Question

Assume that the flour market is perfectly competitive and the price of flour is determined by the market at $9 per kg. Tony owns a mill and sells 10 kg of flour per day. At this output 10 kg, Tony has an average variable cost of $6, an average fixed cost of $2 and a marginal cost of $8 per day. Calculate Tony’s profit or loss at the output 10 kg of flour per day. What should Tony do if he wishes to earn more profit? Explain.

(b) Suppose that the tofu market is perfectly competitive and Omega is one of the many tofu producers in the market.

(i) Initially the tofu market is in a long-run equilibrium. Draw a diagram for the tofu market and a diagram for Omega to explain the long run equilibrium situation.
(ii) Omega discovers a method to significantly reduce both the fixed costs and the variable costs of tofu production. How will this discovery affect Omega and the tofu market in the short run? Explain with suitable diagrams for the tofu market and Omega.
(iii) Describe what will happen at the tofu market in the long run.

Answer 1

a. At competitive price of $9 and output of 10 kg, Tony's total revenue = 9×10=$90.

At the same output level, average fixed cost = $2 and average variable cost = $6. Total average cost = $8. Thus, total cost at 10 kg output, = 10×8 = $80.

Tony's profit = Total Revenue - Total Cost = 90-80 = $10.

Now, marginal cost of firm is $8. And equilibrium is reached when MC = MR. Now, Tony's marginal revenue is $9 ( in competitive market, price =MR = AR).

Thus, tony can increase his output up to the point where MR becomes equal to MC so that his profit increses more than $10.

b. i. The initial situation in the tofu market in the long run is given by the graph on the left hand side. Here, the supply and demand curves intersect to produce price P1 and quantity Q1 in the market.

The right hand side shows the long run equilibrium of Omega's firm. Long run equilibrium is reached where P1 (given in the competitive market) is equal to LAC and LMC shown in blue colour.

ii. When Omega discovers a new technique which reduces both variable and fixed costs, the LAC curve shifts downwards to LAC2. LMC also shifts downward at every price level to LMC2(or same level of LMC can produce more output). Due to this, LMC2 cuts the same MR (at P1 for Omega's firm) at the higher level of output q2.

This higher level implies that Omega now earns supernormal profits in the market.

There will be no change in the market for tofu. This is because in the perfectly competitive market, one firm cannot impact the supply curve or price in the market.

iii. Due to supernormal profits in Omega's firm, other firms will eventually adopt this technology and shift their LAC and LMC curves dowmward. Due to this, the market supply will eventually rise and the new supply curve will intersect the demand curve at new price P2. At this price level, the supernormal profits for Omega and other firms who adopted the technology will wipe and all the firms will earn normal profits in the long run.