Question

New technologies impact a firm by way of costs. Using two new graphs of a perfectly competitive firm’s cost structure and a given market price, compare and contrast the effect on profit maximising level of production, and profits, of each of:

                       i.        increased rent on factory premises.

                      ii.        increased prices for raw materials.

Answer 1

For a perfectly competitive firm, profit is maximize (or loss is minimized) when price (which is the market price, because perfectly competitive firms are price takers) is equal to firm's Marginal cost (MC). The firm earns a positive economic profit (economic loss) if for the profit-maximizing quantity, price (demand) line is above (below) the Average total cost (ATC) curve.

In both the following graphs, profit is maximized at point A where Demand curve (price line) intersects MC curve with price P0 and firm quantity q0. Assuming that the firm is earning positive economic profit, for output is q0, price is above ATC curve. Profit equals area of rectangle P0ABC.

(i) Factory rent is a fixed cost that does not depend on level of quantity produced, so an increase in fixed cost does not impact market price or MC. Therefore profit maximizing level of price and output combination (obtained by equality of Price and MC) will be the same. But higher fixed costs will increase total cost, thus increasing the ATC which will shift the ATC curve upward to ATC1. Profit will decrease. New profit is depicted by area P0AEF.

(ii) Raw materials are variable costs that depend on output produced, so increase in price of materials will increase both MC and ATC, therefore shifting the MC curve upward to MC1 and shifting the ATC curve upward to ATC1. New equilibrium is at point D where output will decrease to q1, and new profit equals area P0DEF. Since P0DEF is less than P0ABC, profit will decrease.