Perfect Competition
What is the key characteristic of a perfectly competitive market?
There are many buyers and sellers, and no single buyer or seller can influence the market price
What is an externality?
a cost or benefit that affects a third party who is not involved in the transaction.
What is a monopoly?
A market structure where a single firm is the sole producer and seller of a product with no close substitutes
What is the main function of the financial sector in an economy?
To facilitate the flow of funds from savers to borrowers, helping allocate resources efficiently
What is foreign exchange?
Foreign exchange is the market where currencies are bought and sold
In perfect competition, how is the price determined?
Price is determined by the intersection of market demand and supply, therefore, firms are price takers
What is the difference between a positive externality and a negative externality?
A positive externality provides a benefit to others (vaccination). A negative externality imposes a cost on others (pollution)
Why can a monopoly set the price of its product?
Because it is the only seller, it faces the entire market demand and can choose the price by deciding how much to produce
What is the difference between a bond and a stock?
A bond is a debt instrument where the issuer borrows money and pays interest, while a stock represents ownership in a company
What determines the exchange rate between two currencies?
Exchange rates are determined by the supply and demand for the two currencies in the foreign exchange market
Why do firms in perfect competition earn zero economic profit in the long run?
Because if firms earn economic profits, new firms enter the market, increasing supply and driving prices down until profits are zero
Why do negative externalities lead to market failure?
Because the social cost is higher than the private cost, causing overproduction or overconsumption compared to the socially optimal level
How does a monopoly’s marginal revenue compare to its price?
Marginal revenue is always less than the price because the firm must lower the price to sell additional units, reducing revenue from previous units sold.
How does the interest rate affect investment and saving in the financial sector?
Higher interest rates encourage saving (because returns are better) but discourage investment (because borrowing costs are higher), and vice versa
How does an increase in a country’s interest rates affect its currency value?
Higher interest rates attract foreign capital, increasing demand for the currency and causing its value to appreciate
Why are the demand curves in perfect competition perfectly elastic?
The firm’s individual output is so small relative to the market that it can sell any quantity at the market price, but none at a higher price
How can governments correct negative externalities? Name two policy tools.
Governments can use taxes to increase the cost of harmful activities or use regulations/limits to restrict harmful activities
What is the effect of a monopoly on consumer surplus compared to perfect competition?
Monopoly reduces consumer surplus because it charges a higher price and produces less output, leading to a deadweight loss in the market
Explain the role of the Federal Reserve (Fed) in the financial sector.
The Fed regulates the money supply and interest rates to promote economic stability, control inflation, and influence unemployment through monetary policy tools
Explain the difference between a fixed exchange rate and a floating exchange rate system
A fixed exchange rate is pegged to another currency or a basket of currencies and maintained by government intervention. A floating exchange rate is determined by market forces without direct government control
How does perfect competition lead to allocative and productive efficiency?
Allocative efficiency occurs because firms produce where P = MC, reflecting consumer preferences. Productive efficiency occurs because firms produce at the lowest point on their average cost curve in the long run
How does the presence of externalities affect the socially optimal level of production compared to the market equilibrium?
Externalities cause the market equilibrium to differ from the socially optimal level of production. In the case of a negative externality, the market produces more than socially optimal (overproduction), and for a positive externality, the market produces less than socially optimal (underproduction)
Explain how barriers to entry maintain a monopoly and provide two examples of such barriers
Barriers to entry prevent other firms from entering the market and competing. Examples include high startup costs, government patents, or control over key resources
Describe how an open market operation works and its impact on the money supply.
The Fed buys or sells government securities to increase or decrease the money supply. Buying securities injects money into the economy (increasing money supply), while selling securities withdraws money (decreasing money supply)
What is the impact of a currency depreciation on a country’s trade balance?
Currency depreciation makes exports cheaper and imports more expensive, which tends to increase exports and decrease imports, improving the trade balance