Question

Suppose that the paper clip industry is perfectly competitive. Also assume that the market price for paper clips is 2 cents per paper clip. The demand curve faced by each firm in the industry is: a. A horizontal line at 2 cents per paper clip. b. A vertical line at 2 cents per paper clip. c. The same as the market demand curve for paper clips. d. Always higher than the firm's MC curve.

Short answer

Choice a: A horizontal line at 2 cents per paper clip.

Step-by-step solution

Understanding Perfect Competition

In a perfectly competitive market, individual firms are price takers. This means they accept the market price as given because they are too small to influence it. Here, the market price for paper clips is 2 cents.

Analyzing the Demand Curve for the Firm

In perfect competition, the demand curve faced by an individual firm is perfectly elastic, meaning it is a horizontal line at the market price. This is because the firm can sell any quantity at the market price, but cannot sell at a higher price.

Determining the Correct Answer

Given that the firm's demand curve is perfectly elastic at the market price, the correct choice is: 'a. A horizontal line at 2 cents per paper clip,' since this describes a perfectly elastic demand curve.

Key concepts

Demand Curve

In the context of a perfectly competitive market, the demand curve faced by an individual firm behaves quite uniquely. When we talk about the demand curve in this setting, we're referring to a horizontal line at the market price. This characteristic means the demand curve is perfectly elastic. But what does this really mean for firms in such a market?
In simpler terms, a perfectly elastic demand curve implies that a firm can sell as much as it wants at the market price. However, if the firm raises its prices even slightly, it will lose all its customers immediately. This is because numerous other firms in the market sell identical products at that market price.
For our paper clip industry example, the demand curve for each firm is a horizontal line at 2 cents per paper clip. This is crucial because it shows that the firm is a price taker, unable to set prices above or below this line. Remember, a horizontal demand curve is an indicator of perfect elasticity where price remains constant and output can vary.

Market Price

The concept of market price in a perfectly competitive market is central and somewhat fixed, aligning all firms to a specific price level. In the case of the paper clip industry, this price is 2 cents per paper clip.
In perfect competition, the market price is determined by the intersection of industry-wide supply and demand. No single firm has the power to change this price, making them "price takers." This means that all firms have to accept the market price as it is, and they adjust their levels of production accordingly.
For students, it's important to understand that market price in a competitive market serves as a universal signal. It ensures that resources are allocated efficiently across the industry, as firms can sell any amount at the going market price, thereby competing primarily on cost efficiency and not on price.

Price Takers

In a perfectly competitive market, a firm is commonly known as a "price taker." This is a fundamental role where the firm must accept the market-determined price for its product. This occurs because each individual firm is relatively small compared to the market as a whole.
The term "price taker" implies that the firm cannot influence the market price through its actions. Therefore, the firm adjusts only its output to maximize profit without changing the price level. For instance, in the paper clip market, each firm accepts the market price of 2 cents per clip.
Understanding this concept clears up why firms in such a market compete mainly through efficiency. They cannot raise prices to increase revenue, so they tend to focus on reducing costs or increasing production efficiency to enhance profitability.

Elasticity

Elasticity, especially in the context of demand, is a measure of how responsive the quantity demanded of a good is to a change in its price. In a perfectly competitive market, the concept of elasticity is intricately linked to the demand curve being perfectly elastic.
A perfectly elastic demand curve means that the elasticity of demand is infinite. This is observed because as long as the firm charges at the market price, it can sell any amount of its goods. However, the slightest increase in price will drop the quantity demanded to zero, reflecting a high sensitivity to price changes.
For students, recognizing the elasticity in perfectly competitive markets is essential. It emphasizes that in these markets, firms must be keenly aware of their pricing strategies as even minor changes can drastically affect their sales volume due to the presence of equal substitutes at a steady market price.