Question

Suppose you learn that a perfect competitor minimizes average variable economic cost when it produces 100 units per day and minimizes average total economic cost when it produces 250 units per day. The minimum average variable cost is $30 and the minimum average total cost is $50. Presume that the firm maximizes profit. Sketch the cost curves and use the sketch to help you answer the questions.

1a) When the market price is $35, in the long run

the number of firms in the market decreases and the market price decreases

the number of firms in the market decreases and the market price increases

the number of firms in the market increases and the market price decreases

the number of firms in the market increases and the market price increases

the number of firms and market price remain constant

1b) When the market price is $35 the firm maximizes profit by

shutting down in the short run

producing between 0 and 100 units per day

producing 100 units per day

producing between 100 and 250 units per day

producing 250 units per day

producing more than 250 units per day

1c) When the market price is $35 the firm

suffers an economic loss in the short run

earns a positive economic profit in the short run

earns a normal rate of return in the short run

Answer 1

1a) When the market price is $35, then the firm is incurring loss per unit sold in the short run because market price (P) < Average Total Cost (ATC). However, a perfect competitor would exit the market in the long run is it continues to incur a loss just like short run. Because we already know that all perfect competitors operating in the market earns zero economic profit. So, if the market price remains $35 in the long run, then the loss-making firms would exit the market and the number of firms in the market decreases. As a result, market price increases and the profit earned by each firm also increases such that each perfectly competitive firm is earning zero economic profit in the long run.

So, When the market price is $35, in the long run the number of firms in the market decreases and the market price increases (Option B).

1b) When the market price is $35 the firm maximizes profit by satisfying the condition : P = MC.

It would not shut down in the short run because P > min. AVC i.e., $35>$30. So, even though the firm is incurring loss in the short run, it would not shut down because that is not the profit maximizing or loss minimizing decision. As we can see in the graph above, the average variable economic cost is minimized when it produces 100 units per day and average total economic cost is minimized when it produces 250 units per day. Now, the firm will produce the profit maximizing quantity where P = MC. We know that MC passes through the min. point of AVC and it would intersect with the horizontal price line when quantity lies somewhere between 100 and 250 units per day. So, When the market price is $35 the firm maximizes profit by producing between 100 and 250 units per day (Option C).

1c) When the market price is $35 the firm suffers an economic loss in the short run because P < ATC;

Or, P*Q < ATC*Q; where Q = profit maximizing quantity

Or, TR < TC;

Or, (TR – TC) < 0;

Or, profit < 0.

So, the firm suffers an economic loss in the short run (Option A).