Question

Suppose the market for fresh pork is a competitive market. Initially, it is operating at its long-run competitive equilibrium at a market price of $50. Owing to the spread of COVID-19, many people turn to buying frozen meat once a week rather than fresh pork every day. As a result, the market price of fresh pork reduces to $30.

a. With the aid of a pair of market-and-firm diagrams, illustrate how this would affect the equilibrium price and quantity in the fresh pork market and the output of a typical butcher of fresh pork in the short-run.

b. Suppose, for the situation in (a), the average cost of a typical butcher of fresh pork is $40, which includes $15 on buying meat from suppliers, $12 on paying rent, $8 on paying hourly wages on staff, and $5 on other costs. Explain whether a typical butcher should shut down in the short run

Answer 1

a)

The above diagram shows the market for fresh pork and an individual firm.Initial demand curve is D and initial supply curve is S in the industry. The market is initially in long run equilibrium at point A where equilibrium price is $50 and output is Q1. At this price, the individual firm is in equilibrium at point C where MC=MR. This is the long run equilibrium of firm where price is equal to average costs and firm is earning normal profits.The firm is producing output M. As  many people turn to buying frozen meat once a week rather than fresh pork every day, the market demand of industry for fresh pork will reduce and shift to D1 . As such equilibrium point of industry is now B and equilibrium price has reduced to $30 and quantity has reduced to Q2. As price has reduced, the individual firm is now in short run equilibrium at point D where MC=MR. As price reduces to $30, output of individual firms also reduces and now the firm sells output N.

b) Given - the average cost of a typical butcher of fresh pork is $40, which includes $15 on buying meat from suppliers, $12 on paying rent, $8 on paying hourly wages on staff, and $5 on other costs.

Average fixed cost is $12 as the rent paid is independent of output. Rest of costs are variable costs - more meat will be buyed from suppliers when demand for fresh pork will rise, more wages will be paid when more output will be produced, and other costs.

Hence, average variable costs= $40 - $12= $28

As price is equal to $30 and average variable cost is $28, (P>AVC), the price is sufficient to cover variable costs. Hence the firm should not shut down in the short run.

When a firm shut downs in the short run, total costs are equal to fixed costs as variable cost is zero at zero output. So, losses in case of shut down are equal to total fixed costs.If price is less than average variable cost, then losses in case of producing are variable costs and fixed costs. Hence losses in case of producing are more than losses in case of shut down.Hence the firm shut downs to minimise losses.

But, when price is more than average variable cost, then losses are equal to some fixed costs as price covers variable costs and some fixed costs. Hence losses in case of producing are less than losses in case of shut down when price is more than average varibale cost. Hence the firm should continue to operate in the short run.