Question

Question 2: Suppose a market is having positive economic profit in the short run, what do you think will most likely happen in the long run? 2.1 2.2 run? Explain in detail. Based on the lecture in the class, why would a firm choose to operate at a loss in the short When do firms decide to shut down production in the short run? Explain. 2.3. Question 3: For each of the following, is the business a price-taking producer? Explain your answers. A cappuccino café in a university town where there are dozens of very similar cappuccino cafés 3.1. i.

Answer 1

Answer to Question No. 2

2.1. If a firm is earning positive economic profits in the short run, this will attract new firms in the industry. New firms will lead to increase in supply in the market. The equilibrium price will fall. This process will continue till all the economic profits are removed from the market. In the long run the firms will earn only normal profits or zero economic profits. The firms will produce at P=ATC.

2.2. A firm in the short run would continue to produce so long as the price is more than the average variable cost of production. That is if the firm is able to cover all of its variable costs, the firm will continue to operate in the market. The firm will continue producing at any price above the minimum of average variable cost. At a price below ATC but above AVC, the firm will be suffering losses but is able to cover its variable costs or operational costs. So long as these costs are covered the firm will not shut down.

2.3. Firms decide to shut down when the market price falls below the minimum of average variable cost of production. If the firm is unable to cover its fixed costs as well as its operational or variable costs of production, the firm will shut down. This is the point where average variable cost is minimum.