Question

(b) Draw a diagram that shows a firm under perfect competition making a profit in the short run. How is price determined in this case?

(c) Draw a diagram to illustrate the case of perfect competition where there is a negative production externality. Show how, if the production externality is ignored, output will differ compared to the alternative where society’s needs are taken into account. Explain briefly how a tax could be relevant in achieving the social optimum

(a) Sketch the Average Fixed Cost curve for a firm, and explain why it is the shape you have shown it.

(b) Explain why it might be rational for a profit-maximising railway operator to offer lower prices to students than to other passengers. In particular, how might your answer to part (a) be relevant here?

(c) What conditions are necessary for a firm to be able to operate pricing of the type mentioned in part (b)?

(d) How should the operator set its prices in this case?

Answer 1

(c) What conditions are necessary for a firm to be able to operate pricing of the type mentioned in part (b)?

First we will consider conditions in short run perfect competition.

a) Firms produce homogenous & similar units of output.

b) There are no barriers to entry & exit in the market.

c) Since every firm tries to maximize its profits they are price takers i.e. no single firm has power to influence market prices.

d) Both consumers & producers have perfect knowledge & they make rational decisions to maximize their self-interests.

In short run perfect competition, a firm will be able to continue its operations if its prices are greater than average total cost because it will be able to earn economic profits & if price is less than average total cost it suffers losses which will force the firm to discontinue operations.