ECON A311

Intermediate Microeconomics

Unit 3
Perfect competition

241
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Contents

Introduction 1

Perfectly competitive markets 2

Profit maximization 3
The supply of output under perfect competition 6
The demand for input under perfect competition 7
Short-run factor demand curve 9
Long-run factor demand curve 10

Industry supply curve 12

Pecuniary externality 13
Long-run industry supply curve 14

The welfare implication of taxes 16

Summary 18

Answers to self-test questions 19

Appendix: Profit maximization 24

 Unit 3 1

Introduction
In Unit 2, we discussed the neoclassical theory of production and the
theory of the firm. We concluded that a firm’s production decisions,
including the level of output and the amount of input used, are a function
of both technology and market structure.

In this unit, we shall study the behaviour of the firm under the setting of
perfect competition. We shall start from the very beginning — the
representative firm in a competitive industry, and discuss the short-run
and long-run behaviour of the representative firm. We shall then extend
the analysis from the firm level to the industry level, and discuss how
government intervention may affect firm behaviour and hence distort the
market.

We’ll also discuss the demand for inputs under perfect competition. It is
often mentioned in standard economics textbooks that the demand for
inputs — for example, the demand for labour — is derived demand. That
is, the inputs are not the ultimate need. Inputs are required for the
production of the final output. Nevertheless, from the producer’s point of
view, the supply of output and the demand for input have to be
determined simultaneously if the objective is to maximize profit.

Lastly, you will see in this unit that how government intervention can
distort perfectly competitive markets. Generally there will be negative
welfare impact when the government imposes taxes on the producer.

To summarize, this unit:

• explains the basic assumptions of perfect competition and

characteristics of a competitive firm;

• analyses the short-run and long-run supply function of a competitive

firm and industry equilibrium;

• determines product price given the cost structure of industry;

• explains the determination of demand for inputs; and

• evaluates government’s tax policy on competitive firms.

2 ECON A311 Intermediate Microeconomics

Perfectly competitive markets

We begin our discussion by imposing an assumption on the behaviour of
firms: firms maximize profit. This simple and yet powerful assumption
enables economists to explain many apparently complex economic
scenarios such as tax policy.

We first introduce the concept of profit function, which is defined by

Profit = total revenue – total cost,

where the total revenue is the product of the market price, P, and the
firm’s output, Q. From the last unit, you know that the output is
generated from a production function generally represented as Q = f(x1,
x2, ... , xn) where the x1, x2, ... , xn are inputs. Given the input prices w1,
w2, ... , wn, the total cost can be expressed as (w1x1 + w2x2 + ... + wnxn).
Thus, the profit, p, is:

p = total revenue – total cost

= P × Q – (w1x1 + w2x2 + ... + wnxn)

= P × f(x1, x2, ... , xn) – (w1x1 + w2x2 + ... + wnxn).

You should recall from the last unit that the cost of production is
determined by three factors:

1 factor prices,
2 technology, and
3 efficiency of production.

In this unit we assume that there is no inefficiency, and unless stated

otherwise, there is no change in technology. You will see that all prices,
including the input prices, are assumed to be constant under the setting of
perfect competition.

A perfectly competitive market is characterized by the following

features:

1 Large number of firms that produce an essentially homogeneous

product.
2 All buyers and sellers have perfect information.
3 Free entry and exit for all firms in the long run.

Under these (ideal) conditions, firms are price takers, in the sense that the
behaviour of individual firms does not affect the market price. In
economics jargon, individual firms face a horizontal demand curve; the
firms do not have any market power over the price of the product.
Consumers have no loyalty to particular producers and will buy from the
producers who ask for an infinitesimally lower price. As a result, all
producers must charge the same price. These concepts are quite
 Unit 3 3

straightforward, as you’ll see in this unit’s first reading, with provides a

more detailed discussion.

Reading
PR (2018) 8.1 ‘Perfectly competitive markets’, pp. 289–91.

Profit maximization
Suppose there are only two inputs in production, labour (L) and capital
(K). The profit function can be simplied as

Profit = Pf (L, K) – wL– rK ,

where w and r are wage rate and rental cost of capital respectively. The
producer’s objective is to maximize profit. It can be shown that (using
calculus) the condition for profit maximization is

w = P × MPL

r = P × MPK

MPL MPk
=
w r

The meaning of these conditions will be explained later.

A more intuitive condition for profit maximization:

marginal cost = marginal revenue, or

MR = MC.

This condition is applicable for firms under all kinds of market setting,
no matter whether the market is perfectly competitive or not.

In the case of perfect competition, the marginal revenue, MR, equals the
market price, P, because firms are price-takers. Thus the profit
maximization condition under perfect competition is

MC = P.

In order to maximize profit, a firm should set its output at the level where
the marginal cost of production equals the market price. You can find a
discussion of this condition in the next reading. Once you’ve read these
couple of pages, go on and work through Self-test 3.1. Remember to
check your answers with those provided at the end of this unit.
4 ECON A311 Intermediate Microeconomics

Reading
PR (2018) 8.2 ‘Profit maximization’, pp. 292–94; 8.3 ‘Marginal
revenue, marginal cost and profit maximization’, pp. 294–97.

Self-test 3.1

1 It is estimated that the price elasticity of demand for chicken is 0.6.

But Gai Kee, a farmer raising chickens, claims that the price
elasticity of demand for his firm is infinitely elastic. How do you
reconcile the difference?

2 Explain why a competitive firm produces at the output where price

equals marginal cost.

3 Let’s say a firm’s total cost to produce q units of output is given by

TC = 1000 + 20q. If the firm is a price taker and the market, P, is 40,
what is the output if the firm’s objective is to (a) break even, (b)
maximize profit?

The readings from your textbook so far have discussed the concepts of
perfect competition and profit maximization. However, you should note
that P = MC is not sufficient for profit maximization. The next few
paragraphs, with the help of the following figure, provide a non-calculus
discussion on the sufficient and necessary conditions for profit
maximization under perfect competition.

Figure 3.1 A graphical illustration of the first and second order condition
 Unit 3 5

The condition P = MC can be visualized graphically as the intersection of

the marginal cost curve and the marginal revenue curve, which is simply
the horizontal line P under the market setting of perfect competition. In
this figure, both A and B are intersections of the marginal cost curve and
the marginal revenue curve; the profit maximization conditions are met
when the output is Q L or QU.

Here, note that MC = P is only a necessary condition for profit

maximization. Suppose the firm sets the output at QU and the firm wants
to increase the output to Q2. Since the marginal cost is increasing while
the marginal revenue is constant, total profit must fall. The decrease in
profit is represented by the area bound by the MC and MR curves
between QU and Q2. The marginal cost is lower than marginal revenue
when output falls below QU. The decrease in profit is represented by the
area bound by the MC and MR curves between QU and Q1. Since total
profit falls when output level is deviated from QU in both directions, QU
is an output level which maximizes total profit.

At the output level QL, the condition MC = P is also met. However, when
the output increases, say, to Q4, the total profit increases by the amount
represented by the area bound by MC and MR curves between QL and Q4,
because marginal revenue is higher than marginal cost in this range.
When the output is reduced from QL to Q3, profit rises by the area bound
by the MR and MC curves between QL and Q3. Since total profit increases
when the output deviates from QL in both directions, QL must be an
output level which minimizes the total profit.

Now it should be clear to you that MC = P is only a necessary condition

for profit maximization. To ensure profit maximization, you have to
inspect the slope of the marginal cost curve. QU represented the output
level maximizing total profit, because the marginal cost is increasing, i.e.
the marginal cost curve is positively sloped. This is an important
observation: the marginal cost must be increasing at the output level
where MC = P in order to ensure profit maximization.

Therefore, the complete set of conditions for profit maximization is:

1 MC = P, and
2 the marginal cost curve is upward sloping.

The first condition is usually labelled as the first order condition, and the
second is called the second order condition, for profit maximization
under the market setting of perfect competition. In practice, we only
mention the first order condition as the condition for profit maximization,
based on the presumption that the output lies in the range of increasing
marginal cost.
6 ECON A311 Intermediate Microeconomics

The supply of output under perfect

competition
Recall the concept of the short-run cost curves you learned about in
Unit 2. The relationship of the marginal cost curve and the average cost
curve is depicted in the following figure.

Figure 3.2 Marginal cost curve and average cost curve

When the market price is P1 the firm sets the output at Q1 to maximize
profit. (Note that Q1 satisfies both the first order and second order
condition). As long as the market price is higher than the average total
cost, the firm makes a profit, (P1 – C1)Q1, represented by the shaded area
in the figure. Thus, the firm adjusts its output level according to the
market price: the output is Q1 when the market price is P1; it is Q2 when
the market price is P2, etc. That is, the portion of the marginal cost curve
above the average variable cost curve is the firm’s short-run supply curve.
Note that the profit is negative when the market price is lower than the
average total cost; the firm’s strategy is to minimize the loss, consistent
with the notion of profit maximization.

In the long-run all inputs are variable, and the output supply schedule is
the portion of long-run marginal cost curve above the long-run average
cost curve. The important point to note is: the firm will not tolerate loss
in the long-run. The firm must generate non-negative profit for all the
output levels associated with the supply schedule, or the firm will cease
to produce. Please proceed to the next reading for the details, then do
Self-test 3.2.

Reading
PR (2018) 8.4 ‘Choosing output in the short run’, pp. 297–302;
8.5 ‘The competitive firm’s short-run supply curve’, pp. 302–5;
8.7 ‘Choosing output in the long run’, pp. 310–16.
 Unit 3 7

Self-test 3.2

1 What is the profit maximization condition for a firm in the long-run?

How is it different from the short-run condition?

2 Mr Chan is considering opening a BBQ restaurant in a park managed

by the government. The price is regulated: $30 per unit on sunny
days and $25 on rainy days. Suppose the cost structure of the
restaurant operates with the total cost TC = 0.05q2 + 20q + 200 and
marginal cost MC = 0.1q + 20, where q is the quantity of output.
What is the output level on sunny days? Rainy days?

The demand for input under perfect

competition
Recall from Unit 2 the discussion of average product and marginal
product. They measure how effectively inputs can generate outputs in
physical terms. This is the reason why some economists prefer to call
them average physical product and marginal physical product. If a
producer’s objective is to maximize profit, the demand for inputs (capital,
labour, etc.) is clearly related to how effective the inputs are, in money
terms, in producing the output. This motivates the definition of the
marginal revenue product (MRP) of input. For example the marginal
revenue product of labour is defined as

MRPL = ∆R/∆L,

the increase in revenue (R) per each unit of increase in labour (L).
Moreover, recall the rule to maximize profit: marginal revenue equals
marginal cost. For simplicity, suppose labour is the input concerned. The
marginal cost of using labour is clearly the wage rate, w. Thus, to
maximize profit, the quantity of labour used must be set at the level
where the marginal revenue product of labour (MRPL) equals the wage
rate:

MRPL = w.

Similarly, the quantity of capital must be set at the level where the
marginal revenue product of capital (MRPK) equals the rental cost of
capital:

MRPK = r.

Reading
PR (2018) 14.1 ‘Competitive factor market’, pp. 543–47.
8 ECON A311 Intermediate Microeconomics

Under perfect competition, R = P × Q, where the price, P, is given

because the firm is a price-taker. Thus, the marginal revenue product of
labour can be represented as

MRPL = ∆(P × Q)/∆L = P × ∆Q/∆L = P × MPL.

The quantity, P × MPL, can be interpreted as the pecuniary value of the

marginal product of labour, which is usually referred to as the value of
marginal product of labour, VMPL. Or,

VMPL = P × MPL.

Similarly, VMPk = P × MPk

Thus, we can state the conditions for profit maximization under perfect
competition in which P, w and r are given:

P × MPL = w ,

P × MPk = r , and

MPL MPk
= .
w r

Now, to supplement the reading you’ve just done, I’ll define for you the
value of average product of labour, VAPL, as

VAPL = P × APL .

Typical VAPi curves and VMPi curves are shown in the following figure.
Note that they are very similar to the average physical product curve and
marginal average product curve depicted in Unit 2. (They must be,
because they differ only by a multiplier, the price, P.)

Figure 3.3 The value of average and marginal product

Let’s take a break for a short self-test.

 Unit 3 9

Self-test 3.3

1 What is the difference between the value of marginal product and the
marginal revenue product?

2 Explain why a profit-maximizing firm under perfect competition does

not want to maximize the output per worker?

Short-run factor demand curve

Next, we will consider the factor demand curve. From the relationship
between marginal cost and marginal product, the following relationship
must hold if the firm’s objective is to maximize profit (i.e. to set output
at P = MC):

P × MPL = w.

Note that this condition is equivalent to P = MC when MC is expressed

as

w/MPL.

This condition can be more compactly expressed as

VMPL = w.

That is, to maximize profit, a producer hires the labour at such a level
that the pecuniary value created by each unit of labour — i.e. VMPL — is
the same as the cost to hire that unit of labour. You can see that this is
again a marginal-cost-marginal-benefit type analysis. Moreover, notice
that a production process is profitable only if the average cost of labour,
which is the wage rate w if the input market is competitive, is lower than
the average revenue due to the labour. Thus, the factor demand curve is
given by the portion of marginal value product curve below the average
value product curve. This is shown as the heavy portion of the VMPL
curve in the following figure.

Figure 3.4 The factor demand curve. The portion of the VMPL below VAPL is
the factor demand curve
10 ECON A311 Intermediate Microeconomics

Long-run factor demand curve

Note that our previous discussion on factor demand is a short-run
analysis. In the long-run, marginal product would respond to the change
in input price. Please refer to the following reading for a brief discussion.

Reading
PR (2018) ‘Demand for a factor input when several inputs are
variable’, pp. 547–48.

When the price of an input changes, the producer substitutes one input
for another (the substitution effect) and alters the level of output (the
scale effect) in order to maintain the total cost of production. The
following figure demonstrates the substitution effect and scale effect in
production. Note that the notions of substitution effect and scale effect in
production are very similar to the substitution and income effect you
learned about when we analysed consumption behaviour in Unit 1.

Figure 3.5 Substitution effect and scale effect

When the wage rate drops from w0 to w1, L1 units of labour are used
produce the same output Q0; the substitution effect is L1 – L0. Since the
cost of labour is lower, more output, Q1, can be produced with the same
cost; the scale effect is (L1* – L1).

Since the objective of the producer is to maximize profit, there is no need

for her to constrain herself to a constant cost of production. However, to
maximize profit, the firm has to produce with the input mix which
satisfies the cost minimization condition

MRTSKL = -w/r,

which was explained to you in Unit 2. Thus, when the price of labour
changes, the marginal rate of technical substitution, MRTSKL, and hence
the expansion path, also changes.
 Unit 3 11

Self-test 3.4

1 The following table shows the marginal product of labour of a

competitive firm at various levels of workers employed. The output
price is $10 and wage rate is $35.

Worker (L) Marginal product (MPL)

1 4.5
2 4.2
3 3.9
4 3.7
5 3.5
6 3.1

a What is the value of marginal products if the price equals $10?

b How many workers should be hired to maximize profit?

2 The production of a firm is given by Q = x11/ 2 x12/ 3 . The wage of the

input x1 is w1 and the wage of input x2 is w2. It can be shown that the
x1/ 3 x1/ 2
marginal products of x1 and x2 are MP1 = 21/ 2 and MP2 = 12 / 3
2x1 3x2
respectively. What are the demand functions for x1 and x2?

3 Suppose that the short-run production function of manufacturing

dumplings is given by Q = 1,000L1/2 where L is the number of
labourers hired per hour by the factory. Assume that the dumpling
business is a competitive industry with the market price of $1 per
dumpling. The marginal product of labour is given by MPL = 500L-1/2.
How much labour would be hired at a competitive wage of $20, $30,
$40? Sketch a demand curve for labour from you results.

4 Explain the substitution and the scale effect. Is it necessarily true that
more capital would be used if the wage rate rises, given that labour
and capital are the only inputs?
12 ECON A311 Intermediate Microeconomics

Industry supply curve

The discussion in the previous section focuses on the supply of
individual firms. Under perfect competition, all firms are identical in the
sense that they provide homogeneous goods and hence have zero market
power. Some economists label the firms in competitive industry as
‘representative firms’.

Since firms compete against one another the competitive industry,

composed of hundreds of thousands of firms, will eventually reach a
long-run equilibrium where each firm is settled at an optimal scale of
production. Moreover, at this long-run equilibrium the profit of each firm
is zero, so that there is no incentive for new firms to enter the industry.
The following reading also addresses these basic concepts.

Reading
PR (2018) 8.6 ‘The short-run market supply curve’, pp. 305–10.

The above reading mentions that ‘the industry’s short-run supply

function is the horizontal summation of each firm’s short-run supply
function’. This statement is true only if input price does not respond to
the change in quantity demanded in the output market in the short-run.

Consider an industry consisting of N firms. We denote the supply

function of a representative firm as

Qis (P;r,technology),

where P is the product price and r the set of input prices. Now the
question is: can we conclude that the market supply is simply the
N
horizontal sum of the supply of individual firm i.e. QT (P) = ∑ Qis (P) ?
i =1

Figure 3.6 Is market supply a simple horizontal sum of the supply of individual
firms?
 Unit 3 13

The market supply is the horizontal sum of individual firms if there is no

interaction, i.e. externality, among the firms. The crucial point is that the
outputs of individual firms, and hence the industry output, are related to
the cost of production. If industry output does not have any effect on the
individual firm’s cost of production, the industry’s quantity supplied at
each price level is the summation of the individual firm’s quantity
supplied. In other words, the industry supply curve is simply the
horizontal sum of individual firms’ supply curves.

Recall from the previous unit that the cost of production is determined by
two factors, input prices and technology. It is clear that an individual
firm’s cost of production falls — i.e. its marginal cost curve shifts
downwards — if industry expansion has a positive impact on
technological progress. A more subtle consequence is that industry
expansion leads to higher demand in inputs, setting pressure for rising
input prices and hence shifting up the marginal cost curve of individual
firms.

In short, the industry supply curve is the horizontal sum of an individual

firm’s supply curve only if:

1 the industry is a small user of the inputs and/or the market supply of
the inputs are infinitely elastic so that input prices are unaffected by
the total industry demand — there is no pecuniary externality; and

2 productivity of individual firms is independent of industry output —

there is no technological externality.

We will illustrate the impact of pecuniary externality on individual firms’

output decisions, and hence the industry supply curve, in the following
section. At this point, you should be able to analyse the effect of
technological externality following the same approach.

Pecuniary externality
If the industry is a large user of an input and the input is a normal factor,
an increase in industry output, leading to competition for inputs, raises
the input price and hence the cost of production. This is known as
pecuniary diseconomy. Under pecuniary diseconomy, factor price
changes as the price of the final product changes; the market demand
curve is less elastic than the sum of the individual demand curves. The
argument is further explained in the following figures.
14 ECON A311 Intermediate Microeconomics

Figure 3.7 Pecuniary diseconomy

Suppose product price increases, say from P0 to P1. The firm increases
the output from qi0 to qi1 along the short-run supply curve MC0 (panel A).
Correspondingly, industry output increases from QT0 (= Σqi0, the sum of
individual firms’ output before the increase in price) to QT1 (= Σqi1, the
sum of individual firms’ output after the increase in price) if there is no
pecuniary effect (panel B). Suppose the input price is r0 when industry
demand for the input is XT0, which is the sum of individual firm’s
demand for the input, xi0. For normal input, the increase in industry
output will bid the input price up to r1 (see panel C). The higher input
price shifts the marginal cost curve to MC1 and the output is qi1*(panel
A). The industry output is QT1* (= Σqi1*, panel B) and the industry
supply curve is the line connecting A and B, which is more inelastic than
the supply curve if there is no pecuniary effect.

Long-run industry supply curve

We now turn to the issue of the long-run industry supply. We want to ask
this question: does the cost of production relate to the industry output in
the long run? It should be easy to see that if there is no change in
technology and there is no externality effect, the long-run cost structure
of individual firms must remain unchanged regardless of the industry
output. This scenario gives rise to a horizontal long-run industry supply
curve. An industry with a horizontal long-run industry supply curve is
called a constant cost industry.
 Unit 3 15

Consider the scenario of external diseconomies. Suppose there is an

increase in the demand for output. This raises the output price to a higher
level, inducing positive profit, hence attracting more firms into the
industry. However, external diseconomies shift the cost curves of
individual firms up, leading to a higher output price at the new
equilibrium. Thus the output price increases as the industry expands.
This is referred to as the increasing cost industry. On the other hand,
external economies would lower the cost of production as industry output
increases, leading to a downward sloping industry supply curve, or a
decreasing cost industry.

What we have just discussed are the logical possibilities. In reality,

however, many industries are increasing cost because firms differ in size
and efficiency. In particular, your textbook suggests that because of the
differences in managerial ability, some firms can produce at lower
average costs. This in turn partially explains why the industry supply
curve is upward sloping.

The following reading contains graphical descriptions of these concepts.

Pay attention to the discussion of economic rent (producer surplus),
which is the benefits enjoyed by the owners of the resources of limited
supply. Complete the following reading, then do Self-test 3.5, which
follows.

Reading
PR (2018) 8.8 ‘The industry’s long-run supply curve’, pp. 316–20.

Self-test 3.5

1 Give an example of ‘pecuniary diseconomy’.

2 Do you agree that the short-run industry supply curve is the

horizontal summation of the supply curves of the individual firms in
the industry?

3 Give an example of an increasing cost industry. What accounts for

the long-run cost structure of this industry?

4 Give an example of a decreasing cost industry. What accounts for the

long run cost structure of this industry?
16 ECON A311 Intermediate Microeconomics

The welfare implication of taxes

Producer surplus is a measurement of the welfare enjoyed by the
producer, whereas consumer surplus is a measurement of consumer
welfare. Thus, the welfare implication of government policy, such as the
imposition of new tax, can be examined by studying the total changes on
producer surplus and consumer surplus.

For example, the welfare impact of government imposing per-unit tax on

an industry is discussed in the following reading. You should particularly
refer to Figure 8.18 (PR p. 321) for how the imposition of per unit tax
shifts up the cost curves of a representative firm under perfect
competition, which will in turn shift up the industry long-run supply
curve. The consequence is that product price is higher but the industry
output is lowered. The extent of how much the price is affected depends
on both the price elasticity of supply and price elasticity of demand of the
industry. It is also clear that both the producers as a whole, and the
consumers as a whole, are adversely affected by the tax policy.

The figure below will help make this clearer for you.

Figure 3.8 The welfare implication of per-unit tax

In the above figure, the sum of the consumer surplus and producer
surplus before the imposition of tax is represented by the area EGH.
When the tax is imposed, the total surplus is reduced to the amount
represented by the area E’GJ, a decrease represented by the polygon
EE’JH. It is clear that both the producers and consumers are negatively
affected by the tax. You may want to argue that tax money is siphoned to
benefit others in the economy so that the overall welfare remains
unchanged. The tax revenue due to the per unit tax is (t × Q’),
represented by the area of the rectangle E’P’PF which is the same as the
parallelogram E’JHF. Thus, the total welfare after the tax is imposed —
which includes the consumer surplus, the producer surplus and the tax
revenue — is the amount represented by the trapezium E’GHF. The
conclusion is clear: the policy of per unit tax generates an unrecoverable
welfare loss represented by the area EE’F.
 Unit 3 17

You should now go ahead and work through the following reading, then
complete the self-test that follows.

Reading
PR (2018) ‘The effects of a tax’, pp. 320–21; ‘Long-run elasticity
of supply’, pp. 321–22; 9.1 ‘Evaluating the gains and losses from
government policies — consumer and producer surplus’,
pp. 327–33; 9.5 ‘Import quotas and tariffs’, pp. 351–55; 9.6 ‘The
impact of a tax or subsidy’, pp. 355–62.

Self-test 3.6

1 The Hong Kong SAR government wants to promote the computer

industry by imposing an export subsidy policy, i.e. manufacturers of
computer hardware will receive a subsidy of t dollars for each unit
they export. Discuss the welfare implications of the policy.
18 ECON A311 Intermediate Microeconomics

Summary
This unit discussed the determination of outputs and inputs under perfect
competition. You learned the meaning of short-run supply curves of
individual firms and showed that it is in fact the firm’s marginal cost
curve. The long-run supply curve, however, depending on the external
effect, or externality, of the industry, is more elastic than the short-run
supply curve.

The industry supply curve in general is not the horizontal sum of

individual firms’ supply curves because of its external effect. Two types
of externalities can be identified: the pecuniary externality related to the
bidding of scarce inputs for production; and technology externality,
related to the technological change due to changes in industrial output.
Owing to externality, an industry could be classified as decreasing cost,
constant cost, or increasing cost, depending on the cost implications
when the size of the industry changes.

I asserted that a firm’s output and inputs are determined simultaneously.

Firms are also price takers if the input markets are perfectly competitive.
To maximize profit, firms employ the inputs up to the level that the price
of the inputs equals the value of the marginal products of the input. The
framework of analysis is the same as that for the output market — the
output is set at the level where the price of the output equals the marginal
cost of the output.

We concluded this unit with an example of government intervention. You

were shown that producers will produce less when government imposes a
unit tax on them. This is in fact an illustration of how government
intervention can distort a perfect competitive market.

In fact, it can be shown that perfect competition generally creates the

most desirable outcomes in terms of production efficiency and allocation
efficiency. This is the subject matter of the next unit.
 Unit 3 19

Answers to self-test questions

Self-test 3.1
1 The 0.6 price elasticity is referred to the chicken industry; consumers
buy 6% less when the price of chickens increases by 10%. The
market price is determined by the market demand and market supply.
However, Gai Kee, a competitive firm, produces only a negligibly
small proportion of industry output. Thus, the firm’s output decision
does not affect the market price. For example, suppose the chicken
industry’s equilibrium weekly output is 1,000,000, at the price of $50
per chicken. Suppose Gai Kee supplies 20,000 chickens each week. If
Gai Kee lowers its output to 10,000, the industry output is reduced to
990,000, a 1% decrease. Thus, the price increases by
ΔQ P 10,000 50
= × , an insignificant amount, to $50.83. Thus,
Q 0.6 1,000,000 0.6
from the standpoint of Gai Kee, the elasticity of demand is infinitely
elastic. You may want to work out the scenario when Gai Kee
supplies only 0.1 percent of the industry output.

2 You can refer to page 262 of BPP for a brief answer. Recall that
profit is highest when marginal cost (MC) equals marginal revenue
(MR), and MR = P under perfect competition.

3 a To break even, total cost = total revenue. Since total cost = 1000
+ 20q, and total revenue, TR = 40q,

1000 + 20q = 40q, q = 500.

b Since TC = 1000 + 20q, it is easy to see that cost increases by 20

if output increases by one unit, i.e. marginal cost, MC = 20. You
can see that P = 40 > MC for all output levels. That is, there is no
limit on the theoretical profit-maximization output level. In
practice, the firm would expand the output to the limit of the
production capacity.

Self-test 3.2
1 In the short-run, the firm produces at an output level where price is
equal to the short-run marginal cost. In the long-run the output should
be set at a level where price equals the long-run marginal cost. Note
that in the short-run the firm sets the output so as to maximize profit
or minimize loss — it is not necessary for the firm to know its total
cost function. Since profit must be non-negative in the long-run, the
firm has to know its long-run total cost function.

2 The market price is $30 on sunny days. From the profit maximization
condition:

30 = 0.1q + 20 ⇒ q = 100,
20 ECON A311 Intermediate Microeconomics

hence profit = P × q – TC = 3000 – (0.05 × 1002 + 20 × 100 + 200) =

300.

If the price = 20,

25 = 0.1q + 20 ⇒ q = 50,

hence profit = 750 – (0.05 × 502 + 20 × 50 +200) = –575.

Self-test 3.3
1 The marginal revenue product is the measurement of the change in
the total revenue when an additional unit of input, for example,
labour, is employed:

MRP = ∆R/∆L.

The value of marginal product is the product of price and marginal

product:

VMP = P × ∆Q/DL,

assuming that the price P is unrelated to the marginal product. You

can see that the former is more general than the latter.

2 If the objective is to maximize profit, the firm equalizes the marginal

revenue product and the wage rate, w. Under perfect competition, it is
equivalent to setting marginal product equals wage rate, w, divided
by output price, P. This profit maximization condition does not yield
maximized average product, as shown in the following figure:

The figure shows the total product curve of labour. The marginal
product of labour is represented by the slope of the curve. The
maximum average product is depicted by the line OA. The profit-
maximized input level is L2, obtained from the tangent of the line CD,
whose slope represents w/P, to the total product curve. The average
product maximizing output is L1. It is clear that L2 and L1 in general
do not coincide.
 Unit 3 21

Self-test 3.4
1 a Since the price is constant at $10, VMPL = P × MPL .

Worker (L) Marginal product (MPL) Value of marginal product (VMPL)

1 4.5 45

2 4.2 42

3 3.9 39

4 3.7 37

5 3.5 35

6 3.1 31

b The profit is maximized when wage rate = value of marginal

product. This condition is satisfied at L = 5.

2 From the profit maximization condition:

x12/ 3 w
MP1 = w1/P ⇒ 1/ 2
= 1,
2 x1 P

x11/ 2 w
MP2 = w2/P ⇒ 2/3
= 2.
3x2 P

Solving the equations,

p6
x1 = ,
144 w14 w22

p6
x1 = .
216w13w23

3 To maximize profit, labour is hired at the quantity such that

MPL = w/P.

This gives:

500L-1/2 = 20, or L = 625 at w = 20,

500L-1/2 = 30, or L = 278 at w = 30,

500L-1/2 = 20, or L = 156 at w = 40.

22 ECON A311 Intermediate Microeconomics

The demand curve is given by

4 You should refer to Figure 17-3 on page 631 of BPP for a quick
answer. Simply put, the substitution effect indicates that if the price,
and hence the relative price of an input (say labour) falls, the
producer employs more labour even if the same amount of outputs
are produced. Moreover, production — and hence the use of labour
— expands because the average and marginal costs are lower. This is
referred to as the output effect.

The higher wage rate induces higher demand for capital due to the
substitution effect. However, since the average and marginal costs
are higher, output contracts, leading to lower demand for capital.
Thus the total effect is ambiguous.

Self-test 3.5
1 First, you have to understand what pecuniary diseconomy is. It refers
to the scenario when expansion in output increases the demand for
input, and hence exerts an upward pressure on the input price. For
example, consider the scenario when the government launches a
series of construction projects. This increases the demand for
construction workers and hence the wage rate, although the
construction industry is perfectly competitive.

2 The statement is true only if firms are homogeneous and there is no

pecuniary diseconomy in the short-run, i.e. industry output does not
have any impact on the input market in the short-run. Under these
assumptions, the cost structure of each firm is independent of the
industry output.

3 China is a major exporter of craft work in jade. This is a labour

intensive industry; the input is primarily skilled labour, which has a
limited supply even in the long-run. When output increases, more
jade-smiths are needed, which would bid up the wage rate and hence
shift the marginal cost curve up. You should notice that the jade craft
work industry is a mature industry with little room for technological
progress and hence no technical externality.
 Unit 3 23

4 The computer industry is a good example of a decreasing cost

industry. When demand for computers increases, the industry
responds by producing more computers. This of course will bid up
the wage rate of the computer engineers in the short-run. However, as
the industry flourishes, more university graduates are attracted into
the industry and new technologies are developed which will drive the
costs down in the long run. Typically, an industry at its developing
stage with ample room for technological progress is a decreasing cost
industry.

Self-test 3.6
1 With the subsidy, the industry supply curve shifted downwards by the
amount t.

The supply curve: the total surplus (consumer plus producer) before
subsidy is represented by the area EHG. With subsidy, the total is the
area E’HJ. The gain (the benefit) is represented the area E’EGJ. The
amount spent (the cost) in the subsidy (t × Q’), represented by the
rectangle KPP’E’, which is equal to the sum of the area of the
triangle E’GE and the rectangle FP”P’K. The cost is greater than the
benefit, indicating a welfare loss represented by the area GFE.
24 ECON A311 Intermediate Microeconomics

Appendix: Profit maximization

If labour and capital are the only two inputs, the profit function can be
written as

π = Pf (L,K) – wL – rK .

Take partial differentiates of π with respect to L and K, and equate them

to zero:

∂π ∂f
=0⇒P –w=0
∂L ∂L

i.e. PMPL – w = 0

∂π ∂f
=0⇒P –w=0
∂K ∂K

i.e. PMPk – w = 0

Thus, we have

PMPL = w ,

PMPK = r ,

MPL MPK
= .
w r