Question

1. An industry currently has 250 firms, each of which has fixed costs of $50 and average variable costs as follows: (20 points) Quantity Average Variable Cost 2 10 a. Compute a firm's marginal cost and average total cost for each quantity from 1 to 6. b. The equilibrium price is currently $46. How much does each firm produce? What is the total quantity supplied in the market? In the long run, firms can enter and exit the market, and all entrants have the same costs as above. c. As this market makes the transition to its long-run equilibrium, will the price rise or fall? d. Will the quantity demanded rise or fall? e. Will the quantity supplied by each firm rise or fall? f. Graph the long-run supply curve for the market, with specific numbers on the axes as relevant.

Answer 1

1. (a) The table would be as below. The VC would be Q*AVC. The TC would be VC+FC, and FC is $50. The MC is change in TC divided by change in quantity and the AC would be TC/Q. Also, at Q=0, VC would be zero, and so would be AVC.

Q	AVC	VC	TC	MC	AC
0	0	0	50	-	-
1	5	5	55	5	55
2	10	20	70	15	35
3	15	45	95	25	31.67
4	20	80	130	35	32.50
5	25	125	175	45	35
6	30	180	230	55	38.33

(b) The firm produces where P=MC or where the highest MC is equal to or less than P, provided MC>AVC. For the price be $46, the firm would produce Q=5 units. If the firm produces 4 units, then firm can increase the output such that it can earn more than the cost (P=MR>MC). If the firm produces 6 units, then the firm would face cost exceeding the revenue (P=MR<MC), and would decrease quantity.

For there be 250 firms, the market supply would be 250 times 5 units, ie 1250 units.

(c) In the long run, the price would be equal to the minimum AC (which is at where Q=3) of all the firms. The minimum AC is $31.67, and hence, the price would decrease to that amount.

As P>AC in this market, there is positive economic profit, and that would attract other firms to enter the market. This would lead to increase in supply, ie for each price level, more can be supplied than before. But that would decrease the price. However, no more firm can enter in the long run, since increasing supply more than where P=AC is, would decrease the price more and would lead to a situation where P<AC and the firm would make loss. That loss would lead to exit of firms in the long run, so that the price again rises to where P=AC.

(d) As the price decrease, the quantity demanded would increase, supposing that the demand doesn't change.

(e) Quantity supplied by each firm would fall. The reason being that AC is minimum where Q=3 for each firm. Hence, the quantity supplied would decrease in the long run.

(f) The graph is as below.

50 40 LRS P=31.67 30– -20 -10

The LRS would be horizontal line at P=AC{minimum}, ie P=31.67.