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: LO10.3 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

The correct answer is (a). The demand curve faced by each firm is a horizontal line at 2 cents per paper clip.

Step-by-step solution

Understand Market Characteristics

In a perfectly competitive market, firms are price takers, which means they accept the market price as given. The market price in this scenario is set at 2 cents per paper clip.

Identify the Firm's Demand Curve

In a perfectly competitive market, each firm faces a perfectly elastic demand curve at the market price. This is because firms can sell any quantity at the market price, and if they charge more, they won't sell any; if they charge less, they're not maximizing profit.

Select the Correct Option

The demand curve faced by each firm in a perfectly competitive market is a horizontal line at the market price. Therefore, each firm's demand curve at 2 cents per paper clip is a horizontal line.

Key concepts

Price Takers in Perfect Competition

In a perfectly competitive market, firms are known as **price takers**. This is because they have no power to influence the market price. The market has many sellers and buyers, each with an insignificant share of the market, so no single firm can dictate prices. Instead, they accept the prevailing market price.
Being a price taker can be visualized as riding a wave—the firm simply goes along with the market dynamics that are already set. For example, if the market price for a product is 2 cents, as it is in the paper clip industry here, firms will sell their product at this price. If they try to charge more, buyers will turn to other suppliers. If they sell for less, they may survive, but they won't maximize their profits.

Elastic Demand Curve in Perfect Competition

In a market where perfect competition exists, the demand curve each firm faces is perfectly elastic. This means the demand curve appears as a horizontal line on a graph.
Imagine the demand curve as a tightrope—it requires perfect balance. At a given market price, which is constant, firms are guaranteed that they can sell as much as they produce. Conversely, any attempt to increase the price results in the loss of all sales, as consumers can easily switch to competitors. Thus, the notion of a perfectly elastic demand curve emphasizes that individual firms in such a market have little to no control over pricing, reinforcing the concept of being price takers.

• Price remains constant at the determined market value, here being 2 cents.
• Firms can sell any volume without changing this price.
• If they charge more, demand drops to zero.
• If they charge less, they miss out on potential profit.

Understanding Market Price

Market price in perfect competition is the level at which supply equals demand for the entire market. It acts as a benchmark for all firms. This price is not just a random figure; rather, it arises from the collective decisions made by all participants within the marketplace, including producers and consumers.
Think of the market price as a giant equilibrium scale—both sides of the scale must balance. Producers adjust the quantity they are willing to supply based on this price, while consumers adjust how much they want to buy. As all firms in a perfectly competitive market accept the current market price, they compete based on efficiency and output levels to maximize their returns.

• Market price dictates profitability.
• Producers sell at this price.
• No single entity sets this price; it's market-determined.

Profit Maximization for Competitive Firms

In a perfectly competitive market, firms aim to maximize profit, achieved when producing where marginal cost (MC) equals marginal revenue (MR). The underlying principle is simple: produce until the cost of making one more unit matches the revenue it brings.
Consider profit maximization like tuning a musical instrument, reaching the point where everything aligns for harmony.
For paper clips priced at 2 cents, the firm will continue to produce until the cost of making an additional clip equals 2 cents. Producing beyond this point would mean incurring more cost than earned revenue, reducing overall profit.

• The rule of thumb is MR = MC.
• Maximize profits by adjusting output levels accordingly.
• Stopping production when additional costs exceed revenue averts losses.