Question

Consider a firm facing conventional technology with U-shaped AVC and ATC and MC. The firm wants to maximize profits given an exogenously fixed price of P = $20. Further, suppose the firm correctly determines that its short run profit maximizing output is 1000 given its costs and the exogenously fixed price of $20.

1. Using the axes as constructed below, depict marginal revenue and marginal cost curves that would support the conclusion that the optimal short run output is q = 1000. Be sure to label all important values. Upload graph

2. Is this a short run equilibrium? Explain.

3. Reproduce your graph from Question 1, but add an average total cost curve to the picture in such a way that the firm is earning zero profits (π = 0).

4. Does your graph in Question 2A depict a short run equilibrium? If so, explain why. If not, explain why not.

5. Again, reproduce your graph from Question 1. For this question, depict a different ATC curve, one where the firm has negative profits (π < 0) at the profit maximizing output of 1000. Add an additional average cost curve that will allow you to determine whether to shutdown or keep producing at Q = 1000.

6. Should the firm produce Q = 1000 in the short run or should it shutdown, producing Q = 0?

Answer 1

1. Refer to Fig. 1(a), where price = average revenue (AR) = marginal revenue (MR) is a horizontal line. The firm maximizes profit when MR = MC, i.e., corresponding to point E. The corresponding output level is shown as 10000.

2. Yes, this is a short run equilibrium as mentioned in the question to that the firm correctly chooses profit maximizing output in the short run.

3. Refer to Fig 1 (b). In the long run, a firm earns zero economic profit, which means that average total cost (ATC) = price. Since, the firm will operate at profit maximizing output level of 1000, at this point price = AR = MR = MC = ATC as shown by point E in Fig 1 (b).

4. Not sure which one is 2 (A), but Fig 1 (b) depicts a long run equilibrium, where price = AR = MR = MC = ATC.

5. Fig 1 (c) shows a scenario where the ATC curve lies above the AM = MR curve, i.e., the form is not able to cover the ATC and hence, it suffers from economic loss (of amount GE per unit of output). The average variable cost (AVC) curve is also added to the diagram to verify for the shut down condition of the firm. As shown, the AVC also lies above price, i.e., the firm is not able to cover the AVC at least and hence it will shut down. On the contrary, for a scenario where the AVC lies below the price, then firm will choose to produce in the shut run even with economic losses.

6. No, given the above scenario in Fig 1 (c), the firm will shut down its operation and produce no output as the price is less than AVC.

Please note that price/cost are represnted in Y-axis and output is represented in X-axis in all the figures.