Question

a) Initially, the market price was p=20, and the competitive firm’s minimum average variable cost was 18, while its minimum average cost was 21. Should it shut down? Why? Now this firm’s average variable cost increases by 3 at every quantity, while other firms in the market are unaffected. What happens to its average cost? Should this firm shut down? Why?

b) Suppose that the demand curve for wheat is Q=100−10p and the supply curve is Q=10p. The government imposes a price ceiling of p=3

i) Describe how the equilibrium changes. ii) What effect does this price ceiling have on consumer surplus, producer surplus, and deadweight loss?

Answer 1

a. When a firm's price is more than its average variable cost it should continue to produce. When P>AVC , total revenue will be greater than the total variable cost. This means the firm is able to cover all its variable costs and the residual revenue is used to cover its fixed costs. If the firm continues production then even though the firm is suffering loss but it will be less than the total fixed cost. But if the firm stops production then the loss will be equal to the total fied cost. so when the market price s 20 which is greater than the average variable cost of 18 then the firm should continue production and not shutdown.

Now if the firm's average variable cost increases by 3 at every quantity then both of its marginal cost and average cost also increase by 3 at every quantity. Therefore, the new AVC will be 21. Now since P<AVC then the firm would lose the portion of variable costs that it is not able to cover plus all the fixed costs. Since the firm will lose more than the total fixed cost therefore it should shutdown and suffer a loss of only total fixed cost rather than producing and suffering a loss of more than total fixed cost.