Question

1. a. Consider a perfectly competitive firm in the short run. On a diagram, draw the firm's average cost, average variable cost, and marginal cost curves. Briefly discuss the relationship among these curves. b. On your diagram, show how the profit maximizing level of output is determined for this firm, given a market price. Show the firm making a positive profit. c. On your diagram, show total revenue, total cost and profits associated with the production level from part b. d. On your diagram show the firm’s short run supply curve. Explain clearly why this is the short run supply curve for the firm.

Answer 1

Answer:

Perfect Competition in Short Run:

Short-Run Market Supply Curve

The short-run market supply curve shows the quantity supplied by all the firms in the market as price varies.

The firms will do one of 3 things in the supply curve:

1. At the shutdown price, firms will choose to either choose to shutdown, or produce the shutdown quantity.
2. When the price is below the shutdown price, firms will shutdown and not produce.
3. When the price is above the shutdown price, firms will produce at the given output.

Short-Run: Equilibrium, & Market Demand Changes

The short-run supply curve and the market demand curve determines the equilibrium price and quantity.

Note: The equilibrium is found at the intersection.

Recall that the market demand curve can change in 2 ways.

Case 1: The demand increases, causing the curve to shift rightward. The result would be an increase to both the market price and the output.

Case 2: The demand decreases, causing the curve to shift leftward. The result would be a decrease to both the market price and the output.

Short Run: Economic Profit & Loss

There are 3 possible outcomes in the short run for firms who are perfectly competitive.

Case 1: Suppose the demand curve is in D_1D1​. Then the firm breaks even and does not gain any profit or loss. This is because p = ATC \, at the profit-maximizing output.

Case 2: Suppose the demand curve is in D_2D2​. Then the firm gains economic profit. This is because p > ATC \, at the profit-maximizing output.

Case 3: Suppose the demand curve is in D_3D3​. Then the firm has economic loss. This is because p < ATC \, at the profit-maximizing output.

Short Run Supply Curve

(i) Short Run Supply Curve of a Firm:

Short run is a period in which supply can be changed by changing only the variable factors, fixed factors remaining the same. That way, if the firm shuts down, it has to bear fixed costs. That is why in the short run, the firm will supply commodity till price is either greater or equal to average variable cost. Thus a firm will continue supplying the commodity till marginal cost is equal to price or average revenue. Under perfect competition average revenue is equal to marginal revenue, so the firm will produce up to that point where marginal revenue and marginal cost are equal.

Short run supply curve of a perfectly competitive firm is that portion of marginal cost curve which is above average variable cost curve. The short run supply curve of a firm in perfect competition is precisely its Marginal Cost Curve for all rates of output equal to or greater than the rate of output associated with minimum average variable cost.

The Firm’s short period supply curve is that portion of its marginal cost curve that lies-above the minimum point of the average variable cost curve. However, short run supply curve of a firm can be shown with the help of fig. 1.

From fig. 1 it is clear that there is no supply if price is below OP. At price less than OP, the firm will not be covering its average variable cost. At OP price, OM is the supply. In this case, firms’ marginal revenue and marginal cost cut each other at A, OM is equilibrium output. If price goes up to OP1, the firm will produce OM1 output. This firm’s short run supply curve starts from A upwards i.e., thick line AB.

(ii) Short Run Supply Curve of an Industry:

An industry is a blend of firms producing homogeneous goods. That way, supply curve of an industry is a lateral summation of all firms. This can be made clear with the help of a Fig. 2.

Here, we have assumed that different firms in the industry are producing identical products.

Each firm at OP price is producing OM output. It is because all firms have identical costs. At OP price, supply of industry is 100 x M = 100M.

Similarly at OP₁ price, all the firms of industry are producing 100 xM₁ =100M₁ quantity of output. These quantities will be called supply or output of industry. SS is the supply curve of industry. Point E shows that at OP price firm’s supply is OM and an industry’s total supply is 100 × M = 100M.

At OP₁ price, firm’s supply is OM1 and industry’s supply is 100M). We get industry’s supply curve by joining points E and E₁.

Thus, under perfect competition, lateral summation of that part of short run marginal cost curves of the firms which lie above the average variable cost constitutes the supply curve of the industry. short run supply curve of a competitive industry will always slope upwards since the short run marginal cost curve of the industrial firms always slope upward.