Question

Consider a perfectly competitive market for Widgets. Depict in a graph a market that determines a market price of $50 and quantity of 1,000,000 units per month. Depict the firm-specific demand curve. At this price the firm finds its profit maximizing quantity is 80 units per month. Average Total Cost is $60 and Average Variable Cost is $45 at this quantity. Is this firm earning economics profits or losses? Calculate fixed costs, should this firm stay open (produce 80 units) or close (produce zero units) in the short run? What will the firm do in the long run? What happens in the market to reflect this change? Show that change in your market graph.

Answer 1

1. The Market Supply(GREEN) and Demand(RED) (Just drew a general upward sloping supply and downward sloping demand curve that intersects at that point) with price in $ on y xis and quantity on x-axis that determines the market price 50$ and the quantity of 1,000,000 units per month:

2. The firm-specific demand curve will be y=50$(Or P=50$ ) which is determined by the market.

3. At this price the firms profit maximizing quantity is 80 units, i.e. the Marginal cost equals the Price=50$ At this point.the Price or Marginal Revenue=50$ is less than the Average Total cost(which include fixed costs etc) = 60$ so the firm is facing economic losses.

The fixed costs= Total costs-Variable costs= Total units*(Average Total costs-Average variable costs)= 80*15=1200$

In the short run the firm should stay open and produce since it is atleast covering its variable costs and then some. A firm should shut down if it cannot even cover its variable losses. In the long run the firm will shut down as it cannot cover its total cost. It is reflected by the supply curve of the market shifting left to a new curve (Purple) due to the firms exiting: