Unit 3 practice test: Production, Cost, and the Perfect Competition Model

In the long run a firm can get out of its lease, so it stays only if it covers all costs. Studios making economic losses exit.

• It rises, as studios cut prices to compete: Losses push firms out, not in.
• It stays the same, as studios cover variable costs: Covering variable cost keeps a studio open in the short run only; in the long run every cost must be covered.
• It falls to zero, as each studio has a loss: Exit stops once the remaining studios are back to zero economic profit.
• Correct: It falls, as studios with losses exit: Right: in the long run, firms with economic losses leave.

Exit reduces the number of sellers, so market supply shifts left and the equilibrium price rises.

• Correct: Market supply shifts left and the price rises: Right: fewer studios offer fewer classes at every price.
• Market demand shifts right and the price rises: Exit changes the number of sellers, so it shifts supply.
• Market supply shifts right and the price falls: Fewer studios means less supply, not more.
• The price stays the same, as each studio's costs are unchanged: The market price rises as supply falls.

Exit continues until the price rises to the lowest point of ATC, where the remaining firms earn normal profit (zero economic profit).

• When the price is back above AVC: Price was already above AVC; firms leave because it is below ATC.
• When half of the studios have left: No set share leaves; exit stops when losses are gone.
• Correct: When the studios left earn zero economic profit: Right: with normal profit, there is no reason to leave.
• When demand rises back to its old level: Demand need not recover: exit itself raises the price.

With many sellers of an identical product and buyers who know the price, any one seller is too small to change the market price: a price taker.

• Harvesters can start or stop at any time: Free entry and exit shape the long run; price taking comes from many sellers of the same product.
• Salt is gathered from the shore: Where the salt comes from does not make a harvester a price taker.
• Each harvester rents her own stretch of shore: Renting land is a cost; it does not make her a price taker.
• Correct: Many small sellers of an identical product, with known prices: Right: no single harvester can move the market price.

A perfectly competitive firm faces a horizontal (perfectly elastic) demand curve at the market price: above it, it sells next to nothing; at it, it sells as much as it wants.

• Correct: They fall to almost zero, as buyers go to other harvesters: Right: her demand is horizontal at the market price.
• They fall by about 10%, as with any demand curve: Her salt is identical to everyone else's, so buyers switch completely.
• They stay the same, as buyers are loyal: Buyers see the salt as identical, so they have no reason to stay.
• They rise, as buyers think her salt is better: Buyers see every harvester's salt as the same.

With free entry and exit, any economic profit draws new harvesters in and any loss pushes some out, so in the long run the price settles at the lowest point of ATC.

• The government sets the price of salt: Nothing in the scenario says the price is set by law.
• Salt is a product that buyers want less of over time: Demand is not the reason; entry and exit remove profit and losses.
• Correct: Anyone can start harvesting, so profits draw in new sellers: Right: free entry and exit push the price to the lowest point of ATC.
• Harvesters agree to keep their profits low: Hundreds of independent sellers do not coordinate prices.