The firm and the industry side by side

Overview

The paired diagrams for a perfectly competitive industry and one of its firms, and how the industry supply curve is built from the firms.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Describe the pair of diagrams used to show a perfectly competitive industry and one of its firms together.

   Model answer

   Draw two panels side by side sharing the same vertical axis scale, which measures price in pounds. The left panel is the industry: quantity for the whole industry on the horizontal axis, a downward-sloping market demand curve and an upward-sloping market supply curve, crossing at the market price. The right panel is the firm: the individual firm's output on the horizontal axis, on a far smaller scale, with a horizontal average revenue and marginal revenue line drawn at exactly the price determined in the left panel, together with the firm's marginal cost and average total cost curves. The link between the panels is that the price is set on the left and imported into the right, which is what price taking means.

2. 2

   How is a perfectly competitive industry's short-run supply curve derived from the supply curves of its firms?

   Model answer

   Each firm's short-run supply curve is its marginal cost curve above minimum average variable cost. At any given price, every firm reads off the quantity at which its marginal cost equals that price, and the industry supplies the sum of those quantities. The industry curve is therefore the horizontal summation of the individual curves, adding quantities at each price rather than adding prices. It slopes upwards because each firm's marginal cost rises with output as diminishing returns set in, so a higher price is needed to draw out a larger total.

3. 3

   An industry has 100 identical firms, each with fixed costs of £60 and total variable costs of 40, 64, 78, 96, 130 and 186 at outputs of one to six units, and market demand is Qd = 880 − 10P. Show that £38 is the long-run equilibrium price and find industry output.

   Model answer

   Average total cost is 100, 62, 46, 39, 38 and 41, so minimum average total cost is £38 at five units, and £38 is the only price at which firms earn exactly normal profit. At that price each firm produces five units, since the fifth unit costs £34 and the sixth costs £56, so industry supply is 100 × 5 = 500 units. Demand at £38 is 880 − 380 = 500 units. Supply equals demand at a price giving normal profit, so there is no incentive for entry or exit and the industry is in long-run equilibrium with an output of 500 units.

4. 4

   Why must every firm in a perfectly competitive industry charge the same price?

   Model answer

   Because the product is homogeneous and buyers have perfect information at no cost. Any firm charging above the market price would find that every buyer knew of an identical cheaper alternative and switched, leaving it with no sales at all. Any firm charging below it would be giving away revenue, since it can already sell its entire output at the market price. A single price therefore rules throughout the industry, and it is set by industry demand and supply rather than by any firm.

5. 5

   Analyse the effect on the industry price and on an individual firm's profit of a rise in market demand in a perfectly competitive industry in the short run.

   Model answer

   In the industry panel the demand curve shifts to the right while short-run supply is unchanged, because the number of firms and their plant are fixed, so equilibrium moves up the supply curve to a higher price and a larger industry quantity. In the firm panel the horizontal average revenue and marginal revenue line shifts upwards to the new price. The firm moves up its marginal cost curve to a larger output, and because average total cost is unchanged, the gap between price and average total cost widens. Supernormal profit therefore appears or grows, shown by a taller profit rectangle.

6. 6

   An industry of 100 identical firms is in long-run equilibrium at £38 with demand Qd = 880 − 10P, each firm producing 5 units. Demand rises by 120 units at every price, so Qd = 1000 − 10P. Find the new short-run price and each firm's profit.

   Model answer

   In the short run no new firms can enter and the existing 100 firms still find five units the best output at any price between £34 and £56, since the fifth unit costs £34 and the sixth costs £56. Industry supply is therefore 500 units. Setting 1000 − 10P = 500 gives P = £50. Average total cost at five units is 190 ÷ 5 = £38, so each firm earns (50 − 38) × 5 = £60 of supernormal profit and the industry earns £6,000. Counting output in whole units makes short-run supply vertical over this price range; with output divisible into smaller amounts it would slope gently upwards and the price would rise a little less.

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