CDS (II) 2024 General Knowledge · Question 97 of 120

Correct — D, The marginal cost decreases at the equilibrium output. For a competitive firm, profit is maximised where price equals marginal cost, but that alone is not enough: the second-order condition requires marginal cost to be rising at that output. If marginal cost were falling where it crossed price, a small increase in output would earn more than it cost and the firm would expand, so that point cannot be an equilibrium. Statement (d) therefore states the opposite of the true condition, which is exactly what the question asks for. The other three are the textbook conditions. Price at or above average variable cost is the short-run shut-down rule, since a firm that cannot cover its variable cost does better producing nothing. Price equal to marginal cost is the first-order condition, because the competitive firm faces a horizontal demand curve at the market price. Price equal to average cost in the long run follows from free entry and exit, which competes economic profit down to zero at the minimum of the long-run average cost curve.

• (a)The market price must be greater or equal to average variable cost in the short run. — This is the correct short-run shut-down condition. Below average variable cost the firm loses more by producing than by closing, so it stops.
• (b)The market price must be equal to marginal cost. — This is the first-order condition for profit maximisation under perfect competition, where price and marginal revenue are the same thing.
• (c)The market price must be equal to average cost in the long run. — Correct as stated. Free entry and exit erode economic profit until price equals minimum long-run average cost.

A perfectly competitive firm is a price taker: it faces a horizontal demand curve at the market price, so price equals average revenue equals marginal revenue. It maximises profit where marginal revenue equals marginal cost, that is where price equals marginal cost, on the upward-sloping part of the marginal cost curve. In the short run it stays open as long as price covers average variable cost. In the long run, entry by new firms when profits are positive, and exit when they are negative, drives price to the minimum of long-run average cost, leaving zero economic profit.

The item is a which-one-is-false, so the work is to recognise three familiar conditions and spot the odd one out. The odd one is subtle because falling marginal cost sounds like efficiency; but a falling marginal cost at the chosen output means the firm has not yet exhausted its gains from expanding. Sketching the U-shaped marginal cost curve and drawing the horizontal price line makes it obvious — the profit-maximising intersection is the one on the rising arm; the intersection on the falling arm is a profit minimum.

• Under perfect competition price equals average revenue equals marginal revenue.
• Profit is maximised where price equals marginal cost with marginal cost rising — the second-order condition.
• Short-run shut-down rule: produce if price is at least average variable cost; otherwise close.
• Long-run equilibrium has price equal to the minimum of long-run average cost, so economic profit is zero and firms earn only normal profit.

• Treating price equals marginal cost as sufficient, forgetting that marginal cost must also be rising.
• Applying the long-run zero-profit condition to the short run, where profits can persist.
• Confusing average variable cost with average total cost in the shut-down rule.

As a which-statement-is-not-correct item on the equilibrium conditions, or as a market-structure match involving perfect competition, monopoly and monopolistic competition.

• practice — not a real PYQ

  A perfectly competitive firm will shut down in the short run when the market price falls below

  • (a)average total cost
  • (b)average variable cost
  • (c)marginal cost
  • (d)average fixed cost

  Answer(b) average variable cost — below that, producing adds to the loss, so the firm does better producing nothing.

• practice — not a real PYQ

  In long-run equilibrium under perfect competition, each firm earns

  • (a)supernormal profit
  • (b)zero economic profit
  • (c)a loss equal to fixed cost
  • (d)profit equal to total revenue

  Answer(b) zero economic profit — free entry and exit push price to minimum long-run average cost, leaving only normal profit.