Short Answer Questions: Chapter 5 explain why profit maximisation requires that marginal cost and marginal revenue must be equal. Q2



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Short Answer Questions: Chapter 5
Q1. Explain why profit maximisation requires that marginal cost and marginal revenue must be equal.
Q2. Explain why after a decrease in demand, the firm will decrease output.
Q3. Do you think supernormal profits are sustainable in the long run in a perfectly competitive market?
Q4. Discuss the concept of productive efficiency.
Q5. What is a natural monopoly?

Essay questions
E1. Describe the main features of a perfectly competitive market and bring some real world examples of markets that are similar in structure.
E2. Explain why creative destruction is an argument in favour of monopoly.

ANSWERS:

Short Answer Questions
Q1. Explain why profit maximisation requires that marginal cost and marginal revenue must be equal.

A: If MR > MC, the firm is making a marginal profit – each additional unit generates a positive profit and adds to overall profits. Hence, it will find it convenient to produce one extra unit. However, once MR < MC the firm is making a marginal loss – each additional unit generates a loss and therefore diminishes total profits. We can, therefore, argue that the firm will increase production if marginal revenue is greater than marginal cost, i.e. MR > MC. But the firm will reduce output if it is incurring a marginal loss, i.e. MR < MC.
Q2. Explain why after a decrease in demand, the firm will decrease output.

A. If demand for a product decreases, then the marginal revenue curve will shift to the left. This is because when the market price decreases at all output levels, the firm will receive a lower price for each additional unit of output. Graphically, marginal revenue now meets marginal cost at a much lower level of output. Firms then decrease output because the marginal revenue has fallen above marginal cost. Hence, with lower marginal revenues the profit-maximising output would be reduced.
Q3. Do you think supernormal profits are sustainable in the long run in a perfectly competitive market?

A. No. Suppose we start from a situation where average revenue is higher than firms’ short run average costs. Firms would be making supernormal profits but this would attract new entrants into the industry. The supply curve shifts to the left2 and the market price falls until firms are making normal profits. There is no longer any reason to enter the market as similar risk-adjusted profits can be earned by putting money in the bank.
Q4. Discuss the concept of productive efficiency.

A. In the long-run equilibrium, the perfectly competitive firm is operating at the minimum point of the average cost curve. This means that the firm is productively efficient as it is producing at least cost. Productive efficiency is different from allocative efficiency, which requires that price is equal to marginal cost.

Q5. What is a natural monopoly?



A. Natural monopoly is a market situation that arises when scale economies are such that only one firm can produce in the market without making losses. Typical examples of natural monopolies are the utility markets such as water, gas and telecommunications, where the infrastructure required to operate in these markets was so large that it restricted entry.

Essay questions
E1. Describe the main features of a perfectly competitive market and bring some real world examples of markets that are similar in structure.

Answer guidelines. You need to highlight that a perfectly competitive market is one where the number of sellers and buyers is large, where firms do not have market power, product is homogenous, there are insignificant barriers to entry and exit, and where information is perfect. One example you can think of is a fish or vegetables and fruit market.
E2. Explain why creative destruction is an argument in favour of monopoly.

Answer guidelines. The idea is that the supernormal profits associated with monopoly can be beneficial for the rest of society because they act as an incentive to innovate. Firms that are not monopolies can be motivated to be innovative and creative. Developing new products for the market, or new production techniques, which provide them with a competitive advantage and destroy the entry barriers of the incumbent firms or monopoly. The innovating firm, through creative destruction, then becomes a monopoly. The firm benefits from higher profits; and society benefits from the supply of new innovative goods and services. One potential drawback with this approach is that firms have to undertake expensive rent-seeking behaviour and they may not always be successful. Some inventions, work, others do not. So for every monopoly brought about by innovation, there can be many failures that have used the scarce resources of the economy.


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