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Imperfect Competition

Did it ever occur to you that the burgers at McDonald's are not exactly the same as the burgers at Burger King? Do you know why that is? And what does the market of fast-food chains have in common with the market of electricity or the global oil market? Do you want to know more about this and how most markets work in the real world? Then read on!

Difference between Perfect and Imperfect Competition

The best way to understand what imperfect competition is to look at the differences between perfect and imperfect competition.

In a perfectly competitive market, we have many firms that are selling the same undifferentiated products - think about produce: you can find the same vegetables sold at different grocery stores. In such a perfectly competitive market, firms or individual producers are price takers. They can only charge a price that is the market price; if they charge a higher price, they will lose their customers to all the other firms selling the same products at the market price. In the long-run equilibrium, firms in perfectly competitive markets don't make economic profits after we account for the opportunity costs of not being able to use the resources for other purposes.

You might be wondering: how is it possible that firms operate with no economic profits in the long run? That is not really how things work in the real world, right? Well, you are certainly not wrong - many firms in the real world do manage to make a handsome profit, even after accounting for opportunity costs. That's because most of the markets that we have in the real world are not perfectly competitive markets. In fact, we rarely have perfect competition in reality, save for the produce markets.

For a refresher, read our explanation: Perfect Competition.

Imperfect Competition Definition

Here is the definition of imperfect competition.

Imperfect competition refers to market structures that are less competitive than perfect competition. These include monopolistic competition, oligopoly, and monopoly.

Figure 1 below shows the different kinds of market structures on a spectrum. They range from the most competitive to the least competitive from left to right. In perfect competition, there are many firms selling the same product; in monopolistic competition, there are many firms competing with differentiated products; an oligopoly has only a couple or a few firms; and in a monopoly, there's only one firm serving the entire market.

Imperfect competition, The spectrum of market structures, StudySmarterFig. 1 - The spectrum of market structures

You bet we have an explanation on all these topics!

Check out:

Imperfect Competition Characteristics

Imperfect competition has some peculiar characteristics which make it different from perfect competition. Let's consider some of them!

Imperfect Competition: Marginal Revenue Below Demand

A hallmark of an imperfectly competitive market is that the marginal revenue (MR) curve facing the firms lies below the demand curve, as Figure 2 shows below. There is a smaller number of competing firms under imperfect competition - in the case of monopolistic competition, there are many firms, but they are not perfect competitors due to product differentiation. Firms in these markets have some influence over the demand for their products, and they can charge a price that is higher than the marginal cost of production. In order to sell more units of the product, the firm must lower the price on all units - this is why the MR curve is below the demand curve.

imperfect competition marginal revenue curve in imperfect competition studysmarterFig. 2 - Marginal revenue curve in imperfect competition

On the other hand, there are many firms selling homogeneous products in a perfectly competitive market. These firms have no influence over the demand they face and have to take the market price as given. Any individual firm that operates in such a perfectly competitive market faces a flat demand curve because if it charges a higher price, it will lose all its demand to competitors. For an individual firm under perfect competition, its marginal revenue (MR) curve is the demand curve, as shown in Figure 3. The demand curve is also the firm's average revenue (AR) curve because it can only charge the same market price no matter the quantity.

imperfect competition individual firm perfectly competitive market studysmarterFig. 3 - An individual firm in a perfectly competitive market

Imperfect Competition: Economic Profits in the Long Run

One important implication of imperfect competition has to do with firms' ability to make economic profits. Recall that in the case of a perfectly competitive market, firms have to take the market price as given. Firms in perfect competition do not have a choice because as soon as they charge a higher price, they will lose all their customers to their competitors. The market price in perfectly competitive markets is equal to the marginal cost of production. As a result, firms in perfectly competitive markets are only able to break even in the long run, after all costs (including opportunity costs) are taken into account.

On the other hand, firms in imperfectly competitive markets have at least some power in setting their prices. The nature of imperfectly competitive markets means that consumers can't find perfect substitutes for these firms' products. This allows these firms to charge a price that is higher than the marginal cost and to turn a profit.

Imperfect Competition: Market Failure

Another main characteristic of imperfectly competitive markets is that they lead to market failures. Why is that? This actually has to do with the marginal revenue (MR) curve being below the demand curve. In order to maximize profit or minimize loss, all firms produce to the point where marginal cost equals marginal revenue. From a societal perspective, the optimal output is the point where marginal cost equals demand. Since the MR curve is always below the demand curve in imperfectly competitive markets, the output is always lower than the socially optimal level.

In Figure 4 below, we have an example of an imperfectly competitive market. The imperfect competitor faces a marginal revenue curve that is below the demand curve. It produces up to the point where marginal revenue equals marginal cost, at point A. This corresponds to point B on the demand curve, so the imperfect competitor charges consumers at a price of Pi. In this market, the consumer surplus is area 2, and area 1 is the profit that goes to the firm.

Contrast this situation to a perfectly competitive market. The market price is equal to the marginal cost at Pc. All the firms in this perfectly competitive market will take this price as given and jointly produce a quantity of Qc at point C, where the market demand curve for the entire industry intersects with the marginal cost curve. The consumer surplus under perfect competition would be the combination of areas 1, 2, and 3. So, the imperfectly competitive market leads to a deadweight loss of the size of area 3 - this is the inefficiency caused by imperfect competition.

imperfect competition inefficiency studysmarterFig. 4 - Imperfect competition with inefficiency

Imperfectly Competitive Market Types

There are three types of imperfectly competitive market structures:

  • monopolistic competition
  • oligopoly
  • monopoly

Let's go through these, one by one.

Imperfect Competition Examples: Monopolistic Competition

You may have noticed that the term "monopolistic competition" has both the words "monopoly" and "competition" in it. This is because this market structure has some characteristics of a perfectly competitive market and also some characteristics of a monopoly. Like in a perfectly competitive market, there are many firms because the barriers to entry are low. But unlike in perfect competition, the firms in monopolistic competition are not selling identical products. Instead, they sell somewhat differentiated products, which gives the firms some degree of monopoly power over the consumers.

Fast-food chains

Fast-food chain restaurants are a classic example of monopolistic competition. Think about it, you have many fast-food restaurants to choose from on the market: McDonald's, KFC, Burger King, Wendy's, Dairy Queen, and the list goes on even longer depending on what region you are in the US. Can you imagine a world with a fast-food monopoly where there's just McDonald's that sells burgers?

Imperfect competition, Monopolistic competition a cheeseburger, StudySmarterA cheeseburger, Source: Pixabay

All these fast-food restaurants sell essentially the same thing: sandwiches and other usual American fast-food items. But also not exactly the same. The burgers at McDonald's are not the same as the ones sold at Wendy's, and Dairy Queen has ice creams that you can't find from the other brands. Why? Because these businesses deliberately make their products a little bit different - that's product differentiation. It's certainly not a monopoly because you have way more than one choice, but when you are craving that specific kind of burger or ice cream, you have to go to that one specific brand. Because of this, the restaurant brand has the power to charge you a little more than in a perfectly competitive market.

We certainly invite you to learn more on this topic here: Monopolistic Competition.

Imperfect Competition Examples: Oligopoly

In an oligopoly, there are only a few firms selling to the market because of high barriers to entry. When there are only two firms in the market, it's a special case of oligopoly called duopoly. In an oligopoly, firms do compete with one another, but the competition is different from the cases of perfect competition and monopolistic competition. Because there are only a small number of firms in the market, what one firm does affects the other firms. In other words, there is an interdependent relationship between the firms in an oligopoly.

Imagine that there are only two firms selling the same potato chips at the same price on the market. It's a duopoly of chips. Naturally, each firm would want to capture more of the market so that they can earn more profits. One firm can try to take customers from the other firm by lowering the price of its potato chips. Once the first firm does this, the second firm would have to lower its price further to try to take back the customers that it has lost. Then the first firm would have to lower its price again... all this back and forth until the price reaches the marginal cost. They can't lower the price further at this point without losing money.

You see, if oligopolists are to compete without cooperation, they might reach a point where they operate just like firms in perfect competition - selling with a price equal to the marginal cost and making zero profits. They don't want to make zero profits, so there is a strong incentive for oligopolists to cooperate with each other. But in the U.S. and many other countries, it is illegal for firms to cooperate with each other and fix prices. This is done to ensure that there's healthy competition and to protect consumers.

OPEC

It's illegal for firms to cooperate and fix prices, but when the oligopolists are countries, they can do just that. The Organization of Petroleum Exporting Countries (OPEC) is a group made up of oil-producing countries. The explicit aim of OPEC is for its member countries to agree on how much oil they produce so that they can keep the oil price at a level that they like.

To learn more, click here: Oligopoly.

Imperfect Competition Examples: Monopoly

On the very far end of the market competitiveness spectrum lies a monopoly.

A monopoly is a market structure where one firm serves the entire market. It is the polar opposite of perfect competition.

A monopoly exists because it's very difficult for other firms to enter such a market. In other words, high barriers to entry exist in this market. There are a number of reasons for a monopoly to exist in a market. It can be the case that a firm controls the resource that is required to make the product; governments in many countries often grant permission for only one state-owned firm to operate in a market; intellectual property protections give firms a monopoly right as a reward for their innovation. Besides these reasons, sometimes, it is "natural" that there's only one firm operating in the market.

A natural monopoly is when the economies of scale make sense for just one firm to serve the entire market. Industries where natural monopolies exist usually have a large fixed cost.

Utilities as natural monopolies

Utility companies are common examples of natural monopolies. Take the electric grid for example. It would be very expensive for another company to come in and build all the electric grid infrastructure. This large fixed cost essentially prohibits other firms from entering the market and becoming a grid operator.

Imperfect competition, Natural monopoly Power grid infrastructure, StudySmarterPower grid infrastructure, Source: Pixabay

What are you waiting for? To learn more, click on our explanation: Monopoly.

Imperfect Competition and Game Theory

The interaction between oligopolistic firms is like playing a game. When you are playing a game with other players, how well you do in that game depends not only on what you do but also on what the other players do. One of the uses of game theory for Economists is to help understand the interactions between firms in oligopolies.

Game theory is the study of how players act in situations where one player's course of action influences the other players and vice versa.

Economists often use a payoff matrix to show how players' actions lead to different outcomes. Let's use the example of the potato chips duopoly. There are two firms selling the same potato chips at the same price on the market. The firms face a decision of whether to keep their prices at the same level or to lower the price in order to try and take customers from the other firm. Table 1 below is the payoff matrix for these two firms.

Game theory payoff matrix
Firm 1
Keep price as before
Drop price
Firm 2
Keep price as before
Firm 1 makes the same profit
Firm 2 makes the same profit
Firm 1 makes more profit
Firm 2 loses its market share
Drop price
Firm 1 loses its market share
Firm 2 makes more profit
Firm 1 makes less profitFirm 2 makes less profit

Table 1. Game theory payoff matrix of the potato chips duopoly example - StudySmarter

If both firms decide to keep their prices as they are, the outcome is the top left quadrant: both firms make the same profits as before. If either firm drops the price, the other will follow suit to try to recapture the market share that they lose. This will continue until they reach a point where they can't drop the price any lower. The outcome is the bottom right quadrant: both firms still split the market but make less profit than before - in this case, zero profit.

In the potato chips duopoly example, there is a tendency for both firms to lower their prices in an attempt to capture the entire market in the absence of an enforceable agreement between the two duopolists. The likely outcome is the one shown in the bottom right quadrant of the payoff matrix. Both players are worse off than if they have just kept their prices as they were. This kind of situation where players tend to make a choice that leads to a worse outcome for all the players involved is called the prisoners' dilemma.

To learn more about this, read our explanations: Game Theory and Prisoners' Dilemma.

Imperfectly Competitive Factor Markets: Monopsony

The markets that we usually talk about are product markets: the markets for goods and services that consumers buy. But let's not forget there's also imperfect competition in the factor markets as well. Factor markets are markets for the factors of production: land, labor, and capital.

There is one form of imperfectly competitive factor market: Monopsony.

Monopsony is a market where there's only one buyer.

A classic example of a monopsony is a large employer in a small town. Since people can't seek work elsewhere, the employer has market power over the local labor market. Similar to an imperfectly competitive product market where firms have to lower prices in order to sell more units, the employer in this case has to raise the wage to hire more workers. Since the employer has to raise the wage for every worker, it faces a marginal factor cost (MFC) curve that is above the labor supply curve, as shown in Figure 5. This results in the firm hiring a fewer number of workers Qm at a lower wage Wm than in a competitive labor market, where the number of workers hired would be Qc, and the wage would be Wc.

imperfect competition monopsony labor market studysmarterFig. 5 - A monopsony in a labor market

To learn more, read our explanation: Monopsonistic Markets.

Imperfect Competition - Key takeaways

  • Imperfect competition is the market structures that are less competitive than perfect competition.
  • Different types of imperfectly competitive product markets include monopolistic competition, oligopoly, and monopoly.
  • In monopolistic competition, there are many firms selling differentiated products.
  • In an oligopoly, there are only a few firms selling to the market because of high barriers to entry. A duopoly is a special case of oligopoly where there are two firms operating in the market.
  • In a monopoly, there is only one firm selling to the entire market because of high barriers to entry. There are different kinds of reasons for a monopoly to exist.
  • Economists use game theory to understand the interactions between firms in an oligopoly.
  • An imperfectly competitive factor market takes the form of a monopsony, where there's a single buyer in the market.

Frequently Asked Questions about Imperfect Competition

Imperfect competition describes any market structures that are less competitive than perfect competition. These include monopolistic competition, oligopoly, and monopoly. 

In a monopoly, there is only one firm serving the entire market. There is no competition.

The marginal revenue curve lies below the demand curve. The firms can charge a price higher than the marginal cost. The output is lower than the social optimum. There are market inefficiencies created by imperfect competition.

In perfect competition, there are many firms selling a homogeneous good. In reality, this rarely happens, and we have different types of imperfectly competitive markets.

Product markets: monopolistic competition, oligopoly, and monopoly. Factor markets: monopsony.

Final Imperfect Competition Quiz

Question

What is the law of supply?

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The law of supply states that as the price of a good or service increases, the quantity of that good or service that producers are willing to offer will increase.

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What is the law of demand?

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The law of demand states that as the price of a good or service increases, the quantity of that good or service that consumers are willing to seek will decrease.

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What determines price elasticity of demand?

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Price elasticity of demand is determined by how responsive the quantity demanded of a good is to changes in its price.

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Which of the following is NOT a type of elasticity of demand?

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Marginal elasticity

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How does the law of diminishing marginal utility affect demand?

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The more of a good or service is consumed, the utility derived from each additional unit will decrease, which means that consumers will be less willing to pay more as quantity of a good or service consumed increases.

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What is income elasticity of demand?

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Income elasticity of demand measures the responsiveness to changes in consumers' income in terms of the quantity of a good or service sought out by consumers. 

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Name three tools that the government may use to influence the economy.

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  • Regulations and policies
  • Subsidies
  • Taxes

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Where can equilibrium be found in a supply and demand model?

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Equilibrium is the point of intersection between the supply and demand functions.

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What is equilibrium?

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Equilibrium is the quantity-price point where quantity demanded equals quantity supplied, and thus produce a stabilized balance between the price and quantity of a resource in the market.

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Which of the following examples represent inelastic demand best?

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Emerging trend for a technology equipment the producer of which owns a patent on.

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What is a demand schedule?

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Demand schedule is a table of various quantities of a good or service that consumers are willing to seek out at various price levels.

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Which of the following factors may affect price elasticity of supply?

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There are numerous factors that can affect price elasticity of supply, such as availability of resources needed for production, changes in demand for the product that the firm produces, and innovations in technology.

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Question

Which of the following is NOT a factor that may cause.a shift in demand for a good or service?

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Price of the good or service

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An increase in quantity demanded at every price level will translate on a graph as:

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Rightward shift of the demand curve

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A leftward shift of the demand curve means:

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Decrease in quantity demanded at each price level

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Shifts of the demand curve are described as:

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Leftward / rightward

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When the demand curve shifts rightward, all else held constant the price of the equilibrium point:

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Increases

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Which of the following is not an example of normal goods?

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Luxury cars

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If consumers' income falls, quantity demanded of normal goods will:

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Decrease

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Which of the following is NOT a category of related goods?

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Dependent goods

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If the price of a complement increases, the demand curve for a good that it complements will:

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Shift leftward

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What are substitute goods?

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Substitute goods or substitutes are goods that satisfy the same desires or needs for consumers as another good, thus serving as an alternative to the latter.

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Product B is a substitute for product A. Suppose that the price of product B falls below the price of product A. How will this affect the demand curve for product A?

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The demand curve for product A will shift leftward as the quantity demanded will decrease, since consumers will be more inclined to purchase product B instead.

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Which of the following is the best example of consumers' taste influencing a rightward shift in demand for a product?

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Fans of a popular celebrity purchasing a product after an endorsement by the celebrity

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If consumers expect prices for a certain product to decrease due to promises of future subsidies, the demand curve for that product will likely...

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Shift leftward, as consumers may prefer to postpone the purchase of that product in hopes to save money.

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Suppose a college experiences a sharp decrease in the number of students regularly attending classes in person in favor of online learning. Due to this decrease in population, the demand curve for parking spots on campus will:

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Shift leftward

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The extent to which quantity of any good or service demanded will fluctuate due to changes in any factors of influence depends on the measure of:

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Elasticity of demand

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Market disequilibrium occurs when...

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Quantity of a product or service demanded exceeds quantity supplied, or quantity supplied exceeds quantity demanded

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A shortage occurs when...

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Quantity demanded exceeds quantity supplied

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What does price elasticity of supply measure?

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PES measures the responsiveness of quantity of a good or service supplied to changes in market price.

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How do you calculate PES?

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PES is calculated by dividing percentage change in quantity supplied by the percentage change in price.

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When calculating price elasticity of supply, what would the result of your calculations have to be in order for supply to be considered price elastic?

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Price elasticity of supply would have to be greater than 1.

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What does it mean when supply is unit-elastic?

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Supply is unit elastic when PES equals 1, which means that quantity supplied changes proportionately to changes in price.

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Suppose you determine supply to be perfectly inelastic. What would the supply function look like on a graph?

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The function is a vertical line.

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Does the supply curve shift as a result of changes in price or quantity supplied?

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Supply curve does not shift when the price of a good changes. Supply curve shifts only if the economic factors other than the price change.

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If the supply curve shifts _____, quantity supplied at every price level will increase.

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Rightward

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If the supply curve for a certain product/service shifts leftward, this means that the quantity supplied...

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Decreases

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True or false: price of the product or service is one of the factors that directly cause sideward shifts of its' supply curve.

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False. Changes in price of the product/service do not reflect in sideward shifts of the supply curve.

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Which of the following is NOT one of the economic factors that may cause the supply curve to shift?

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Consumers' preferences

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Suppose there is a significant increase in the price of steel, which is one of the inputs that producers of cars use in their production. This increase in price of steel would likely shift the supply curve for cars...

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Leftward

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Suppose that the latest advances in technology allow producers of certain physical products to reduce their energy expenses in the production process. As a result, the supply curve of such producers would shift...

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Rightward

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When the price of a complementary good increases, quantity supplied of the complemented good will likely...

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Increase

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When the price of a substitute good decreases, the supply curve for the substituted good will likely shift...

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Rightward

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Since a higher number of producers in the market results in higher quantities of a good or service supplied, a decrease in the number of producers would shift the supply curve...

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Leftward

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If producers expect unfavorable market conditions for their good or service in the near future, what may happen to the quantity they supply and the respective supply curve?

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Supply curve will shift leftward causing the quantity supplied at every price level to decrease.

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Suppose producers have a reason to believe that the price for their good or service may increase in the near future. How will this affect the supply curve?

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Favorable market conditions would result in supply curve shifting rightward, resulting in more quantity supplied at every price level.

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If producers experience a raise in taxes on some of their inputs, the supply curve for their ultimate product will likely shift...

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Leftward

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If producers begin to receive subsidies for their product, this will likely compel them to...

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Increase quantity supplied

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If a supply curve shifts rightward, how will the shift affect the price value that corresponds to the market equilibrium, all other things held constant?

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The new equilibrium price will decrease from the initial value before the shift.

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Suppose you were to calculate price elasticity for a certain product and your result came out to be 1.2, what does this say about how price elastic the given supply is?

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Supply of the given product is price elastic.

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