Question

Assume the market for coffee mugs is perfectly competitive. Firms in the market are producing output, but are currently making economic losses.

a. How does the price of coffee mugs compare to the average total cost, the average variable cost, and the marginal cost of producing coffee mugs?

b. Draw two graphs, side by side, illustrating the present situation for the typical firm and in the market.

c. Assuming there is no change in either market demand or the firms’ cost curves, explain what will happen in the long run to the price of coffee mugs, marginal cost, average total cost, the quantity supplied by each firm, and the total quantity supplied to the market.

Answer 1

Firms in the market are currently making economic losses.

a. This implies that the current market price of coffee mugs is less than the average total cost, but since production is continued, it is greater than the average variable cost. It should be equal to the marginal cost of producing coffee mugs because this is the profit maximization rule to select the output.

b. The graph is shown below. We have expected that demand must have fallen in the short run so the current equilibrium price is P1 and ATC is equal to P0.

c. Assuming there is no change in either market demand or the firms’ cost curves, in the long run since firms are bearing losses, they will start leaving the market which will decrease the supply. The supply curve shifts to the left, which raises the price of coffee mugs. There is no change in marginal cost, average total cost, or average variable cost curve but the increase in price, raises the quantity supplied by each firm, and reduces the total quantity supplied to the market due to lower number of firms