Question

Assume a perfectly competitive firm has positive fixed costs and marginal costs that initially fall and then rise.

Draw a diagram showing this firm’s marginal cost, average variable cost, and average total cost. (Hint: Pay careful attention to where the marginal cost curve intersects the others).

Identify the minimum price the firm must receive before it shuts down, and the minimum price before it exits in the long run.

Now, show what would happen if this firm experienced an increase in its variable costs of production. How does this affect the shut down price? How about the exit price?

Answer 1

Assuming a perfectly competitive firm has positive fixed costs and marginal costs that initially fall and then rise.

A diagram showing this firm’s marginal cost, average variable cost, and average total cost is shown below:

In the diagram below, AVC = Average Variable Cost, AC = Average Total Cost, MC = Marginal Cost, A = Shut down point in the short run, B = Zero-profit point. In the vertical axis, Price is plotted and in the horizontal axis, Output is plotted.

Price Zero Profit Point AC AVC Shut Down Point Q1 Q2 Output

From the diagram above, we see that the Marginal Cost curve intersects the minimum point of the Average Variable Cost Curve and the Average Cost Curve. The Marginal Cost is initially falling, reaches the minimum point and then it starts to rise where it intersects the Average Variable Cost Curve and the Average Cost Curve.

The minimum price the firm must receive before it shuts down is P1. This occurs at point A, the shut down point in the short run, where the corresponding price is P1 and the corresponding quantity is Q1.

The minimum price before it exits in the long run is P2. This occurs at point B, the zero profit point in the long run, where the corresponding price is P2 and the corresponding quantity is Q2.

If this firm experienced an increase in its variable costs of production, the AVC cost curve would shift up from AVC to AVC1 as shown in the diagram below and so the AC curve which is a total of the AVC curve and AFC (Average Fixed Cost) curve would also shift up from AC to AC1 as shown in the diagram below.

This would increase the shut down price from point A to C and the price would increase from P1 to P3 as shown in the diagram below.

This would also increase the exit price from point B to D and the price would increase from P3 to P4 as shown in the diagram below.

Price AC1 AC AVC1 AVC Q1 Q3 Q2 Q4, Output