Question

The following is a free response question released by the College Board from a previous AP exam to be used as practice for future exams. You can complete the assignment in this document, using the drawing tools in Word (or any photo editing program) or print this document, and complete the activity by hand, submitting a scan or photo of your work. When you are done, submit the assignment for grading by your instructor. This question will be graded out of 7 points.
1. Assume that two firms are operating with identical cost schedules, but one firm is in a perfectly competitive industry and the other is in a monopolistically competitive industry.

(a) Using two correctly labeled graphs, show the long-run equilibrium price and output levels for each of these two firms.

(b) Compare the long-run equilibrium price and output levels for these two firms.

(c) What level of economic profit will each firm earn in the long run? Why do these results occur?

(d) For each of the two firms at the equilibrium quantity, indicate whether the firm’s demand curve is perfectly elastic, inelastic, unit elastic, inelastic, or perfectly inelastic. How can you tell?

Answer 1

Solution and Explanation:

(a). Firm in perfect competition produces at minimum efficient scale, MEC where average cost AC is minimum. The price is determined by the market supply and demand.

(b) Note that q1 is at the minimum of AC while Q* is to the left of q1. Similarly, P1 is equal to MC while P* is higher than MC. This shows that firms in perfect competition produce more and charge less than the firms in monopolistically competitive market.

(c) All firms in monopolistically competitive market as well as perfectly competitive market earn zero economic profit in the long run. This is because there is a free entry and exit

(d) Demand is steeper for firms in monopolistically competitive market so that demand is elastic. Demand is horizontal for any quantity which means it is perfectly elastic for a firm in competitive market.