of the following gives the correct explanation of why the consumer would be worse off if income were reallocated among the goods a, b …n? A reallocation

A. would mean a smaller quantity of goods and services would be purchased

B. would cause the gain in utility of at least one good to be more than offset by the loss in utility of at least one other good

C. would cause a misallocation of resources used in the production of the goods for which expenditure had changed

D. would cause the terms on which existing goods might be exchanged to alter

The correct answer is B.

7

Suppose after an economy had achieved long run equilibrium the market demand for the product in the figure shifted to the right. What would happen in the short run? The price would rise and

A. the market supply curve shift to the right
B. the firm would move up its LMC
C. the firm would move up its MC
D. new firms would enter the industry

C

In the ‘market’ diagram the supply curve is the summation of all the firms’ (in this market) short run marginal cost curves. The rightward shift in demand curve, given S, will cause the price to rise which in turn will cause the firms, given profit maximising behaviour to move up their MC curves as they equate price with MC. Thus C is correct. In the short run the supply curve is given and no ‘fixed’ resources move into the industry. Thus A, B and D are wrong.

8

Suppose after an economy had achieved long run equilibrium the market demand for the product in the figure shifted to the right. What would happen in the long run?

A. Price of the product and firms’ profit would increase
B. New firms would enter the market; what would happen to the price of the product is unknown
C. New firms would enter the market; the price of the product would remain constant
D. Each firm would move up its long run marginal cost curve

B

The shift in demand to the right would cause firms to move up their short run marginal cost curves to achieve equilibrium; this would result in above normal profits which in turn would attract new firms into the industry, shifting the short run supply curve to the right. If the entry of new firms did not cause factor input prices to increase the long run supply curve would be a horizontal line and the price of the product would return to its original equilibrium level. If however the entry of new firms caused factor input prices to increase the long run supply curve would be positively inclined, i.e. upward sloping and the new equilibrium price of the product would be higher than it was before.

9

Suppose after an economy had reached long run equilibrium the market demand for the product in the figure shifted to the left. What would happen in the short run?

A. The market supply curve would shift to the left
B. Firms would move down their short run marginal cost curves
C. Profits would decrease and firms would leave the industry
D. Profits would remain unaltered as firms would leave the industry

B

To maximise profit firms move up/down their marginal cost curves in response to price changes. Thus B is correct. In the short run the number of firms in the industry by definition, is fixed thus A, C and D are wrong.

10

Suppose after an economy had reached long run equilibrium the market demand for the product in the figure shifted to the left. What would happen in the long run?

A. The minimum point on the long run average cost curve would decrease
B. The market supply curve would shift to the left
C. Firms would experience a decline in profits
D. The firm’s long run supply curve would shift to the left

B

To minimise losses firms in the short run would move down their marginal cost curves, the price of the product would fall and firms would earn less than normal returns. This in the long run would force some firms out of the industry causing the market supply curve to shift to the left. Thus B is true. Unless factor input prices were affected, the long run cost curves would remain unaltered; in the long run equilibrium normal profits/returns would exist. Thus A, C and D are wrong.

12

If the firm’s average variable cost curve were to be drawn in the figure


I. its minimum point would equal the distance from the origin to where the market supply curve cuts the vertical axis

II. LMC would pass through its minimum point
Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

A

Where the market supply curve begins indicates the price below which no firm will supply any output because average variable costs (AVC) will not be covered and as a consequence a firm would lose less by closing down. Thus where the S curve touches the vertical axis indicates the minimum point of the firm’s AVC. Thus I is true. The MC curve must go through the minimum points of both the ATC and AVC and as a consequence the LMC curve must intersect the AVC above its minimum point. Thus II is wrong.

14

Family A, golf enthusiasts, owns 3 weeks per annum of time share in the Algarve, Portugal. Family B owns an apartment in St Andrews, Scotland, home of golf. The next year the Open Golf Championship is being played in St Andrews B is going to exchange the St Andrew’s apartment for the one week of the Championship for the 3 weeks of family A’s time share in Portugal. Which of the following can be concluded from this transac-tion?

A. B gains more than A since 3 weeks are greater than 1 week

B. A gains more than B since A gains the Golf Championship as well

C. Both A and B gain from the exchange; relative gains cannot be assessed

D. The family who first proposed the exchange, suggested the terms and concluded the exchange benefits more

C

Exchange permits individuals to become better off without an increase in the amount of goods and services available. The goal in an exchange is to find someone with a good, which for you, has high marginal utility (low for the exchanger) who wishes a good in your possession which is yielding you a relatively low marginal utility (high utility for the exchanger). Both benefit from exchange but comparison of interpersonal utilities is not possible no matter who initiated the exchange process or who proposed the terms. Thus A, B and D are wrong.

15

For an economy to be economically efficient it must
I. be technologically efficient
II. ensure all wants are satisfied
Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

A

For economic efficiency to prevail the goods and services produced must be produced using the minimum amount of resources (technological efficiency) and must be those which satisfy society’s wants as fully as possible, i.e. given the resource constraint. This does not imply all wants are satisfied. Thus I is true and II is wrong.

15

Which of the following is correct?

I. The LAC is derived from ATCs
II. The LMC is derived from AVCs

A. I only
B. II only
C. Both I and II
D. Neither I nor II

A

The LAC curve is an envelope curve indicating the optimally sized plant for any given level of output; i.e. it traces out the lowest average total cost for each output level. Given its ‘saucer shape’ there will be one plant at which ATC is a minimum and this will be the optimally sized plant and reflect minimum LAC. Thus I is true.

The LMC curve traces out the marginal cost of producing an additional unit of output when all factor inputs are variable. The MC curve reflects the cost of an additional unit of output in the presence of fixed factor inputs. There is no connection therefore between the LMC and AVCs. Thus II is wrong.

16

Which of the diagrams represents the Law of Diminishing Marginal Utility?

A. A only
B. B only
C. C only
D. D only

B

The Law of Diminishing Marginal Utility states that as an individual consumes more of a good in a given time period total utility increases but at a decreasing rate. The only diagram to exhibit such characteristics is B.

18

In which of the diagrams are average and marginal utility equal?

A. A only
B. B only
C. C only
D. D only

The correct answer is D.

19

The drug addict stated that the Law of Diminishing Marginal Utility did not apply to him. Just the reverse! The more of the drug he took the more he enjoyed it. If a Law of Increasing Marginal Utility held for a consumer what would the implication be? It would mean that

A. the consumer would experience a decrease in total utility the more of a good he consumed

B. the consumer would purchase only one good

C. the price of each good would exceed its marginal cost

D. markets for goods would not be competitive

B

Increasing marginal utility implies total utility increases at an increasing rate. Thus A is wrong. A consumer’s behaviour has no implications for the production process; thus C and D are wrong. If each additional unit of a good consumed were to yield greater satisfaction than the previous unit a consumer would gain total utility the more he consumed of any one good. Thus it would be to his benefit to consume one good only – think of the drug addict.

20

A firm operating in a perfectly competitive market will maximise profit by producing the output level at which price (P) equals marginal cost (MC) because the cost of producing

I. one additional unit would exceed the additional revenue gained
II. one fewer unit would exceed the additional revenue gained

Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

A

At output levels less than that at which P = MC, P > MC. As long as this condition holds producing one additional unit adds more to revenue (P = marginal revenue) than it does to cost. Thus II is wrong. At output levels greater than that at which price P > MC producing one additional unit adds more to cost than it does to revenue. Thus I is correct.

21

If in a 3 good economy MUa/MCa >  MUb/MCb > MUc/MCcto achieve economic efficiency which of the following will have to occur?

A. More of a will have to be produced
B. More of b will have to be produced
C. The marginal cost of c will have to increase
D. The marginal cost of a will have to decrease

A

For economic efficiency to prevail the marginal equivalency conditions must hold, i.e. MUa/MCa >  MUb/MCb > MUc/MCc . If resources were transferred from industry c to industry a MUa/MCa would decrease and MUc/MCc would increase. It is theoretically possible that both could equal; MUb/MCwithout any resources moving into industry b. Thus A is true and B is wrong. If all three industries are competitive and average costs are unaffected by marginal movements of resources the prices of which are determined also in competitive markets marginal cost need not change.

22

The reasons a modern economy never reaches long run equilibrium are


I. consumers’ tastes and preferences are constantly changing
II. rapid technological changes alter resources and product prices continuously
III. the relationship between productivity curves and cost curves are not constant


Which of the following is correct?
A. I and II only
B. II only
C. II and III only
D. I, II and III

A

For the Marginal Equivalency Conditions (MEC) to exist in the long run:

Once firms make decisions, however, and make investments, they are back in the short run where changes in tastes and preferences, and changes in factor prices to name but two will prevent MEC being established. Thus I and II are true. Average and marginal productivities always determine average and marginal costs. Thus III is wrong.

23

In what ways does each of the following

  1. the appearance of new goods and services

  2. changing tastes and preferences

  3. changes in factor input prices

  4. technological change

prevent an economy from reaching a long run economically efficient solution to the fundamental problem of unlimited wants coupled with scarce resources?

The Question Asked

In what ways does each of the following

  1. the appearance of new goods and services

  2. changing tastes and preferences

  3. changes in factor input prices

  4. technological change

prevent an economy from reaching a long run economically efficient solution to the fundamental problem of unlimited wants coupled with scarce resources?

Suggested Answer

For economic efficiency to prevail the marginal equivalency conditions (MEC) must hold, i.e.

Equation 1: MUa/MCa = MUb/MC= ... = MUn/MCn

In the long run the relevant MC is the long run marginal cost (LMC).

The MEC is derived from equilibrium in the consumer and firm markets.

For the consumer, utility is maximised when

Equation 2: MUa/Pa = MUb/P= ... = MUn/Pn

For the competitive firm profit is maximised in the long run when

Equation 3: Pa = LMCaPb and Pn = LMCn

Substituting for the Ps yields the MEC.

The appearance of new goods and services the characteristics of which the consumer is completely/relatively ignorant could involve experimentation and/or sampling before significant purchases were made and/or these new goods substituted for old. In such a time period the consumer would not be in equilibrium maximising utility. What the consumer would be doing was acquiring information to permit him/her to maximise utility in the future. Thus equation (2) would not hold.

For the same reason, changing tastes and preferences would prevent equation (2) being fulfilled. In addition however changing tastes, unanticipated by firms, could lead to shortages/surpluses so that P ≠ MC in the short run and therefore not in the long run. Thus equation (3) would not hold.

Equation (3) would not hold either if factor input prices changed and/or if new inventions/innovative production techniques appeared.

Thus if equations (2) and (3) do not hold, equation (1) will not hold.

23

Explain in detail the behaviour of a firm’s costs in the short-run.

Fixed costs (FC) are costs of the factors which cannot be varied in the short-run and which are unrelated to output levels (Q), e.g. rent on premises, property taxes, interest charges. Even if the firm produces zero output, fixed costs are incurred.

Since they do not vary with output levels average fixed costs will decline as output increases, asymptotically approaching zero as output becomes infinite!

i.e. FC/Q declines as Q increases

Marginal Fixed Costs, i.e. △FC/△Q = 0 since △FC = 0

Total variable costs increase as output increases and decrease as output decreases but not normally in a linear fashion because of increasing/diminishing marginal returns to variable factor inputs.

Average variable cost is determined by the average productivity of variable factor inputs and their market prices and marginal cost is determined by the marginal productivity of variable factor inputs and their market prices.

When marginal costs (MC) is less than average variable cost (AVC), AVC must be declining, i.e. the cost of each additional unit produced is less than the average and must therefore reduce the average. When MC is greater than AVC, AVC must increase.

Therefore, MC must pass through the minimum point on the AVC curve.

ATC = AVC + AFC

TC = VC + FC

MC = △VC/△Q or △TC/△Q i.e. △FC = 0

The AVC curve will approach the ATC as AFC approaches zero.

24

Explain the distinction between the short-run and the long-run in microeconomics.

The short-run and long-run in economics do not refer to fixed time periods but instead refer to the time required to bring about changes in the inputs of various factors of production. The short-run exists when at least one factor input cannot be varied. The long-run refers to that period when all factors inputs are variable, i.e. the planning period. Once a long-run decision has been made and factors committed, e.g. a plant/factory has been built the firm is back in the short-run. What constitutes the long-run varies from industry to industry, e.g. extending a nuclear power plant is likely to take longer than extending a university dormitory.

26

For a firm to be in long run equilibrium, it must be earning normal profits...

...producing at an output where ATC and LAC are minimized and P=LMC=MC

27

For an economy to be in long run equilibrium:

29

General Equilibrium implies that:

No economic unit in the entire economy wants to change its behavior.

30

Give a short introduction to Economic Efficiency.

  • People are better off when they specialize in the production of something and exchange it for other goods that other people are better off at producing 
  • Total Utility will be greater with trade or exchange 
  • Specialization increases the quality and quantity of goods and services produced, and therefore the materialistic well being of society is enhanced 
  • If markets are freely competitive, the tendency is for a capitalist economy to be technologically efficient due to self interest and the desire to be profitable 
  • For an economy to be called economically efficient, it must also produce the combination of goods and services that satisfies consumers wants as fully as possible

31

If   then resources...

...will move from the production B to A.

The law of diminishing marginal utility will cause MUb to increase and MUa to decrease as more of A and less of B are produced. So equilibrium is achieved over time.

33

In a competitive market, the equilibrium price and quantity is determined by the...

...intersection of the supply and demand curves.

34

In a two good world composed of profit maximizing producers and utility maximizing consumers, the following must hold:

35

In the short run, a firm is in equilibrium (P=MC=MR) with the following curves:

(Draw curve)

36

In the short run, a firm is in equilibrium...

...P=MC=MR

38

In the short term, the firm will use... 

different amounts of the variable inputs of production to vary the output.

 

I.e.  If the demand for beer decreases and for tea increases, variable factors will move from the beer industry to the tea industry until the quantity produced in the tea market is increased so that the market is in equilibrium again.

Consumers will als re-allocate their income from beer to tea until the ratio of marginal utility to price equals out again.

39

In long-run, purely competitive, industry equilibrium

I. no firms are making either more or less than a ‘normal’ profit.

II. no firms wish either to enter or leave the industry.

III. price equals minimum long-run average cost. Which of the following is correct?

A. I only.
B. I and II only.
C. I and III only.
D. I, II and III.

The correct answer is D. The definition of industry equilibrium is that no forces
exist to cause change. This means that firms are making profits, average revenue (price) equals long-run average cost (which includes normal profit), and no incen-
tives exist for firms to enter or leave the industry.

40

If, in a competitive industry, market prices and quantity are in equilibrium,

I. no buyer wants any more at that price.

II. sellers would not be willing to supply more even at a higher price.

III. there is no excess demand or excess supply.


Which of the following is correct?

A. I only.
B. I and III only.
C. I, II and III.
D. Not I or II or III.

The correct answer is B. When a market is in equilibrium, buyers can buy all they wish to at the going price and sellers can sell all they wish to at the going price; in other words excess demand and excess supply are non-existent. This does not imply that sellers would not be willing to supply more at higher prices.

41

The correct answer is B. At a price of $2, excess demand exists; to clear the market,
price must rise. At $3, however, excess supply exists. Thus the equilibrium price
must lie between $2 and $3. At a price of $4, excess supply exists and those suppli-
ers willing to offer services at lower prices will do so to obtain sales, i.e. there will be
a movement along the supply curve. The demand curve given by the first two
columns will not change as prices change.

42

The main reason that a particularly efficient firm in a purely competitive industry cannot continue indefinitely to make more than normal profits is that


A. other firms will adjust their behaviour.

B. resources will leave the industry.

C. the extra profits will make the firm complacent, and it will lose its efficiency.

D. the government will tax away the extra profits.

The correct answer is A. Given that we are dealing with a purely competitive
industry, any firm earning above-normal profits (i.e. having a lower average-cost curve) would be imitated by other firms. This would result in the industry supply curve shifting to the right, a lower equilibrium price, and the re-establishment of
normal profits for all firms. Resources will flow into the industry; lazy and complacent
firms will be forced out.

44

Suppose the furniture industry is perfectly competitive and has been in long-run equilibrium. Then a rise in consumer demand for furniture takes place. Which of the following is the most likely sequence of events?

A. A quick rise in price, which will reduce demand, thereby returning the price to its original level.

B. A quick expansion of output as new firms enter, and then a slow rise of price to a higher equilibrium level.

C. A quick rise of price, increasing profits, and then a slow fall of price as new firms enter.

D. Decreased profits as firms are forced to produce beyond capacity, and then the exit of unprofitable firms.

The correct answer is C. When an industry is in long-run equilibrium and experiences a rise in consumer demand (a shift to the right of the demand curve), the short-run industry equilibrium will occur at that output and price at which the
new demand curve intersects the industry’s short-run supply curve (the summation of the firms’ marginal cost curves). Thus there will be an increase in price and producers’ profit. The above-normal profits will in the long run attract new firms,
hence increasing industry supply. This in turn will force down the price until a new long-run equilibrium is established.

45

Which of the following is correct? The term ‘general equilibrium’ for a purely competitive economy implies that:

A. things are generally stable, though a few changes may be taking place.

B. no economic unit in the entire economy wants to change its behaviour.

C. industries as a whole are in equilibrium, but individual firms are not.

D. consumers in the economy are all well off.

The correct answer is B. If a purely competitive economy were in equilibrium, by
definition no force would exist to cause change. Consumers could not become better off by adjusting their spending patterns (they would all be maximising utility)
and no resource could earn a higher return by moving to another industry (they
would all be earning normal profits). In the real world, of course, general equilibri-
um is never reached because change, e.g. inventions, is continually occurring but consumers and firms aim for the state of general equilibrium – a useful analytical concept.

46

Which of the following is correct? The short-run industry supply curve in a perfectly competitive industry is:

A. a horizontal line.

B. inelastic in the long run.

C. the summation of firms’ marginal cost curves above the AVC curves.

D. determined by the intersection of marginal revenue and marginal cost curves.

The correct answer is C. The short-run supply curve of a firm is its marginal cost
curve above the minimal point of the average variable cost curve. A profit-
maximising firm will offer an additional unit of output as long as the extra revenue
(price, in a perfectly competitive industry) exceeds the extra cost of production, i.e. the marginal cost; thus the marginal cost curve determines the supply curve. For an
industry as a whole, the short-run supply curve is the summation of the firm’s short-
run marginal cost curves.

47

In order to make the most efficient use of a city’s trains and buses, how should train and bus fares vary during the day?

A. They should be relatively low during rush hour to reduce cost for the maxi-mum number of people.

B. They should be relatively low during rush hour to transport as many people as possible at that time.

C. They should be relatively high during rush hour to allocate the limited space to the rush hour travellers who value it most highly.

D. They should be the same at all times to avoid travellers altering their schedules because of price differences.

The correct answer is C. In order for resources to be used efficiently, it is necessary that the prices of goods and services produced by those resources be equal to marginal cost. Clearly, the marginal cost of transportation services is higher during rush hour if trains and buses are filled to capacity since each traveller prevents some
other potential traveller from consuming the services. The price should be set
during rush hour so that there is no excess demand. This will ensure that the people
who travel during rush hour are the people who value it most, i.e. the people who
are willing to pay that high price. During the off-peak hours, the price should just
cover the cost in terms of resources used up associated with carrying an additional passenger. Looked at from another point of view, such a pricing scheme would
serve to spread the use of transportation facilities over the day, thereby reducing the
amount of equipment required to handle the peak load.

48

At going wage rates for military service, a country has been forced to resort to compulsory military service (conscription) to meet personnel requirements. As compared with a system that achieved the required personnel by relying on prices determined in a free market for military service, the conscription system results in which of the following:

A. a lower income for conscripts and a higher income for the civilian population.

B. a higher income for conscripts and a lower income for the civilian population.

C. a higher income for both conscripts and the civilian population.

D. a lower income for both conscripts and the civilian population.

The correct answer is A. The existence of conscription implies that at going wage rates there is excess demand by the government for military personnel. If there were a shift to a market system in which wages were raised to a level where personnel requirements were achieved by offering a sufficiently high wage, then the income of military personnel would rise and the taxes required to pay for the higher military
budget would also have to rise. Actually, since using the price system to determine
who would join the service would result in those people joining who were least unwilling to join (or who had the least desirable alternatives), it would be possible
under such a system for everyone to be made better off if there were some means
by which the conscripts who would not join under the price system could be made to compensate other taxpayers who face higher taxes. Since there normally would
not be such a means, the conscripts have lower income and civilian taxpayers higher
income under the conscription system.

49

‘If at the going price there is excess demand, competitive firms will shift their supply curves to the right, causing prices to rise and quantity to increase until an equilibrium is reached.’ Which of the following is correct with regard to competitive markets? The above statement is:

A. essentially correct in describing how equilibrium is reached.

B. correct regarding how suppliers behave, but ignores buyers’ reactions.

C. incorrect because the supply curve will not shift.

D. incorrect, because it confuses shifting supply curves with shifting demand
curves.

The correct answer is C. A supply curve tells what quantities would be offered at
different prices. If a market were in disequilibrium with excess demand existing, not
all buyers would be satisfied and market forces would result in a rise in price. At the
higher price a larger quantity would be offered – but there would be a movement
along the supply curve and not a shift in the position of the curve.

50

In a private enterprise (free-market) economy, one of the principal

I. effects of competition is to force prices to the lowest level consistent with normal profits.

II. functions of profits is to indicate to the government where wages are too low. Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

The correct answer is A. While profits indicate where capital can most efficiently be allocated, they yield no information about the wage level that, in a private-enterprise economy, is determined by the demand for and supply of labour. Thus, for any
given firm, no causal relationship exists between profit and wage level. In addition,
concluding that a wage is ‘too low’ involves making a value judgement. In a private-
enterprise economy, resources will be allocated in accordance with consumers’
wants only if firms’ production decisions are responsive to consumers’ expenditure
decisions. An increase in demand for a good will at first be reflected in higher prices
of that good and in higher profits from producing it. Firms will try to take ad-
vantage of this higher profitability by producing more of that good, but only if there
is competition will firms fully accommodate consumers’ preferences by expanding output to the point where consumers’ valuation just matches the cost (including normal profit) of production.

51

Since MC = price,

...each good is also being produced in a technically efficient manner.

53

There are several reasons why a competitive economy may not result in an economically efficient one:

  1. New goods and services are always entering the market and so firms may never reach long term equilibrium (where LRMC = MR = P)
  2. Changing technology
  3. Changing fashions etc.

54

There are several reasons why a competitive market may not achieve economic efficiency.

  1. New goods are constantly appearing and old ones disappearing, this can prevent firms from reaching long term equilibrium
  2. Changes in factor prices and supplies may inhibit a firm from reaching long term equilibrium
  3. Rapid technological change can make existing plant and equipment obsolete and prevent the attainment of long run equilibrium.

55

When does abnormal profits occur?

Pe>ATC

56

Which of the following is correct? The term ‘general equilibrium’ for a purely competitive economy implies that:

A. things are generally stable, though a few changes may be taking place.

B. no economic unit in the entire economy wants to change its behaviour.

C. industries as a whole are in equilibrium, but individual firms are not.

D. consumers in the economy are all well off.

The correct answer is B. If a purely competitive economy were in equilibrium, by definition no force would exist to cause change. Consumers could not become better off by adjusting their spending patterns (they would all be maximising utility) and no resource could earn a higher return by moving to another industry (they would all be earning normal profits). In the real world, of course, general equilibri-um is never reached because change, e.g. inventions, is continually occurring but consumers and firms aim for the state of general equilibrium – a useful analytical concept.