Question

1. Suppose that firm B makes rugs and that its fixed costs are 10,000 per month. The Average Variable cost is $100 per rug. Suppose that it get a price of $500 per rug. How many rugs does the firm have to sell to breakeven?

2.Draw a graph of a firm in perfect competition making a profit. Be sure to include the ATC,AVC, MC, and MR curves. Identify the quantity and price where they would maximize their profit. Show the area of the profit on the graph.

Answer 1

(1) At breakeven, total revenue = total cost. Consider that the firm need to produce Q amount of output at break even.

Hence, breakeven level of revenue = 500 Q, since price = $500 per rug

Fixed cost = 10,000 and average variable cost = $100 per rug. Hence, total cost = 10,000 + 100 Q

Equating total revenue and total cost, we get, 500 Q = 10,000 + 100 Q => 400 Q = 10,000

=> Q = 10,000/400 => Q = 25

Hence,  the firm needs to produce 25 units of output to break even.

(2) Consider that a competitive firm faces a price P* at the market as shown by the horizontal line AR = MR in diagram 1 below. The average cost (AC), average variable cost (AVC) and marginal cost (MC) are also shown. The form will maximize profit when MR = MC, i.e., at point E. Corresponding to point E, it is observe that the firm will produce Q* amount of output at a price P*.

We also observe that the price of P* is higher than the average cost (=CQ*) at Q* level of output. This results in a positive per unit profit of amount EC (i.e., EQ* - CQ*). With Q* output, total profit earned by the firm can be represented by the area of the rectangle P*ECP1.

Please note that this scenario presents a profit making firm. It is very much possible that a firm may incur loss or may make zero economic profit depending upon the cost structure.