Question

1. Draw equilibrium of a perfectly competitive firm under the following conditions (one diagram for each):

a) Short run profits

b) Short run losses

c) Long run equilibrium with zero economic profits

2. State the condition (in terms of costs and revenues) that describes allocative efficiency that occurs in LR equilibrium and explain what happens to Producer Surplus in this case.

3. A firm accepts a price of $22 in a market consisting of many producers all making essentially the same product. The firm’s total cost function is C = 40 + 2q + 2q² and its marginal cost is given by 4q + 2. Find the following:

a) Profit maximising output of the firm

b) Total profits made by the firm in the short run.

Answer 1

The diagram below shows the short-run equilibrium of a firm earning economic profit in a perfectly competitive market. The equilibrium condition is price (P) equal to the marginal cost (MC). The red shaded region is the economic profit earned by the firm. We can see that the price is greater than the average total cost (ATC). In perfect competition since the price is given so price is equal to the marginal revenue (MR).

The diagram below shows the short-run equilibrium of a firm suffering loss in a perfectly competitive market. The equilibrium condition is price (P) equal to the marginal cost (MC). The red shaded region is the loss suffered by the firm. We can see that the price is less than the average total cost (ATC).

The diagram below shows the long-run equilibrium for a firm in perfectly competitive market. The long-run equilibrium condition is price = long-run marginal cost (LMC) = long-run average cost (LAC). In the long-run a firm in the perfectly competitive market earns zero economic profit as the price is equal to the LAC. In the diagram SMC is short-run marginal cost and SAC is short-run average cost.