Question

For each of the following scenarios, analyze the short run impact on both the profit-maximizing price charged andthe profit-maximizing quantity produced and sold by the firm. Briefly explain each answer. Draw a separate, fully-labeled diagram for each scenario. Each diagram mustinclude the firm’s initial MC, AC, and MR lines, as well as any new lines that change as a result of what is given in the question. Be sure to indicate the initial and final profit maximizing price and output in each diagram. 1. A perfectly competitive firm that experiences a decrease in its fixed costs. 2. A perfectly competitive firm that experiences an increase in its marginal costs. 3. A perfectly competitive firm that experiences an increase in its marginal revenue.

Answer 1

1)

A decrease in fixed costs will have no impact on MC curve since it ultimately cancels out the effect of additional change. MC is more meaningful while referring to Variable costs. However, since AC is TC/Q and TC=TVC+TFC, AC falls if fixed costs fall as in shown. Initial profit is PE1AB while that after reduction in fixed costs is PE1CD.

2)

If MC rises, AC also rises since a rise in MC means a rise in TC. And AC=TC/Q.

Thus, MC rises from MC1 to MC2 and AC rises from AC1 to AC2 leading to fall in output and total profits from PE2CD to PE1AB.

3)

A rise in MR is shown by the shift of the price line from P1 to P2. Costs remain unaffected and this brings leads to a rise in total output from Q1 to Q2 and in profits from P1E1AB to P2E2CD.