Question

Suppose that the pen-making industry is perfectly competitive. Also suppose that each current firm and any potential firms that might enter the industry all have identical cost curves, with minimum ATC \(=\$ 1.25\) per pen. If the market equilibrium price of pens is currently \(\$ 1.50\), what would you expect it to be in the long run? a. \(\$ 0.25\) b. \$1.00. c. \(\$ 1.25\) d. \(\$ 1.50\)

Short answer

In the long run, the price will be \( \$1.25 \).

Step-by-step solution

Identify Current Market Situation

In a perfectly competitive market, the price at which a product is sold is determined by supply and demand. Given that the current market equilibrium price of pens is \( \\(1.50 \), it indicates that this is the price at which the current supply meets the current demand. Each firm's minimum average total cost (ATC) is \( \\)1.25 \).

Analyze Profitability

Firms are experiencing a price \( (P = \\(1.50) \) that is higher than their minimum ATC \( (\\)1.25) \). This means firms are currently earning economic profits, as they are selling their outputs at a price above the cost it takes to produce each unit.

Predict Long-Run Adjustments

In the long run, economic profits in a perfectly competitive market attract new firms to the industry, because there are no barriers to entry. As more firms enter the market, the supply of pens increases.

Determine Long-Run Equilibrium

The increase in supply will lower the equilibrium price until it equals the minimum ATC, at which point economic profits will disappear. In the long run, firms will earn zero economic profit, meaning the price of pens will settle at the minimum ATC, which is \( \$1.25 \).

Key concepts

Market Equilibrium

Market equilibrium is a key concept in understanding how prices are set in a perfectly competitive market. It occurs when the quantity of a product supplied matches the quantity demanded, ensuring that there is no excess supply or demand. In the scenario of the pen-making industry, the current market equilibrium price is set at $1.50 per pen. This price is where the amount of pens firms wish to supply equals the number that consumers want to buy.

In a perfectly competitive market, all firms are price takers, meaning they must accept the market price determined by the combined forces of supply and demand. This ensures that no single firm can influence the market price on their own. It is crucial to note that equilibrium prices do not remain static. They may shift due to various factors such as changes in consumer preferences, production costs, or the entry of new firms into the market. In this exercise, the market is predicted to move towards a new equilibrium price of $1.25 in the long run as supply increases and economic profits are eliminated.

Average Total Cost

Average Total Cost (ATC) represents the average cost of producing each unit of output. It is calculated by dividing the total cost of production by the quantity of output produced. In our case of the pen-making industry, the minimum ATC is $1.25 per pen. This figure is important because it signifies the lowest price at which firms can profitably supply their goods without incurring losses.

The ATC curve usually takes a U-shape due to economies and diseconomies of scale. Initially, as production increases, the ATC decreases due to spreading out the fixed costs over more units. However, as production continues to grow, the ATC may increase if the firm experiences inefficiencies or higher variable costs. The minimum ATC is where the firm achieves the greatest cost efficiency per unit.

• Lower ATC: Economies of scale realized, reducing cost per unit.
• Higher ATC: Diseconomies of scale, increasing the cost per unit.
  
  

Ultimately, the equilibrium price in the long run in a perfectly competitive market will adjust to equal the minimum ATC, ensuring that each firm covers its costs of production without making a profit.

Economic Profit

Economic profit plays a crucial role in the dynamics of a perfectly competitive market. It is calculated by subtracting total costs, including opportunity costs, from total revenue. When firms in the pen-making industry face a market price of $1.50, which is above their minimum ATC of $1.25, they are enjoying positive economic profits. This profit is the incentive for other firms to enter the industry, as it signals higher returns than other investments could offer.

However, when new firms enter the market, the increased supply typically lowers the price to match the lowest ATC, eliminating economic profit. This is a hallmark of perfect competition: firms will earn zero economic profit in the long-run equilibrium. Essentially, economic profit attracts competition which, over time, drives the price down to the cost of production, including the opportunity cost of capital. This ensures an efficient allocation of resources, where firms only stay in the market while they can cover their opportunity costs.

• Positive Economic Profit: Attracts new firms, increases supply.
• Zero Economic Profit: Long-run state where firms only cover their costs.
• Signaling Mechanism: Shifts resources to where they can be most efficiently used.
  
  

Understanding economic profit is vital for students to see how competitive markets self-regulate and achieve efficient outcomes over time.