Exhibit 8-1

-The perfectly competitive firewood market is composed of 1,000 identical consumers and 1,000 identical firms. Exhibit 8-1 shows cost data for one firm and demand data for one consumer. What is the equilibrium price?

Question

Exhibit 8-1
 
-The perfectly competitive firewood market is composed of 1,000 identical consumers and 1,000 identical firms. Exhibit 8-1 shows cost data for one firm and demand data for one consumer. What is the equilibrium price?

Quizplus · Accepted Answer

In a perfectly competitive market, individual firms are price takers, meaning they take the market price as given and have no power to influence it. Therefore, the equilibrium price in the market is determined by the intersection of market demand and market supply. Since there are 1,000 identical consumers, market demand is simply 1,000 times the quantity demanded by one consumer (Qd = 90 - P). Market supply is the horizontal sum of all individual firm supplies. In this case, each firm has a marginal cost of production of $40, so the firm's supply curve is simply the marginal cost curve above $0. Therefore, the market supply curve is simply the horizontal sum of 1,000 identical firm supply curves, or Qs = 1,000(Qs = P - 40 at P > $40). Setting Qd = Qs and solving for P, we get:

1,000(90 - P) = 1,000(P - 40)
90 - P = P - 40
130 = 2P
P = $65

However, this is only a potential equilibrium price because it is below each firm's average variable cost of production ($80), meaning firms would shut down in the short run and exit the market in the long run. The actual equilibrium price must be high enough to cover both marginal cost and average variable cost to ensure firms stay in business in the short run and enter or exit as necessary in the long run. In this case, the equilibrium price must be at least $80. At $80, each firm earns zero economic profit (total revenue = total cost), so they are indifferent between shutting down and continuing to produce. At any higher price, firms will earn positive economic profit and have an incentive to enter the market in the long run, increasing market supply and driving down price until economic profit is zero again. Therefore, the equilibrium price in the firewood market is $100, which covers both marginal cost and average variable cost for each firm and ensures economic efficiency in the market.

Exhibit 8-1 -The Perfectly Competitive Firewood Market Is Composed of 1,000 Identical