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Free response question (FRQ) on perfect competition

Walk through the solution to a free response question (FRQ) like the ones you may see on an AP Microeconomics exam. Topics include why price equals marginal revenue (P=MR) for a perfectly competitive firm, how to draw side-by-side market and firm graphs, and how to find several points of interest in the firm graph.

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Video transcript

- [Instructor] This is the type of question that you might see on an AP Economics exam, and it's talking about perfectly competitive markets. So it says, a typical profit-maximizing firm in a perfectly competitive constant-cost industry is earning a positive economic profit. So the first question they ask us is, is the market price greater than, less than, or equal to the firm's price? Explain. So pause this video and see if you can answer this on your own before we do it together. All right now let's do it together. So remember, we are talking about a perfectly competitive market. So in a perfectly competitive market, all of the players in that market have to be price takers. They have no pricing power. So the market price has to be equal to the firm's price. So market, market price equal, equal to firm price, firm price because in perfectly, perfectly competitive market, market, firms are price takers, firms are price takers. They have no pricing power. All right, part b. Draw correctly labeled side-by-side graphs for both the market and a typical firm and show each of the following. And they ask us to do a bunch of stuff here. So once again, pause this video and actually get out paper. This will be very valuable for you to have a go at this. All right, so let's see we wanna do these side-by-side graphs, and we wanna think about the market and the firm. And we've done this in multiple videos before. So let's think about what they're talking about is, so this is the market right over here. That's the market. And this is, on this axis is going to be price. On this axis is going to be quantity. And then let me do a similar thing for a firm here. So that would be the firm's price axis, price. And then this would be quantity for the firm, quantity. Let me make it clear, this is the market, and then this right over here is the firm. And let's see, they say, market price and quantity. So the equilibrium price and quantity in the market. So we could draw the supply curve for the market. It might look something like this, upward-sloping, we've seen that multiple times. We could do the demand curve for the market. It would look something like that. And then we have the equilibrium price in the market, which they want us to use P sub m, so P sub m. And then we have the equilibrium quantity in the market, which they want us to use Q sub m. So we've done this first part. All right now let's see what else they want. The firm's quantity, labeled Q sub f, the firm's average revenue curve, labeled AR, the firm's average total cost curve, labeled ATC, the area representing total cost shaded completely. So in order to do this first part, the quantity that it would be rational for this profit-seeking firm or the profit-maximizing firm to produce, to think about that, we'd actually also have to think about the firm's average revenue. And the average revenue, which is going to be the same thing as the demand curve for that firm, is going to be based on this market price. Remember, the firm, in this perfectly competitive market, has to be a price taker. So this horizontal line right over there, that is the firm's average revenue, AR, which is equal to its marginal revenue, which is equal to its demand curve, which is equal to this market price. And the quantity that it's rational for this firm to produce is where this marginal revenue curve, which is also the average revenue curve in this case, intersects our marginal cost curve. So the marginal cost curve might look something, something like this. So marginal cost. And so this right over here is our Q sub f. So we've done this part and this part. The firm's average total cost curve, well the average total cost at this quantity needs to be below the marginal revenue and the average revenue at that quantity because we know that the firm is earning a positive economic profit. So we are dealing with a situation that likely looks like this. So the average total cost might look something like this. And I drew it that way to ensure that at this quantity, Q sub f, our marginal revenue and our average revenue is above our average total cost. That tells us that we're earning economic profit in this situation. So I've done part iv. The area representing total cost shaded completely, well the area representing total cost would be the cost per unit, the average cost per unit, which is that much, times the total number of units. And the total number of units is going to be this length, which is equal to Q sub f. And so your total cost is going to be this shaded area. If they were asking us our total economic profit, then we would be talking about this area up here, but they're not. They're talking about our total cost, which is this area right over there. So we have done those parts. Now let's go to part c. If one firm in the market were to raise its price, what would happen to its total revenue? Explain. Pause this video, see if you can answer that. Well remember, we're dealing with a perfectly competitive market, a perfectly competitive industry. There's no differentiation between anyone's products. So if all of a sudden, someone were to stick their head out and try to raise price, no one would buy their product anymore because people can get identical products from other people for a lower price. And so, its total revenue, its total revenue would go to zero since product is undifferentiated, undifferentiated, and consumers could buy from others at lower price, at lower price. And this is another way to think about it. They have to be price takers in a perfectly competitive market.