Question

The market for fertilizer is perfectly competitive. Firms in the market are producing output but are currently incurring economic losses.

a) How does the price of fertilizer compare to the average total cost, the average variable cost, and the marginal cost of producing fertilizer?

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

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

Answer 1

Answer

The market for fertilizer is perfectly competitive. Firms in the market are producing output but are currently incurring economic losses.

A) Since there are economic losses and we are in the short run. P = MC, as a general condition for production. But P < ATC since there are losses. And then P > AVC since firm is still operating and hence not shut down

B) The graph is shown below

C) In the case of perfect competition when there are economic losses, now firms have an option to leave the market since a lower price incurs them economic losses. This implies that as some firms leave the market, there is a leftward shift in the market supply curve. In this sense, entry and exit of firms continuously brings the changed price closer to the original price such that as soon as the price level is restored, there is no further entry or exits.

This implies that the leftward shift in the market supply will continue and hence the price level will start rising and it will keep increasing. When the remaining firms notice that their losses have been completely vanished as price levels has been restored, the exit stops. So the supply curve will shift only enough to bring the price back to its original level.