Question

Explain your reasoning and write legibly

Describe a shock that would decrease the global supply but not shift the cost curves of an individual producer. Use a graph to explain the short run and long run consequences of this shift for the global market and for the individual firm. Make sure to show the short run profit or loss on your graph and explain what brings the market back into long run equilibrium.

Answer 1

The model of demand and supply is very simple. The demand curve shows the quantities of a particular good or service that buyers will be willing and able to purchase at each price during a specified period. The supply curve shows the quantities that sellers will offer for sale at each price during that same period. When we combine the demand and supply curves for a good in a single graph, the point at which they intersect identifies the equilibrium price and equilibrium quantity.

A supply shock creates a material shift in the aggregate supply curve and forces prices to scramble towards a new equilibrium level. Not all supply shocks are negative; shocks that lead to a boom in supply cause prices to drop and raise the overall standard of living. A positive supply shock may be created by a new technique. One positive supply shock that can have negative consequences for production is money inflation. Negative supply shocks have many potential causes. Any increase in input cost expenses can cause the aggregate supply curve to shift to the left, which tends to raise prices and reduce output. A natural disaster, such as a hurricane or earthquake, can temporarily create negative supply shocks.

The price P of a product is determined by a balance between supply S and the demand D. The diagram shows a positive shift in demand from D₁to D₂, resulting in an increase in price (P) and quantity sold (Q) of the product.

The three diagrams show the three situations in which a firm could find itself in the short run.

In the top diagram, the given price is P1. The firm wants to maximise profits, so it produces at the level of output where MC = MR. This occurs at point A. Drop a vertical line to find the firm's output (Q1). At Q1, AR > AC and the difference between average revenue and average cost is the distance AB. This is the profit per unit. To find the total super normal profit, we must multiply the profit per unit per the number of units.

In the middle diagram, the given price is P2. In this case, it is clear that the firm will not be making a profit. The AC curve is above the AR curve at all levels of output. The firm will still want to minimise its losses. This can be done, again, with the old formula, MC = MR. This occurs at point D giving output Q2. At Q2, AR < AC and the difference between average revenue and average cost is the distance DE. This is the loss per unit. To find the total losses, we must multiply the loss per unit per the number of units.

In the final diagram, at the bottom, the given price is P3. Again the firm will produce the level of output for which MC = MR. This occurs at point G, giving a level of output of Q3. Notice that at this point, AR = AC, so the firm is making normal profit.

So, in the short run, a perfectly competitive firm could be making super normal profit, or a loss, or just normal profit, depending on the given market price.