Question

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

a.[5 marks] 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.[10 marks] 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. [10 marks] 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

(a) Relationship between ATC,AVC and MC:

ATC and AVC firstly decline and then after a certain quantity of output , it starts rising. AVC is flatter than ATC and ATC is above AVC because of the inclusion of AFC. MC cuts ATC and AVC at their respective minimums. MC reaches its minimum earlier than ATC and AVC.

Now, how price of fertilizer related to ATC,AVC and MC:

Firm is currently experiencing economic losses, it implies that price must be less than average total cost (ATC. However, because firms in the industry are currently producing output, price must be greater than average variable cost(AVC). If firms are maximising profits , price must be equal to marginal cost(MC).

(b) Here is the following graph which shows the present situation for the single firm and the entire market:

Present situation is depicted in the above figure when price is less than ATC . Supply curve is represented by S. Firm is currently producing Q units of output at price P.

(c) Assuming that there is no change in demand curve or in cost curves , then how the market will adjust in the long run: Because fims are incurring losses, there will be exit in this fertilizer industry. This means that the market supply curve will shift to the left , and this will increase the price of the fertilizer. As the price rises,the remaining firms will increase the supply of the quantity .Therefore, exit will continue until price (P1) is equal to minimum of average total cost (ATC). ATC will be lower in the long run than than in the short run. Quantity supplied in the fertilizer market also falls to Q1. (This is also shown in the above graph).