Question

a.Excess/abnormal profits play an important role in the perfect competition. Explain.

b. Why might average total costs initially decrease in the short-run?

c. Should qualified accountants wash their own cars?

Answer 1

a. In the short-run, we have both fixed and variable inputs. The equilibrium condition for the perfectly competitive market is attained when two conditions are satisfied: Marginal Cost (MC) = Marginal Revenue (MR) = Average Revenue (AR) = Price (P). The abnormal/excess/supernormal profit is calculated by the difference between AR and AC (i.e, AR-AC), and the related rectangle. This profit gives the signal to other economic agents. Since the perfectly competitive market is featured by free-entry, the willing economic agents keep on entering the market resulting in more supply of the commodity. Therefore, P(/AR) drops down and in the long-run, and eventually, it becomes equal with the AC, where, no excess profit is earned anymore.

b. In the short-run, we assume some variables (say capital) is fixed. So, keeping the fixed inputs at a certain level, if we continuously employee more and more of the other input, at the initial stage, total production will increase at an increasing rate. This is because fixed capitals are now getting employed with the help of the additions of the variable input.

We compute Average Cost (AC) as Total Cost (TC)/Output. Therefore, as in the initial stage, output (the denominator) increases at an increasing rate, the AC starts falling.

c. Washing car requires time and cost of hiring a worker. For the required time of car washing, if the earning amount of a qualified accountant exceeds the cost of hiring a worker, he should not wash his own car, otherwise can.