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 left 2 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.