Question

Assume that the market for fertilizer is perfectly competitive. Firms in the market are producing output but they are experiencing economic losses.

a.Explain how ATC, AVC and MC are related (Note: the relationship of these cost curves is same whether there is loss or profit). Explain how the price of fertilizer compares to the ATC, AVC and MC of producing fertilizer.

b. Draw two graphs side by side illustrating the present situation for the single firm and the entire market. Cleary label the diagrams and explain what you draw for both diagrams.

c. Assuming there is no change in demand curve or in 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. Draw a new set of diagrams to show the firm’s and market’s long-run equilibrium.

Answer 1

The Formula of ATC is

ATC = AVC + FC

Where ATC = Average Total Cost; AVC = Average Variable Cost; FC = Fixed Cost .

We know that the equilibrium condition occur when

MR = MC.

Where MR = Marginal Revenue; and MC = Marginal Cost.

MC curve always intersect the ATC curve at minimum point of ATC curve. When P = MR = AR = MC = ATC then in market equilibrium condition firm has neither loss nor profit. When P < ATC then firm faces loss. When P > ATC then firm faces economic profit.

Above discussion describes the relationship between MC, ATC and AVC.

The above diagram no. 1 shows that at equilibrium price P1 firm's market supply is Q1 where the market equilibrium position is E and at this equilibrium position firm faces loss but yet it produces output in short run . Now let market demand falls and demand curve shifts from D1 to D2. As demand decreases firm reduce it's production level and hence at new market equilibrium point E1 the output supply is decreased from Q1 to Q2 where price level also decreases from P1 to P2. As production decreases , the cost of firm decrease.

Diagram No.2 shows that there is no changes in curves and firm faces loss . If this condition continues for a long time then firm shut down it's production and exit from the market.