Question

Assume that the following conditions exist for a perfectly competitive firm:

price = $8.50, current output = 100 units, ATC at current output = $9.00, AVC at current output = $8.00, total fixed costs =$100 and MC at current output = $8.00.

a. Is the firm earning any economic profit currently? How much is its profit or loss?

b. Is the firm maximizing its economic profit? What should the firm do to maximize profit or minimize loss?

c. Given your answers in part b, how will the market adjust to reach long-run equilibrium? Include appropriate graphs in your explanation.

Answer 1

(a)

Since Price is less than ATC, firm is incurring economic loss.

Loss = Q x (ATC - P) = 100 x $(9 - 8.5) = 100 x $0.5 = $50

(b)

Since price is higher than MC, there is a marginal profit equal to (Price - MC), so profit is not being maximized. To maximize profit, firm has to increase output until price and MC are equal.

(c)

Short run economic loss will cause firms to exit, which will decrease market supply, increase market price and decrease firm loss until each firm incurs zero loss.

In following graph, left panel depicts the market equilibrium where demand and supply curves (D0 and S0) intersect at point A with market price P0 and market output Q0. In right panel, firms accept P0 as their own price (which is firm's demand and MR curves) and produces at point C where P0 intersects MC with firm output q0. Currently, ATC is higher than P0, so firm is making a loss equal to area P0CEF.

Exit of firms decreases market supply, shifting S0 leftward to S1, intersecting D0 at point B with higher market price P1 and lower market output Q1. Firms consider P1 as their new price, and new long run equilibrium is at point D where P1 intersects MC and ATC with higher firm output q1. Firms incur zero economic loss.

P, MC ATc M C St So ATC F D Po Do