Question

You should be able to answer each of the following questions in a just a few sentences. Graphs or figures might be good to include if they help you to make a better argument or to explain your answer more clearly.

1. Skip and Peggy are brother and sister and they fight about everything. Skip says that perfectly competitive firms maximize profit where marginal revenue equals marginal cost. Peggy says perfectly competitive firms maximize profit where price equals marginal cost. Settle this sibling rivalry once and for all.

2. Gisella runs a small stand selling lemonade in a perfectly competitive market. Her husband, Dustin, tells her that forecasted cold weather is going to lower the market price for the day and that she is likely to lose money today if she opens her stand. He suggests that she shuts down for the day (i.e., the short run) to avoid the negative profit. Is he right? Why or why not?

Answer 1

1)

Price AR-MR Quantity

In a perfectly competitive market, a producer will maximize profits when price is equal to the marginal cost ( P=MC). so from the above diagram, the firm maximizes profits at point (E) where the demand curve (AR) is intersecting the MC curve. Also in a perfect market firm, AR=MR=P . This indicates that the Factor Price is equal to marginal revenue of the factor. Thus a perfect market firm maximizes its profits at P=MC level. Therefore Peggy's statements hold validity.

2)

YA - МС ATC Price AVC AR= MR Note: 124<- Shest run loss

A firm in a perfectly competitive market will either make short run-  losses , abnormal profits or normal profits. From the above diagram, we can see that when the Average Total cost is greater than the price for the product then the firm is bound to incur losses in the short run. As the industry sets the price for the firm in a perfect market, the firm has no power to change its price. So in such a situation where ATC > P ( Price) , a firm is at a risk of incurring losses.

In the case of Gisella's lemonade stand, bad weather or any other uncontrollable external factors poses as a risk in business operation and makes in difficult for the business to earn any profit. In such a situation of cold weather , her lemonade stand is bound to make losses and incur more cost in operating on that specific day or days if she is to operate he stand regardless of weather condition, as people do not prefer to drink lemonade or any cold drink on a cold day.

So , her husband Dustin is right and she should close her stand for the duration of cold weather, in order to avoid short run losses.