Code & Course Essay Example

Assignment 2


Question :

How does a perfectly competitive firm decide what price to charge? (250 words).

In perfectly competitive markets, firms are price takers. A firm cannot therefore decide on what prices to charge on its own. The market forces of demand and supply decide on the prices to be charged by the firms in the industry. A firm that charges a slightly higher price than the one dictated by the market will lose almost its entire market. The market forces clear the market off to an equilibrium price and quantity. In a graph, the equilibrium price is attained at the intersection of a demand and supply curve. Therefore, for this equilibrium price to be attained, the quantity demanded Q* of a commodity must be equal to the price P* of that commodity.

If a firm starts at a market price that is below an equilibrium price, the quantity demanded of its products will be higher than the quantity supplied, creating an excess of demand commonly referred to as a shortage. The firm will have to raise the price of its product towards the equilibrium price, since buyers will be willing to pay more money to buy the product that is in shortage. This raising of the price will continue until the equilibrium price P is attained after which further increases in price will be irrational. On the other hand, if a firm enters a market where a price of the commodity is above equilibrium price, the quantity supplied of its products will be higher than the demand for them, creating a market surplus. The firm will lower its price in order to attract more customers for its products which will lead to a lower price towards the equilibrium price. Once the price is attained, further decreases I prices will not be rational.

Why will profits for firms in a perfectly competitive industry disappear in the long run?

When investors discover market niches and enter a market, the demand for their commodities is usually significantly high while supply is low. Customers pay the amount dictated by the firms initially. This is a reflection that all firms in the industry are able to make supernormal profits. However, based on the fact that there exists no entry or exit barriers in perfectly competitive markets, large numbers of investors are attracted to the industry upon realisation that there are super-normal returns in the industry. As this happens, supply for the commodity increases resulting to an increase the supply of the commodity. The entering firms will lead to a higher competition for customers which will subsequently lower the prices of commodities. The trend will continue until an equilibrium price is attained. At the equilibrium point, all the firms will get normal profits, resulting to an elimination of the previous supernormal profits. No more entrants are attracted to the market.

Why will lossesfor firms in a perfectly competitive industry disappear in the long run? ( 250 words )

Firms may initially enter markets with higher production costs than the revenue they generate. This could be because buyers are not willing to buy the commodity at a profit-generating price. The firms therefore suffer huge losses from their investments. As a result of the loss, since as mentioned earlier there are no barriers for leaving or entering a perfectly competitive market, some of the industries will voluntarily leave the market. As this happens, supply for the commodity decreases resulting to a shortage of the commodities. The customers start purchasing the product at higher prices than the initial price. The prices rise until an equilibrium price is attained where all the industries in the market conform to normal profits. At this point, the previous losses have disappeared while no more industries are leaving or being attracted to the market.