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ECN 104 Lecture Notes - Perfect Competition, Economic Surplus, Allocative Efficiency

Course Code
ECN 104
Tom Barbiero

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Answer to Assignment Seven 1-4
1. Consider the two diagrams below. Diagram A represents a typical firm in a perfectly competitive
industry. Diagram B represents the supply and demand conditions in that industry.
(a) Describe the price, output, and profit situation for the individual firm in the short run.
(b) Describe what will happen to the individual firm and the industry in the long run. Show the changes
on diagrams A and B.
(a) The firm will sell its output for a price of $3.00 per unit. It is taking an economic loss because MR of
$3.00 is less than ATC.
(b) In the long run, firms will leave the industry because existing firms are taking economic losses. This
decrease in the number of firms will shift the supply curve for the industry to the left and lead to an
increase in the market price to $4.00. At this price, the individual firm will neither be making an
economic profit nor taking an economic loss. It will be in equilibrium. See graphs above.
2. Describe the graph for a long-run supply curve in an increasing-cost industry. Why does it have this
For the graph, quantity or output for the industry will be on the horizontal axis and price will be on the
vertical axis. The slope of the graph for a long-run supply curve in an increasing-cost industry will be
upsloping. It shows that shows that an increase in the level of output is associated with an increase in the
price of the product. The reason for the upward slope is that as firms increase output, they bid up resource
prices, and this increases the minimum average total cost of the product.
3. How would a perfectly competitive industry adjust and restore allocative efficiency when there is an
increase in the demand for a product?
Perfect competition is a dynamic market structure that can easily accommodate change and restore
equilibrium. Dynamic adjustments will occur automatically in perfect competition from changes in
demand, changes in resource supplies, or from changes in technology. If demand for a product increases,
the price of the product will increase (P > MC). This situation means there is an underallocation of
resources to the production of the product. It will create temporary economic profits for representative
firms in the industry. The economic profits will attract new firms to the industry to supply output. This
increased supply will result in a decline in price until the equilibrium of P = MC is restored.
4. How are producer and consumer surpluses maximized in a competitive market?
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