Question

The crop seed market for commercially produced plants such as corn, cotton, soybean, canola, etc. used to be close to perfectly competitive before the 90s. As will be explained in the next question this market got less and less competitive since then.

For this question, consider a seed producer in Washington State in 1985 selling corn seeds. Suppose this company is making economic losses.

a. How does the price of corn seeds compare to the average total cost and the average variable cost of producing corn seeds in the short run? Draw the cost curves (average total cost, average variable cost, and the marginal cost) of this representative firm and the price of corn seeds to illustrate its situation in the short run?

b. Now suppose there is a positive demand shock for corn (ie: demand for corn increases) and so the price of corn seeds goes up. The corn seed producer in part-a begins making an economic profit. Draw the cost curves (average total cost, average variable cost, and the marginal cost) of this representative firm and the price of corn seeds to illustrate its new situation?

c. Now that the corn seed producer from part-a is making a profit, what will happen to the corn seed market in the long run? What will happen to the economic profit of an individual corn seed producer? What will happen the quantity supplied by each firm in this market (increase, decrease or ambiguous change?) and the total quantity supplied in the market?

Answer 1

According to the question, we think about the corn seed seller in Washington State in 1985. As the question suggests, the crop seed market of corn was perfectly competitive. Now, suppose a company in this competitive market is making economic losses, the cost curves of representative firm will look like this in the short run:

  

where; P is the market price, Q is the quantity supplied. The shaded region is the economic loss that Washington State corn seed company faces in 1985. The company is able to cover its average variable costs but not its total costs, hence the losses. AVC < P < ATC

(b) Suppose there is a positive demand shock for the demand of corn seeds, the market demand curve shifts to right, increasing the new demand as well as rising the prices. With new demand, the market faces a temporary excess demand situation. An individual firm like Washington State corn seed company will increase it output and the cost curves will look something like this:

where the new quantity is Q₁ (Q₁ > Q) and new market price is P₁ (P₁ > P). Our firm starts making economic profits with the condition P > ATC > AVC.

(c) Now we need to analyse this situation. As the question suggests we have a situation of perfect competition. With rising economic profits and no barriers to entry or exit, new firms will start joining the industry. With too many suppliers for corn seeds, an individual firm will have the produce less and less as more and more firms join the market. In the long run, prices of corn seeds will start falling from P₁, till it reaches ATC₁. Firms operating below this level will exit the market and each individual firm will make zero economic profits in the long run. With more firms, market supply of corn increases and supply by each individual firm decreases, thus driving profits out of the market.