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Price determination in a free market

1. What determines price in a free market?

2. What are the conditions of perfect competition. Name each and explain with an example how the real markets can violate one of more of these conditions. Finally, and this is important, why would a firm want to violate them.

3. What is the relationship between inflation and unemployment. Be sure to state, in numerical, percentage value, the natural rate of unemployment. Explain as well the danger we face if the unemployment rate drops below that natural rate.

Natural Rate of Unemployment: _____ %

4. At what point does a profit maximizing firm produce?
5. At what point does a profit maximizing firm shut down?
6. Why would a profit maximizing firm continue producing when it is not making a profit (but is meeting its variable costs?
7. Define Gross Domestic Product (GDP) its components. What was the approximate size of the US GDP last year.

Size of US GDP: $______________________

8. What are opportunity costs, and how do they help a firm decide which of its many products to produce to maximize profit.?

9. Define inflation and explain why is it harmful?

10. How do the laws of supply and demand determine that a basketball player can earn $2.2 million, but a teacher earns only $52,000.00? Is this outcome fair?

11 & 12
When explaining the solutions to the following two questions, be sure to use the economic terminology below: (substitute details from the question into the parenthetical and bracketed verbiage.
The (change, i.e., whatever has happened in the hypothetical) has caused the [Demand or Supply] curve to shift [left or right] causing movement along the [supply or demand, i.e., the other curve] curve to a new, [higher or lower] equilibrium point.

11. As a result of a hurricanes Katrina and Rita, thousands of Cajun evacuees immigrate to Little Rock. What will happen to the price of the average dinner at a Cajun restaurant ceteris paribus?

12. A series of hurricanes destroys the tomato harvest throughout the South. What will happen in the tomato market as a result of the bad tomato harvest ceteris paribus?

Solution Preview

1. What determines price in a free market?

Buyers use their desire for the product to determine how much they will pay. Sellers use their production costs to determine what price to sell the product for. If there is a great deal of demand for the product, sellers will find that they can sell the product for more than it costs to produce. When other sellers see this, they will gravitate to the production of the good that's in demand. This leads to a greater supply. Sellers then find that they need to lower their prices in order to sell more goods. Eventually the market finds equilibrium at a point where the amount being produced is the socially optimal one (marginal benefit = marginal cost).

2. What are the conditions of perfect competition. Name each and explain with an example how the real markets can violate one of more of these conditions. Finally, and this is important, why would a firm want to violate them.

Perfect competition requires many insignificant buyers and sellers and identical products. In the real world, often a single firm will dominate a market. Also, products are usually different in some way. Each company that produces toothbrushes, for example, attempts to make their toothbrushes seem better than the competition's. In this way, they begin to move away from perfect competition. As their products becomes more ...

Solution Summary

The relationship between inflation and unemployment; prices in a free market; conditions of perfect competition and related questions.

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