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Chapter 8 THE FIRM AND THE INDUSTRY UNDER PERFECT COMPETITION TRUE-FALSE QUESTIONS PERFECT COMPETITION DEFINED 1. Perfect competition is an ideal market structure. ANSWER T, M, R 2. Perfectly competitive markets have absolutely no drawbacks. ANSWER F, M, R 3. Perfect competition forms one extreme of the market structure spectrum. ANSWER T, E, R 4. Perfect competition is characterized by numerous firms. ANSWER T, E, R 5. It is relatively easy for a firm to enter a perfectly competitive market. ANSWER T, M, R 6. Perfectly competitive markets feature relatively high barriers to entry. ANSWER F, E, R 7. Under the theory of perfect competition, firms and buyers know the availability and prices associated with all products in the market. ANSWER T, M, R 8. Under perfect competition, firms are relatively ignorant of the actions of their competitors. ANSWER F, E, R 9. In perfect competition there are differences in the products sold by various firms. ANSWER F, M, R 10. In the long run, a perfectly competitive industry tends to develop differentiated products. ANSWER F, D, R 259

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Chapter 8

THE FIRM AND THE INDUSTRY UNDER PERFECT COMPETITION

TRUE-FALSE QUESTIONS

PERFECT COMPETITION DEFINED

1. Perfect competition is an ideal market structure.ANSWER T, M, R

2. Perfectly competitive markets have absolutely no drawbacks.ANSWER F, M, R

3. Perfect competition forms one extreme of the market structure spectrum.ANSWER T, E, R

4. Perfect competition is characterized by numerous firms.ANSWER T, E, R

5. It is relatively easy for a firm to enter a perfectly competitive market.ANSWER T, M, R

6. Perfectly competitive markets feature relatively high barriers to entry.ANSWER F, E, R

7. Under the theory of perfect competition, firms and buyers know the availability and prices associated with all products in the market.ANSWER T, M, R

8. Under perfect competition, firms are relatively ignorant of the actions of their competitors.ANSWER F, E, R

9. In perfect competition there are differences in the products sold by various firms.ANSWER F, M, R

10. In the long run, a perfectly competitive industry tends to develop differentiated products.ANSWER F, D, R

11. Perfectly competitive firms are known for being “price makers.”ANSWER F, E, R

12. The market for toothpaste is a good example of perfect competition.ANSWER F, E, A

13. Perfectly competitive markets are not the best at producing the goods that are desired by consumers.ANSWER F, E, R

259

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260 Chapter 8/The Firm and the Industry Under Perfect Competition

14. Perfectly competitive markets are not the most efficient type.ANSWER F, E, R

THE COMPETITIVE FIRM

15. A perfectly competitive firm is a “price taker” because it cannot sell its product for more than the market price.ANSWER T, E, R

16. A perfectly competitive firm is a “price maker.”ANSWER F, M, R

17. A perfectly competitive firm may, under some circumstances, be able to affect the market price.ANSWER F, E, R

18. A perfectly competitive firm has a horizontal demand curve because it can sell as much as it wants at the market price.ANSWER T, E, R

19. The demand curve of a perfectly competitive firm is vertical.ANSWER F, E, R

20. In perfect competition, a firm’s marginal revenue equals the price of the product.ANSWER T, D, A

21. A perfectly competitive firm will not operate where MC = MR but at MC = AC.ANSWER F, M, R

22. A firm operating at MC = MR must be making a profit.ANSWER F, E, A

23. A perfectly competitive firm can maximize profits by producing the quantity at which MR exceeds MC by the greatest amount.ANSWER F, M, A

24. In the short run, a perfectly competitive firm can make a profit, a loss, or shut down.ANSWER T, M, R

25. In the short run, a perfectly competitive firm can make a profit, a loss, or go out of business.ANSWER F, M, R

26. Once a firm’s marginal revenue curve is known, the output level can be determined.ANSWER F, M, A

27. The short-run equilibrium output of a competitive firm is found by equating marginal cost with price.ANSWER T, M, R

28. Total profit of a competitive firm can be found by multiplying profit per unit times units sold.ANSWER T, E, A

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29. If a firm sells its output at a price greater than AC, it will earn economic profit.ANSWER T, E, A

30. If a firm sells its output at a price greater than AVC, it will earn economic profit.ANSWER F, M, A

31. In the short run, a firm may have accounting losses and remain in operation.ANSWER T, M, A

32. If TR < TC, a perfectly competitive firm will always shut down.ANSWER F, M, A

33. As long as TVC < TR, a firm will have a positive level of output in the short run.ANSWER T, E, A

34. Using only marginal revenue and marginal cost, we can determine whether a firm is incurring a profit or a loss.ANSWER F, M, A

35. The lowest price that a competitive firm will accept without closing its doors is found by examining the average variable cost curve.ANSWER T, M, A

36. It pays the firm to produce only if total variable costs exceed total revenue.ANSWER F, D, A

37. In the short run, if price is below AC, maximizing profits really means minimizing total losses.ANSWER T, D, A

38. The short-run supply curve for a perfectly competitive firm is that portion of the MC curve above the AVC curve.ANSWER T, E, R

39. The short-run supply curve for the perfectly competitive firm is that part of the marginal cost curve that lies above the average fixed cost curve.ANSWER F, M, A

40. A perfectly competitive firm’s short-run supply is infinite at the market price.ANSWER F, E, R

THE COMPETITIVE INDUSTRY

41. In the short-run, only a limited number of new firms may enter a perfectly competitive market.ANSWER F, M, R

42. The short-run market demand schedule in perfect competition is positively sloped.ANSWER F, E, R

43. The market demand schedule in perfect competition is horizontal.ANSWER F, E, R

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44. The entry of new firms into a perfectly competitive market shifts the demand curve outward.ANSWER F, M, A

45. Zero economic profit means that the firm’s owners receive no compensation for their investment.ANSWER F, M, R

46. The opportunity cost of a given investment is the potential earnings forfeited by tying up money in the investment.ANSWER T, E, A

47. Economic profit equals gross earnings minus the firm’s direct costs.ANSWER F, M, R

48. Zero profit in the economic sense means that firms are earning a normal rate of return.ANSWER T, M, R

49. A firm that is earning zero economic profit should go out of business.ANSWER F, M, R

50. In a long-run equilibrium in a perfectly competitive market, the average firm earns positive economic profits.ANSWER F, E, R

51. In a long-run equilibrium in a perfectly competitive market, firms are selling at a price equal to marginal cost.ANSWER T, E, R

52. In a long-run equilibrium in a perfectly competitive market, firms are selling at a price equal to average cost.ANSWER T, E, R

53. In the long run, a perfectly competitive firm maximizes profit so P = MC = AC.ANSWER T, E, R

54. In the long run, a perfectly competitive firm earns no accounting profits.ANSWER F, E, A

55. In long-run equilibrium, a firm in perfect competition has no economic profit.ANSWER T, M, R

56. An industry supply curve is the horizontal summation of the supply curves of all of the individual firms.ANSWER T, E, A

57. In the long run, any firm may enter or leave a perfectly competitive market.ANSWER T, E, R

58. The number of firms in a perfectly competitive industry is not fixed in the long run.ANSWER T, M, A

59. For a perfectly competitive firm, the long-run supply curve is the long-run average cost curve.ANSWER T, M, A

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PERFECT COMPETITION AND ECONOMIC EFFICIENCY

60. In long-run equilibrium in perfect competition, every firm is producing at minimum average cost.ANSWER T, E, R

61. Firms in a perfectly competitive market produce at minimum average cost in the short run and the long run.ANSWER F, M, A

62. Subsidizing firms that pollute will reduce pollution in the long run.ANSWER F, E, R

MULTIPLE-CHOICE QUESTIONS

PERFECT COMPETITION DEFINED

63. A marketa. may be an organized exchange.b. refers to a set of sellers and buyers whose actions affect a commodity’s

price.c. is that area in which buyers and sellers compete to effect a product price.

M,R d. All of the above are correct.

64. To determine whether a market is perfectly competitive, economists examine thea. number of firms in the market.b. similarities among the products of the different firms in the market.c. ease of entry and exit by firms in the market.

E,R d. All of the above are correct.

65. The strength of the competition faced by a company can profoundly affect itsa. pricing.b. output decisions.c. input decisions.

M,A d. All of the above are correct.

66. Which of the following is not a characteristic of perfect competition?a. Firms and consumers all have perfect information about the good and

market.b. Sellers can enter the market easily.c. All goods sold are identical.

E,R d. All consumers have identical individual demand curves.

67. A perfectly competitive firm is a pricea. giver.

E,R b. taker.c. maker.d. leader.

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68. Which of the following is a characteristic of a perfectly competitive market?a. a few large firmsb. firms producing specialized products in order to attract consumersc. each individual firm having some control over the market price

E,R d. a large number of small firms

69. One of the following is not a characteristic of perfect competition. Which is it?M,R a. Firms advertise to increase their market share.

b. Profits are low.c. Consumers pay little attention to brand names.d. Firms pay no attention to their competitors’ output levels.

70. Firms in perfect competition are often described as priceE,R a. takers.

b. makers.c. setters.d. leaders.

71. Which of the following most resembles a perfectly competitive market?M,I a. the stock market

b. the publishing industryc. the steel industryd. the new car market

72. Perfect competition is the term used to describea. an industry in which all businessmen are honest and accommodating.

E,I b. an industry in which numerous firms produce identical products.c. an industry untouched by government regulation.d. the kind of industry any American would support.

73. Economists study perfect competitiona. because many markets are perfectly competitive.b. for its descriptive realism.

M,R c. to establish a benchmark by which to measure the performance of the economy.

d. All of the above are correct.

74. Which of the following is closest to the economist’s definition of perfect competition?a. the airline industryb. the soft drink industry

E,I c. the fishing industryd. the long-distance telephone service

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75. The result that perfectly competitive firms produce at the lowest per-unit cost is derived from the assumptions ofa. homogeneous products.b. few sellers.c. firms facing horizontal demand curves.

D,I d. free entry and exit.

THE COMPETITIVE FIRM

76. In a market with perfectly competitive firms, the market demand curve is usually ______ and the demand curve facing each individual firm ______.a. upward sloping; horizontal

M,R b. downward sloping; horizontalc. horizontal; downward slopingd. downward sloping; downward sloping

77. A firm facing a horizontal demand curvea. cannot affect the price it receives for its output.b. always produces at an output at which P = MR.c. faces perfectly elastic demand for its product.

E,I d. All of the above are correct.

78. For a perfectly competitive firm, marginal revenue equals average revenue because thea. firm’s supply curve is horizontal.b. industry’s demand curve is horizontal

D,A c. firm’s demand curve is horizontal.d. industry’s supply curve is horizontal.

79. In a perfectly competitive industry, influence over price is exerted bya. individual sellers.b. individual buyers.c. the largest firms.

M,R d. the forces of supply and demand.

80. The competitive firm has no influence over price becauseM,A a. its output is so insignificant relative to the market as a whole.

b. anti-trust laws constrain perfectly competitive firms.c. consumers establish the prices of products.d. it doesn’t know its demand curve.

81. At a perfectly competitive firm’s short-run equilibrium level of output,M,R a. P = MR = MC.

b. P = MR, but MR does not equal MC.c. P = MC, but MR does not equal MC.d. MR = MC and P < MR.

82. In short-run equilibrium, a perfectly competitive firmE,R a. may earn a profit or a loss.

b. always earns a profit.c. never earns a profit.d. earns a profit only if the firm has no fixed cost.

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83. A firm in short-run equilibrium always earns positive profits if a. SRAC > P > SRAVC.

M,I b. SRAR > SRAC.c. MR = MC.d. SRAC > MC.

FIGURE 8-1

84. If the profit-maximizing firm depicted in Figure 8-1 is perfectly competitive, how much output should it produce?a. Ab. B

E,A c. Cd. D

85. A firm earns a profit of exactly zero at its optimal output level only ifa. P = MR.b. P = MC.

M,A c. P = AC.d. P = SR AVC.

TABLE 8-1Q (in units) AFC (in dollars) AVC (in dollars) MC (in dollars)

0 C C C2 2.5 18 104 1.25 14 146 0.83 18 428 0.63 30 94

10 0.5 50 170

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86. In Table 8-1 are the short-run cost schedules of a perfectly competitive firm. If the market price of output is $50, the firm will produce ______ units and earn a profit of ______.

D,I a. 6; $187.02b. 6; $48c. 8; $154.96d. 8; $245.04

FIGURE 8-2

87. Figure 8-2 shows demand and short-run cost curves for a perfectly competitive firm. At its profit-maximizing level of output, the firm’s short-run TC is represented by area

M,I a. ADFO.b. BGHC.c. BGIO.d. ADGIO.

88. Figure 8-2 shows demand and short-run cost curves for a perfectly competitive firm. At its profit-maximizing output, the firm’s total ______ is represented by area ______.a. loss; GBHCb. profit; ADGHC

D,I c. loss; ADECd. profit; EGH

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89. Figure 8-2 shows demand and short-run cost curves for a perfectly competitive firm. In the short run, this firm woulda. earn positive economic profits.

M,I b. earn economic losses.c. go out of business.d. Cannot be determined with the information given.

TABLE 8-2A perfectly competitive producer has the following short-run average cost curve and marginal cost curve:

SR AC = 2Q + 3MC = 4Q + 3

where costs are measured in dollars and Q represents the firm’s output in units.

90. If the market price of wangdoodles is $15 each, the profit-maximizing producer whose short-run cost curves are given in Table 9-2 should produce ______ wangdoodles.a. 0

D,I b. 3c. 6d. 15

91. The firm whose short-run cost curves are given in Table 8-2 has a long-run fixed cost of

M,A a. $0.b. $2.c. $3.d. $4.

92. In the short run, perfectly competitive firms cana. make an economic profit.b. take a loss.c. break even.

E,R d. All of the above are correct.

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FIGURE 8-3

93. In Figure 8-3, the profit maximizing firm will operate at a level of a. OJ.b. OG.

E,A c. OI.d. OH.

94. In Figure 8-3, the perfectly competitive firm is realizing aa. loss equal to ABCE.b. profit equal to ABCE.

M,A c. profit equal to ABDF.d. loss equal to ABDF.

95. In Figure 8-3, the firm’s minimum cost per unit occurs at an output ofa. OJ.

E,A b. OG.c. OI.d. OH.

96. In perfect competition, marginal revenue always equalsa. total revenue.b. price.

E,R c. average cost.d. marginal fixed cost.

97. A perfectly competitive firm should continue to expand output untila. total revenue exceeds total costs.b. total revenue exceeds variable costs.

E,R c. marginal revenue equals marginal costs.d. average revenue equals variable costs.

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98. A competitive firm will always maximize profits by producing wherea. per-unit costs are lowest.b. total costs and total revenue are equal.

E,R c. P = MC.d. P = AC.

FIGURE 8-4

99. Figure 8-4 shows the industry’s supply and demand curves in panel (1) and the cost curves of a firm in the industry in panel (2). At S1, the firm isa. shut down.b. incurring losses.c. earning zero economic profits.

M,A d. earning economic profit greater than zero.

100.Figure 8-4 shows the industry’s supply and demand curves in panel (1) and the cost curves of a firm in the industry in panel (2). At S2, the firm isa. shut down.b. incurring losses.

M,A c. earning zero economic profits.d. earning economic profit greater than zero.

101.Figure 8-4 shows the industry’s supply and demand curves in panel (1) and the cost curves of a firm in the industry in panel (2). At S3, the firm is

M,A a. shut down.b. incurring losses.c. earning zero economic profits.d. earning economic profit greater than zero.

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102.The perfectly competitive firm’s short-run shutdown rule is to shut down immediately ifa. TR < TC.b. TR < SRFC.

M,A c. TR < SRVC.d. TR < MC > Q.

103.At a firm’s profit-maximizing level of output, its price is $200 and its short-run average total cost is $225. The firma. has a profit of $25 per unit of output.b. should shut down if its short-run average fixed cost is less than $25.c. has a loss of $100 per unit of output.

D,I d. should shut down if its short-run average variable cost exceeds $25.

104.A firm can stay in business while taking a loss in the short run as long as it covers itsa. fixed costs.

M,R b. variable costs.c. fixed and variable costs.d. A firm can never stay in business when it experiences losses.

105.A firm will shut down ifa. TR – TC > TFC.b. TR + TC > TFC.

D,A c. TC – TR > TFC.d. TFC + TVC > TR.

106.A firm will shut down in the short run ifM,A a. P < AVC.

b. P > AVC.c. AVC > AFC.d. TR > TC.

107.If a firm shuts down in the short run, its losses are equal toa. TC – TR.

M,A b. TFC.c. TVC.d. MC.

108.Sunk costs are created in the short run bya. contract for labor services.b. lease agreement on real estate.c. purchasing machinery.

M,I d. All of the above are correct.

109.If a firm shuts down, itsa. sunk costs remain unchanged.b. revenue will fall to zero.c. short-run variable costs will fall to zero.

M,I d. All of the above are correct.

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110.The short-run supply curve of a perfectly competitive firma. goes through the lowest point on its short-run average total cost curve but

not on its short-run average variable cost curve.b. goes through the lowest point on its short-run average variable cost curve

but not on its short-run average total cost curve.M,A c. goes through the lowest point on both its short-run average variable cost

and its short-run average total cost curves.d. goes through the lowest point on its short-run average total cost curve and

may or may not go through the lowest point on its short-run average variable cost curve.

111.In perfect competition, an increase in fixed costs will eventually cause all excepta. reduction in industry output.

D,A b. reduction in a firm’s output.c. reduction in the number of firms.d. decrease in industry supply.

112.The short-run supply curve of the competitive firm is the firm’sa. MC curve.b. AVC curve.

M,R c. MC curve above the minimum point on the AVC curve.d. MC curve above the minimum point on the AFC curve.

113.If the price falls below minimum SRAVC, the quantity supplied by the firm will bea. the quantity at minimum MC.

M,A b. zero.c. the quantity at the point where MC intersects AC.d. the quantity at minimum AC.

114.The quantity which a firm will supply in the short runa. can be read from its average cost curve.b. can be read from its average variable cost curve.

M,A c. can be read from the firm’s marginal cost curve above average variable cost.

d. is always zero above minimum average variable cost.

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FIGURE 8-5

115.In Figure 8-5, points which lie on the firm’s short-run supply curve area. A, B, C.

M,A b. C, D, H.c. F, E, G.d. A, C, H.

THE COMPETITIVE INDUSTRY

116.The supply curve for a competitive industry is obtained bya. making an empirical study of historical data.b. vertically summing the supply curves of firms in the industry.c. horizontally summing the average cost curves of firms in the industry.

M,R d. horizontally summing the supply curves of firms in the industry.

117.The short run for the industry is defined as a perioda. too brief for new firms to enter the industry.b. too brief for old firms to leave the industry.c. in which the number of firms in the industry is fixed.

E,I d. All of the above are correct.

118.The long run for the industry is defined as a period of time long enough fora. any new firm that desires to enter the industry.b. any old firm that desires to leave the industry.c. all aspects of production to vary, including the number of firms in the

industry.E,I d. All of the above are correct.

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119.When a firm leaves a perfectly competitive industry,D,I a. the individual demand curves facing remaining firms shift up in the long

run.b. short-run industry equilibrium is re-established at a new point along the

original short-run industry supply curve.c. the short-run industry supply curve shifts to the right.d. at the new long-run equilibrium, the remaining firms in the industry will

each receive a higher profit.

120.The short-run supply curve of the competitive industry is found by summing thea. AC curves of the individual firms in the industry.b. AVC curves of the individual firms in the industry.

M,I c. MC curves above AVC of the individual firms in the industry.d. There is no short-run supply curve in a competitive industry.

121.A firm in a perfectly competitive industrya. is unaffected by the entrance of new firms into the industry, since entering

firms affect only the prices they themselves receive.b. always produces more output in the long run than in the short run.

M,R c. may choose a different input mix in the long run than in the short run.d. earns economic profit in the long run but not in the short run.

FIGURE 8-6

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122.Figure 8-6 shows supply and demand conditions in a perfectly competitive industry and for a firm in that industry. Assume the industry initially has supply curve S1 and demand curve D1. If demand shifts to D2, then in the short run price will

E,I a. rise to A.b. rise to some level between A and B.c. remain at B.d. fall to C.

123.Figure 8-6 shows supply and demand conditions in a perfectly competitive industry and for a firm in that industry. At a price of $C, the firm woulda. earn zero economic profit.

M,A b. earn negative economic profit.c. have a zero opportunity cost of capital.d. have a negative opportunity cost of capital.

124.Given an industry demand curve, QD = 20 – 2P, and an industry supply curve, QS = 2 + P, industry equilibrium price in the short run will bea. $20.b. $10.

D,A c. $6.d. $3.

125.Given an industry demand curve, QD = 20 – 2P, and an industry supply curve, QS = 2 + P, industry equilibrium quantity in the short run will bea. 18.b. 12.c. 10.

D,A d. 8.

126.We expect the demand curve in the perfectly competitive industry to beE,R a. negatively sloped.

b. vertical.c. horizontal.d. perfectly elastic.

127.When a firm enters the steel industry, the short-run equilibrium price of steelE,A a. always falls.

b. falls only if existing firms gang up on the entrant.c. falls only if existing firms are earning no economic profit.d. falls only if the new firm is more efficient than existing firms.

128.Firms entering a competitive industry will cause the price of the product toE,A a. fall.

b. rise.c. remain constant.d. become more responsive to consumer demand.

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129.Perfectly competitive firms ______ earn zero economic profit in long-run equilibrium because ______.a. always; firms in perfectly competitive industries always maximize output

and so flood the market until the equilibrium price of output is driven to zero

b. sometimes; the demand curve for an individual perfectly competitive firm may or may not cross the company’s long-run average total cost curve at its lowest point

M,I c. always; firms enter whenever their economic profit is positive and exit whenever it’s negative, so in long-run equilibrium economic profit must always be zero

d. never; no firm would be willing to produce if it received zero economic profit

130.If the opportunity cost of capital is below the rate of return to capital in the perfectly competitive beauty salon industry,

D,I a. resources will flow into the industry.b. beauty salon owners must be earning negative economic profit.c. the beauty salon industry cannot be in long-run equilibrium.d. beauty salon owners must be earning negative marginal revenue at their

current levels of output.

131.The difference between zero profit and zero economic profit is thatM,R a. economists include opportunity cost in zero economic profit, while

accountants do not include opportunity cost in zero profit.b. economists do not include opportunity cost in zero economic profit, while

accountants do include opportunity cost in zero profit.c. economists include opportunity cost in zero profit, while accountants do

not include opportunity cost in zero economic profit.d. economists do not include opportunity cost in zero profit, while

accountants do include opportunity cost in zero economic profit.

132.Helga owns Viking, Inc., started with her $100,000 inheritance. Helga’s accountant informs her that her firm earned a profit of $100,000 last year, and that if she chooses to invest the money she can expect a 10% return. If Helga did not run Viking, she would not work. What were Helga’s economic profits last year?a. Zerob. $100,000c. $90,000

D,A d. $95,000

133.Richard Bland quit his job as an accounting professor to start his own restaurant. He gave up a salary of $50,000 per year and withdrew $100,000 in bank CDs earning 5 percent to buy a building and equipment. In the restaurant’s first year it had direct expenses of $75,000 and revenues of $150,000. The restaurant’s economic profit wasa. $15,000.

D,A b. $20,000.c. $75,000.d. not possible to determine from the information given.

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134.A perfectly competitive firm would be willing to remain in the industry in the long run at zero economic profit becausea. it would find it too difficult to exit from the industry in the long run.b. accounting profit would be negative.

E,A c. revenue is equal to all costs, including the opportunity cost of capital and labor.

d. its sunk costs would prevent it from leaving the industry.

135.Zero economic profits for a perfectly competitive firm in the long run meansa. the firm must exit the industry.

E,A b. the firm is in equilibrium.c. the firm will shut down until the market improves.d. average revenue is insufficient to cover long-run average cost.

136.Long-run average cost of the perfectly competitive firm includes thea. cost of raw materials per unit of output.b. opportunity cost of labor per unit of output.c. opportunity cost of capital per unit of output.

M,I d. All of the above are correct.

137.Which of the following statements is not true in a perfectly competitive industry in long-run equilibrium?

D,I a. A profit-maximizing firm may produce any output level at which P < LRAC.b. Every firm produces at an output level at which MC = LRAC.c. There is no entry or exit from the industry.d. No firm earns an economic profit.

138.The perfectly competitive widget industry is in long-run equilibrium. A profit-maximizing manufacturer receives total revenue of $55,000. He uses his labor, $15,000 worth of wire, and $15,000 worth of steel to make the widgets. The manufacturera. is earning an economic profit of $25,000.b. must have an opportunity cost of labor of less than $25,000.

D,A c. must have an opportunity cost of labor of exactly $25,000.d. must have an opportunity cost of labor of more than $25,000.

139.The entry of firms into a competitive industry causes the supply curve toa. increase its slope.b. decrease its slope.

E,A c. move farther toward the right.d. move toward the left.

140.An increase in demand will cause an increase in industry output in the long run because

M,I a. new firms enter the industry.b. new firms enter the industry and all firms increase their output.c. all firms decrease their output but more new firms enter.d. no firms enter but the existing firms increase their output.

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141.The market for a perfectly competitive industry clears at a price of $3, and the minimum average cost for all firms is $2.50. In the long run, we would expect an increase ina. each firm’s output.

M,A b. the number of firms.c. each firm’s profit.d. each firm’s average cost.

142.The long-run supply curve of an industry equals the industry’sa. long-run marginal cost curve.b. the horizontal sum of all firms’ supply curves at any point in time.

D,R c. long-run average cost curve.d. long-run total variable cost curve.

143.Regardless of quantity in long-run equilibrium, the industry price cannot exceed the

M,R a. long-run average cost of supplying that quantity.b. total variable cost of supplying that quantity.c. long-run total cost of supplying that quantity.d. minimum long-run marginal cost of supplying that quantity.

144.The long-run industry supply curve in perfect competition is derived from thea. short-run industry supply curve which shifts as new firms enter the

industry.b. short-run industry supply curve which shifts as old firms exit the industry.c. freedom of firms from sunk costs so that new cost curves become long-run

curves.M,I d. All answers above are important in deriving the long-run industry supply

curve.

145.In a perfectly competitive industry, if price exceeds LRAC, we may be surea. equilibrium has not been reached.b. new firms will continue to enter the industry.c. the long-run industry supply curve will shift to the right.

E,I d. All of the above are correct.

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146.The process of adjustment to a new long-run equilibrium in a perfectly competitive industry is complete whena. no firms want to enter or exit the industry.b. every firm has adjusted its production process to make the most efficient

use of its resources.c. investors in the industry receive the standard economy-wide rate of return

on their investments.M,I d. All of the above are correct.

FIGURE 8-7

147.In Figure 8-7, the price at long-run equilibrium isa. $5.b. $10.

M,A c. $20.d. $35.

148.At its long-run equilibrium level of output, the demand curve facing an individual perfectly competitive firm is tangent to itsa. total economic profit curve.

M,A b. long-run average cost curve.c. marginal cost curve.d. marginal revenue curve.

149.Firms will continue to enter a competitive industry untila. the supply curve is vertical.b. the supply curve is meaningless.

M,R c. any excess returns have been competed away.d. all resources are fully employed.

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150.A perfectly competitive industry in long-run equilibrium is described as efficient because firms

M,R a. produce at the low point on their average cost curve.b. produce where marginal cost yields a profit.c. earn no more than the cost of capital.d. are not profitable.

151.If you must determine the long-run equilibrium output of a competitive firm and you are permitted to see only one curve, which of the following curves is most helpful?a. demandb. marginal cost

D,A c. average costd. average fixed cost

FIGURE 8-8

152.In Figure 8-8, through which point must a horizontal demand curve pass to yield a long-run equilibrium?

M,A a. Ab. Bc. Cd. All of the above is correct.

153.In Figure 8-8, output at which point represents short-run but not long-run equilibrium?a. A

M,I b. Bc. Cd. All of the above is correct.

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FIGURE 8-9

154.Figure 8-9 displays the cost curves of a perfectly competitive firm. Profits at a price of $10 would be approximately

M,I a. $1 per unit.b. $3 per unit.c. $5 per unit.d. $10 per unit.

155.For the perfectly competitive firm in Figure 8-9, what is the long-run price and quantity?a. P = 4, Q = 150

M,A b. P = 9, Q = 200c. P = 10, Q = 200d. P = 5, Q = 150

156.In the long run, the perfectly competitive firm in Figure 8-9 will leave the industry if the price falls belowa. $10.

M,A b. $9.c. $5.d. $2.

157.In the short run, the firm in Figure 8-9 will shut down if the price falls belowa. $8.b. $6.

M,A c. $5.d. $1.

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158.The entry of new firms into an industry will very likelya. shift the industry supply curve to the right.b. cause the market price to fall.c. reduce the profits of existing firms in the industry.

E,I d. All of the above are correct.

159.In long-run equilibrium under perfect competition,a. the firm and the industry will have the same cost curves.b. only a very few firms will be earning economic profits.

M,A c. the demand curves facing individual firms will fall to the level of minimum AC.

d. individual firms will tend to increase their outputs.

160.Which of the following statements concerning equilibrium in the long run is not true?

M,R a. Most firms earn economic profits in the long run.b. The firm can vary its plant size in the long run.c. Economic profits are eliminated as new firms enter the industry in the long

run.d. For firms in long-run equilibrium, P = MC = AC.

PERFECT COMPETITION AND ECONOMIC EFFICIENCY

161.In long-run equilibrium, the perfectly competitive firm producesa. where P = MC = AC.b. at the lowest point on its long-run average cost curve.c. where its long-run average cost curve is tangent to its horizontal demand

curve.M,I d. All of the above are correct.

162.The most efficient market structure in the long run isE,R a. perfect competition.

b. monopolistic competition.c. oligopoly.d. monopoly.

163.If government forced a firm to charge a price equal to marginal cost in a situation where there are scale economies,a. new firms would enter the industry.

D,A b. the firm would be forced to go bankrupt.c. positive economic profit would grow even larger.d. marginal cost would exceed average cost.

WHICH IS BETTER TO CUT POLLUTION—THE CARROT OR THE STICK?

164.A tax on polluting firmsM,A a. would shift the LRAC curve upward.

b. would shift the LRAC curve downward.c. would have the same impact on the firm as a subsidy.d. tends to have the perverse effect of increasing pollution.

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165.If the objective of economic policy is to decrease the amount of pollution by an industry in the long run, thea. most effective policy action would be a subsidy to firms for the reduction

of emissions.M,A b. most effective policy action would be a tax on polluting firms.

c. appropriate course of action for government is to do nothing.d. appropriate course of action for government is to increase R&D outlays to

develop technology to remove the emissions from the environment.

166.A subsidy to firms intended to reduce pollution in an industry woulda. shift the LRAC curve upward.b. have the same impact on the firm as a tax.c. likely drive some existing firms from the industry.

M,A d. likely have the paradoxical effect of increasing pollution in the industry in the long run.

ESSAY QUESTIONS

167.Give a complete but concise definition of the following terms.a. perfect competitionb. perfectly competitive firm’s demand curvec. shutdown pointd. long-run equilibrium in perfect competitionANSWER E, Ra. Perfect competition is a market structure in which there are many small

firms each selling a homogeneous product, with freedom of entry and exit and complete information.

b. The perfectly competitive firm’s demand curve is horizontal, which means it can sell as much as it wishes at the prevailing market price.

c. The shut-down point for the firm in the short run is the output point where average revenue is less than average variable cost.

d. Long-run equilibrium for the perfectly competitive firm is an output level such that P = MC = AC and economic profit is zero.

168.Define the following terms and explain their importance to the study of economics.a. marginal costb. marginal revenuec. short-run equilibriumd. supply curve of the firme. economic profitANSWER E, R

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a. Marginal cost is the cost to the firm of producing and selling an additional unit of the good.

b. Marginal revenue is the amount of extra revenue the firm receives for producing and selling one more unit of a good.

c. Short-run equilibrium occurs in the time period in which some commitments cannot be changed. The number of firms in the industry cannot be changed. The competitive firm will equate P to MC > AVC to choose profit-maximizing (or loss-minimizing) price and output. If price is below the minimum of AVC, the firm will minimize losses by shutting down.

d. The supply curve for the competitive firm is MC > AVC. If price is below the minimum of AVC, the firm will minimize losses by shutting down.

e. Economic profit equals net earnings, in the accountant’s sense, minus the opportunity cost of capital and of any other inputs supplied by the firm’s owners. It is assumed that firms seek to maximize economic profits. In a competitive industry in the long run, economic profits are zero.

169.What are the assumptions of the model of perfect competition? Explain why each is important for short-run and long-run equilibrium.ANSWER M, RThere are four assumptions:

1. Numerous small firms and customers. Each buyer and each seller is so small that each has only a negligible portion of the whole market. Therefore, none is able to control price or output of the industry.

2. Homogeneity of product. Or, no product differentiation, including brand names or trademarks. Because the product offered by any seller is identical to that offered by any other seller, consumers do not care from which firm they buy. Therefore, no producer is able to charge a premium price.

3. Freedom of entry and exit. New firms can enter the market with no impediments, and firms are able to leave the industry with no problems. If there are economic profits in the industry, we expect firms to enter, increasing industry supply and driving price lower.

4. Perfect information. Each firm and each customer is well informed about the available products and prices. They are able to compare prices and seek the lowest price.The result is that the firm has no control over price and is a price taker. Market demand and market supply determine the price. The firm will maximize short-run profits by equating MR = P = MC > AVC and by producing at the quantity at which this equilibrium occurs. If P < minimum AVC, the firm will minimize losses by shutting down. In the long run, firms will enter or leave the industry based on profit opportunities, and there will be no economic profits or losses. If the price should rise or fall enough to cause economic profits or losses, there will be entry or exit of firms until economic profits of all firms in the industry are zero.

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170.Of the following industries, which are perfectly competitive? Of those which are not, why do they not fit the model?a. local bankingb. gasoline stationsc. college-level educational institutionsd. local radio and televisione. local farmers’ marketANSWER M, Ia. Local banking is not (generally) perfectly competitive. In small towns,

there are at most only a few banks. In larger cities, there are more banks from which to choose. Further, banks compete on image, size, service, etc., and not always on price. Location and hours of service may vary.

b. Gasoline stations are close to perfectly competitive, but many customers will shop on the basis of brand names. If so, the industry is monopolistically competitive.

c. Colleges are differentiated. They are generally distinguished by size, quality of instruction, etc. This is an example of monopolistic competition.

d. Local radio and television can be oligopolistic in many smaller markets and close to monopolistic competition in large markets. Differentiation is common, with different formats (talk, classical, rock, etc.).

e. Local farmers’ markets are probably the closest to perfect competition on the list. Each buyer and seller is small relative to the market; produce is not usually differentiated; and all are able to shop quickly and easily to compare price and output quality.

171.Why study perfect competition, if it rarely exists?ANSWER E, RPerfect competition is the circumstance where the market performs best, demonstrating Adam Smith’s “invisible hand” in action. Each firm, acting in its own self-interest—the pursuit of maximum profit—ends up acting in society’s best interest; products are produced and sold at minimum average cost in the long run. Also, even if the conditions of the model are not fulfilled, firms may still act as if the assumptions held. So the model’s predictive power may extend beyond the cases of agricultural and stock markets.

172.Draw a graph illustrating the relationship between the demand curve of the perfectly competitive firm and the perfectly competitive industry. Label all curves and axes correctly.ANSWER M, IThe diagram of the firm and industry should look like Figure 8-1 in the text. The firm’s demand curve should be horizontal at the industry equilibrium price.

173.Why doesn’t a competitive firm reduce its price below the industry price to increase sales?ANSWER E, AA competitive firm can sell all it wishes at the going industry price; that is the meaning of a horizontal demand curve. There would be no point to charging less if one can sell all one wants at a higher price. Furthermore, such a policy would result in losses in the long run, where industry price results in zero economic profits and any lower price would result in losses.

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174.Why doesn’t a perfectly competitive firm charge a price slightly higher than the industry price in order to earn extra profit?ANSWER E, AA perfectly competitive firm is producing a product that is identical to the output of each of its competitors. Additionally, it is only one firm of many in the market. Thus, no buyer would pay a price above the industry rate in order to buy from one particular firm; instead, the consumer would simply buy from one of the many other firms.

175.What makes the demand curve of the perfectly competitive firm uniquely different from that of firms in other kinds of market structures?ANSWER E, RThe perfectly competitive firm’s demand curve is horizontal, which means it can sell as much as it wants at the market price. This is possible because each firm under perfect competition is so insignificant relative to the market as a whole that it has no influence over price; it is a price taker.

176.What is the difference between the short run and the long run as economists define the two?ANSWER E, RThe short run is a period of time within which at least one resource is fixed. It could be a commitment for a rental lease, for example. The short run is also a period too short for new firms to enter the industry or for firms currently in the industry to exit. For the long-run period, all resources may vary; hence, all costs are variable costs. New firms may enter the industry and old firms may exit.

177.Draw a graph illustrating a competitive firm in short-run equilibrium that is earning an economic profit. Be sure to label all curves and axes correctly.ANSWER D, IThe diagram should look like Figure 8-2 in the text. Note that price must be higher than the minimum of average cost.

178.If a firm has short-run losses, will it stay open? Under what conditions will a firm close in the short run? Explain.ANSWER D, AThe firm suffers losses if P < AC so that revenue does not cover costs. The firm will stay open if P > minimum of AVC. If the firm shuts down, revenue falls to zero but fixed costs continue as obligations of the firm. Therefore, if P > minimum of AVC, the firm can cover its variable (avoidable) obligations and a portion of fixed (unavoidable) obligations. Such a decision cuts losses, so that it is more profitable to produce than to close. However, if P < minimum of AVC, the firm should close. Revenue is insufficient to cover variable (avoidable) costs, much less cover some portion of fixed (unavoidable) costs. Loss minimization in this case requires closing down.

179.Explain the reasoning behind the shutdown rules. When is it appropriate to operate with a loss?ANSWER M, I

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1. The firm will make a profit if total revenue (TR) exceeds total cost (TC). In that case, it should not plan to shut down either in the short run or in the long run.

2. The firm should continue to operate in the short run if TR exceeds short-run variable cost (TVC). It should plan to close in the long run if TR is less than TC.

The first rule requires no explanation. The second rule relies on the distinction between fixed and variable costs. The firm can avoid variable costs in the short run by shutting down. However, it is unable to avoid fixed costs by shutting down. If a firm shuts down, its losses will equal the amount of its fixed costs. If revenue exceeds total variable cost (or, equivalently, if price exceeds the minimum of average variable cost), the firm should operate, pay all variable costs and some portion of fixed costs, to minimize losses.

180.If there are no profits in competitive equilibrium, why do firms produce? How can they stay in business?ANSWER E, IThe “no profits” conclusion of competition refers to economic profits—there is no excess rate of return to the typical firm. However, each firm is able to earn sufficient accounting profits to cover the opportunity cost of invested factors and to continue operating. The source of the confusion is failing to distinguish between accounting and economic profits.

181.A firm sells in a competitive market in which price is $10. Its marginal cost is 2 + .5Q. Determine the profit-maximizing level of output.ANSWER M, AThe solution requires equating P = MC to determine Q:P = 10 = MC = 2 + .5Q10 = 2 + .5Q8 = .5QQ = 16

182.A firm sells in a competitive market in which price is $12. Its marginal cost is 6 + .25Q. Determine the profit-maximizing level of output.ANSWER M, AThe solution requires equating P = MC to determine Q:P = 12 = MC = 6 + .25Q12 = 6 + .25Q6 = .25QQ = 24

183.Describe the process that would occur in the long run in a competitive industry if there were economic profits. Illustrate this with a diagram.ANSWER M, IThe diagram should look like Figure 8-7 in the text. If there are economic profits, firms will enter the industry. The industry supply will increase and the price will fall. As the price falls, the profits of each firm will fall. The (representative) firm will therefore cut output, moving downward on its marginal cost curve. The process of entry will end when each firm is at the bottom of average cost so that there are no economic profits.

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184.Draw a graph showing the typical competitive firm losing money but continuing to operate. Explain why the firm continues to operate rather than shut down.ANSWER M, IFigure 8-10 shows price (= MR) above minimum AVC but below minimum AC. The firm is losing money but less money than if it shuts down. Since price exceeds AVC, it is covering all its variable costs and has funds left over, which can cover a portion of fixed cost. If the firm shuts down, it loses all its fixed cost.

FIGURE 8-10

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185.Graphically show a firm earning a profit; shade the appropriate profit rectangle. Explain how the profit formula represented by the rectangle is analogous to TR – TC.ANSWER E, AFigure 8-11 shows price (= MR) above minimum AC. The firm operates at the quantity Qc where P = MC. The shaded rectangle is (Pc – ACc)Qc. This is simply a restatement of TR – TC, since TR = P Q and TC = AC Q.

FIGURE 8-11

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186.A firm’s minimum AC is $10, its minimum AVC $7. Show this firm’s short-run supply curve, explaining how you obtained it.ANSWER M, IDraw a U-shaped AC and AVC, with Q at minimum AVC at a smaller level than for AC (Figure 8-12). MC passes through each of these minimum points. The firm’s short-run supply is MC above minimum AVC. Below minimum AVC, the firm produces zero. Only when P exceeds minimum AVC will the firm find it worthwhile to operate; below minimum AVC the firm is better off shutting down and losing its fixed cost.

FIGURE 8-12

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187.If the typical firm’s minimum average variable cost is $10 at an output of 50 units, if marginal cost is $20 at 70 units, and there are 1,000 firms in the industry, sketch supply curves for the typical firm and for the industry as a whole.ANSWER M, IFor the firm, plot two supply points corresponding to P = $10 and Q = 50, P = $20 and Q = 70 (Figure 8-13). For the industry, multiply the Q’s by 1,000, so that industry Q = 50,000 at P = $50 and industry Q = 70,000 at P = $20.

FIGURE 8-13

188.There are currently 1,000 firms in a competitive industry. Minimum long-run average cost is $80 and price $100. Explain what will happen to price, profit, and the number of firms in this industry over time.ANSWER E, IPrice exceeds minimum long-run average cost, so that firms are earning an economic profit. This will induce additional entry over time. As supply increases (rightward shift), price will fall to minimum long-run average cost of $80. Economic profit will drop to zero.

189.How does a firm that is losing money in the short run decide whether to shut down or continue to produce to minimize its losses?ANSWER M, AThe firm should continue to produce in the short run if TR exceeds TVC; if TR falls below TVC, the firm should shut down.

190.Sally Rand owns a ceiling fan company. She sells 1,000 ceiling fans at $50 each. Each fan costs her $20. She uses her own money to buy the fans; she withdraws the money from her savings account where it earns 5 percent interest. Before going into the ceiling fan business, she worked as a fan-dancer at $25,000 a year. Should Sally remain in business?ANSWER M, A

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If her economic profit is at least zero, Sally should stay in business. Her TR = $50,000 and her total accounting cost is $20,000, for an accounting profit of $30,000. She forgoes interest on savings of $20,000 (.05) = $1,000 as well as forgone earnings of $25,000. This leaves $4,000 in economic profit, so she should stay in business.

191.Explain how the short-run supply curve of the competitive firm is derived.ANSWER M, ASince the firm is either minimizing losses or maximizing profit in the short run if it produces where MC = P above minimum AVC for any price above minimum AVC, the quantity can simply be read off the MC curve. Thus the MC curve above minimum AVC becomes the firm’s short-run supply curve.

192.Explain why Adam Smith believed that competitive markets are a key component of achieving the gains from the invisible hand.ANSWER E, RAdam Smith believed that individuals acting in their own self-interest would end up acting in society’s best interest. This process is borne out by competition, in which firms pursuing maximum profit end up producing a good at the lowest possible AC and selling it at a price equal to the minimum LRAC.

193.Explain how the short-run industry supply curve for a perfectly competitive market is derived.ANSWER E, AAt any given price, the quantities supplied by individual firms are simply added. The resulting curve is a horizontal summation of all the individual firms’ supply curves.

194.Explain why taxes on pollutants reduce pollution while subsidies to firms cutting their pollutants actually increase pollution.ANSWER M, ITaxes cause an increase in cost and a leftward shift of supply. Output decreases and there is less pollution. Subsidies cause individual firms to cut their emissions, but they also induce additional firms into the market. Since costs of production decrease, the new equilibrium output will increase.

195.Show what happens to the industry equilibrium when new firms enter a perfectly competitive market in the long run.ANSWER M, AThe diagram of the process should be similar to Figure 8-7 in the text. The industry supply curve shifts outward and industry price falls.

196.What is the relationship between the long-run industry supply curve and the short-run supply curve in a perfectly competitive market?ANSWER M, AThe long-run industry supply curve evolves from the short-run supply curve. As new firms enter, the short-run supply curve shifts toward its long-run position. Also, as short-run fixed cost commitments become variable, the short-run cost curves become the long-run cost curve.

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197.To own a taxicab in New York City, you must own a medallion. New York City regulates the number of official cabs by limiting the number of medallions. Explain why the New York cab industry is not competitive by reviewing the four conditions necessary for competition. NYC violates which one?ANSWER E, IProduction is by many firms, each selling an identical product. There are no barriers to entry or exit, and consumers and producers have perfect information. The medallion is a barrier to entry to new firms, which can only enter the industry by buying a medallion from existing taxicab owners.

198.What is the difference between the accountant’s concept of profit and the economist’s view of profit?ANSWER E, AAccountants tend to include in TC contractual costs only. The economist measures TC as the cost of all the firm’s inputs, including the opportunity cost of the capital or any other inputs, such as labor, provided by the firm’s owners. Accounting profit is generally larger than economic profit, so that positive accounting profit may correspond to zero economic profit.

199.Illustrate the cost curves and average revenue (demand) curve for the perfectly competitive firm in long-run equilibrium.ANSWER E, IThe illustration should look like Figure 8-9(a) in the text.

200.Why do economists consider perfect competition to be the most efficient market structure?ANSWER E, RPerfect competition is the most efficient market structure because, in the long run, each firm in the market will be producing at its minimum average cost, or per-unit cost (see Figure 8-9a in the text, for example). This means that consumers get desired goods and services at the lowest possible prices, and also that the firms are economizing on society’s scarce resources to the greatest extent possible.