Question

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i) A profit-maximising firm faces a downward-sloping demand curve for its output and has marginal costs that increase with output. Show, on a single diagram, how its profit maximisation decision can be represented both in terms of a feasible set optimisation and its marginal revenue and marginal cost. Why is there a deadweight loss in this case? (5) ii) Now assume the firm is a typical firm in a perfectly competitive market. Show the firm's optimal choice alongside the market equilibrium, and briefly explain why there is no deadweight loss in this case. (4) iii) Assume an initial equilibrium in which the firm in part b) is making a loss. Explain how the market and a typical surviving firm will adjust in these circumstances so that normal profits will be made. You should illustrate your answer diagrammatically. (4)

Answer 1

Price MC a ) PM EI A FAR IK MR QM b) Price MC Ppc k Mel + AR Opc ) MC AC Poice? B P-MR AVC

i)

A monopoly sets a price where MR = MC. At this level, the profits are maximum. MR cuts MC at point E and the corresponding price on the demand curve is Pm.

In this market, the deadweight loss arises due to excess market power. The firm is free to charge any price to maximize its profits. Such a high price restricts the quantity of goods to be produced in the market. Market becomes inefficient and there is a social cost which is imposed on the society in form of deadweight loss = Area AE1E in panel a)

ii)

Under perfect competition, P is charged = MC. There is no deadweight loss because both Allocative and Productive Efficiencies are achieved in the market. Each firm is a price taker and has no control on the price.

iii)

Panel c) shows the situation where the firm is making economic loss = Area ABCD.

Price is below the average cost but is higher than the average variable cost. So, the firm will not shut down its operations. In order to earn normal profits, it will continue to produce in the market. Production continuation ensures that every firm earns normal profit in the long run.