Question

Consider the market and a representative competitive firm. Draw the market equilibrium, then marginal cost, average cost, and marginal revenue curves for a competitive firm correctly producing a non-zero quantity, which is earning a negative profit, but is still producing. Make sure to label all the curves and axes. In the long-run, what will happen to the price? (9 points)?

Answer 1

A perfect competitor maximizes profit (or minimizes loss) by equating price with marginal cost (MC). For such a firm, demand curve is horizontal at market price, since the firm is a price taker. For a firm operating at a negative profit, Price is less than ATC but higher than AVC.

In long run, exit being free, some loss-making firms will exit the market and market supply will fall, shifting market supply curve leftward. So in long run, market price will be higher.

In following graph, left panel depicts the firm and right panel depicts the market. D0 and S0 are market demand and supply curves intersecting at point A with price P0 and market quantity Q0. Firms consider P0 as their price and minimizes loss at intersection of demand (D = MR = P0) and MC curves which is at point B with firm output q0. Price is higher than AVC, therefore firm is remaining in business in short run. Loss is indicated by area of rectangle P0BCD.