NUMERICAL EXAMPLE ABOUT PERFECT COMPETITION

Below is a numerical exercise about perfect competition.

It may be really useful to solve it before answering questions 6 - 8 in the quiz.
You can try first by yourself and then check your answers with the solution given at the
end.
In the toothbrush industry aggregate demand is given by:
Q = 8000 14P
There is a number of identical, perfectly competitive firms active in the industry, with the
following costs of production:
FC = 36
MC = 4 + 2q
AVC = 4 + q
a. Suppose each firm is able to sell as many toothbrushes as it wants at the price of 20.
How many toothbrushes will each firm produce?
b. How many firms are currently active in the industry? What is the short run industry
supply curve?
c. What is the typical firms economic profit/loss? What do you think will happen to the
number of firms in this industry in the long run?
d. What is the long run equilibrium price, P, and quantities q, Q.
How many active firms, N, will there be in the long run?

ANSWER KEY
a. Suppose each firm is able to sell as many toothbrushes as it wants at the price of 20$.
How many toothbrushes will each firm produce?
We know that the profit maximizing quantity is where MC = MR.
Since we are in perfect competition, P = MR so MC = P.
Therefore, we can use the MC equation to find the quantity q each firm will produce.
MC = P 4+2q = 20 q =

16
=8
2

b. How many firms are currently active in the industry? What is the short run industry
supply curve?
The aggregate supply quantity Qs is equal to the quantity produced by each firm q
multiplied by the number of firms N in the market:
Q s = N q N =

Qs
.
q

In order for the market to be in equilibrium, the quantity demanded must be equal to the
quantity supplied: Q s = Q d .
To get the quantity demanded in the market we just need to substitute P = 20 in the
demand curve given by the exercise:
Q d = 800014P = 80001420 = 8000280 = 7720
Hence,
Q s = Q d = 7720
and
N=

Q s 7720
=
= 965 .
q
8

We have the supply curve by each individual firm, which is MC = P = 4+2q but we
still need to find the short run industry supply curve.
Going back to the equation for the aggregate supply quantity Q s , we get

q=

Qs
Qs
.
=
N
965

If we substitute the above equation for q into the individual supply curve we find the
short run industry supply curve
P = 4+2q = 4+

2Q s
Q s = 482.5P1,930
965

c. What is the typical firms economic profit/loss? What do you think will happen to the
number of firms in this industry in the long run?
The economic profit is equal to total revenues minus total cost.
TR = Pq = 208 = 160
TC = TVC + FC = AVCq+FC = (4+q)q+36 = 128+36 = 132
= TRTC = 160132 = 28
As you can see, there are positive profits in the toothbrush industry so we expect N to
increase because new firms will enter the market in the long run.
d. What is the long run equilibrium price, P, and quantities q, Q.
How many active firms, N, will there be in the long run?
This is the trickiest part.
In order to find the equilibrium price P, we need to use two conditions:

the profit maximization condition P = MC;

the long run zero-profit condition P = ATC.

By combining the two, we get MC = ATC.

The exercise doesn't give us the direct formula for ATC but we can easily derive it from
the AVC and FC.
ATC = AVC + AFC = AVC+

FC
36
.
= 4+q+
q
q

So, equating MC and ATC, we get:

MC = ATC 4+2q = 4+q+

36
2
q = 36 q = 6 .
q

By substituting q = 6 in the individual supply curve, we find the price P:

P = MC = 4+2q = 4+26 = 16
The demand curve is the same as in the short run so:
Q d = 800014P = 80001416 = 8000 224 = 7776
Again, we can compute the number of firms active in the market in the long run in the
same way we did for the short run:
Q s = Q d = 7776
and
N=

Q s 7776
=
= 1296 .
q
6

As expected, the number of firms N has increased because new firms have entered the
market, attracted by the positive economic profits.
Finally, we can write the aggregate supply curve:
q=

Qs
Qs
2Q s
=
P = MC = 4+2q = 4+
Q s = 648P2592
N
1296
1296

What about profits?

We are in a long run equilibrium so the zero-profit condition holds:
P = ATC = 0