Question

1.) At current output a profit maximizing competitive firm gets $8 per unit produced and has average total costs of $12. When the market price is $8, the firm's marginal cost curve crosses its marginal revenue curve where Q=120 units.

a. Draw two graphs side-by-side: On the left side, sketch a representation of the market equilibrium (i.e. supply, demand, market equilibrium quanity and market equilibrium price). On the right side, sketch a representation of the individual competitive firm's cost curves (I do not have much information about the actual shape, but draw something consistent with the given data). Make sure the market equilibrium price determined in my leftmost graph appears in my rightmost graph: Each individual firm takes the market price as given!

b. What is the firm's current level of profit? Do you anticipate entry or exit into the market? Explain your reasoning.

Answer 1

(a) In left panel of following graph, D0 & S0 are market demand & supply curves intersecting at point A with market price P0 (= $8) & market quantity Q0. Firms take this price as taken and it is shown in the right panel where firms produce at point B where P0 intersects MC, with firm output q0 (= 120). At this level, ATC being higher than P0 , there is a loss equal to area P0BCD.

(b) Since ATC > Price at current output level, there is a loss.

Loss = q0 x (ATC - P0) = 120 x $(12 - 8) = 120 x $4 = $480

Since firms are making short run economic loss, exit being free, some firms will exit the market and the process will continue until each existing firm earns zero economic loss.