Question

Healthy Potato is a firm in competitive industry with a large number of potato producing firms.

a. Draw a graph to show the initial equilibrium.

b. If there is bad news that eating too many potato can cause cancer. What will happen in both short run and long run? Describe how that industry adjusts to this situation. Explain your answer graphically, showing both the typical potato producing firm's marginal cost and average total cost curves, as well as the market supply and demand curves. Distinguish between the short run and the long run.

Answer 1

It is given that it is a competitive market, therefore the market will be different than the individual seller. The market equilibrium price and quantity are determined where the market demand equals the market supply. That is,

Demand = Supply

And this equilibrium is taken by the individual sellers like Healthy potato firm.

For an individual firm, the marginal revenue is equal to the price, as it takes the price as given.

The individual firm's equilibrium is determined where the Marginal cost of the firm is equal to the price of marginal revenue. i.e. MC= MR = P

a.) In the initial long-run equilibrium:

The potato market is at equilibrium where the market demand equals the market supply.

That is Market demand = Market supply

And this equilibrium price (P) is taken by Healthy potato firm. The Healthy potato produces where its marginal cost is equal to the marginal revenue or price. In the long-run equilibrium, the Healthy Potato firm produces at its minimum average total cost. Since in the long run, in the competitive market, the firms earn zero economic profit and only normal profit. It means that firms produce at their lowest average cost.

MC= MR = P

The average total cost is at its minimum at the equilibrium.

Therefore the potato market and Healthy potato firm can be seen as:

Description of the diagram,

The left hand diagram shows the potato market. Where D is the market demand curve and S is the market supply.  Where the equilbirm price and quantity are P and Q* respectively.

The right and diagram is of Healthy potato firm. This price P is taken by the Heathy potato firm as given. And it produces where the MC=P=MR. And therefore its equilibrium quantity is q*.

The firm's average total cost curve is at its minimum in the long run as it earns zero economic profit.

b.) BAD NEWS REGARDING CONSUMPTION OF POTATOES:

Because of the bad news regarding the consumption of potato. That excessive potato consumption causes cancer. The health-conscious consumers will decrease their potato consumption and therefore the demand for potato will decrease. This will sift the market demand to the left.

Chain of effects in the short run;

The decreased demand will create an excess supply at the old equilibrium price. And the surplus condition will then urge suppliers to compete against each other. Suppliers will try to induce customers with lower prices. And therefore the price will decrease. As we know from the law of demand and the law of supply.

This fall in price will increase the quantity demand and decrease the quantity supply. And eventually, the market will again achieve its equilibrium at a lower price and the lower equilibrium quantity.

This new price is again by the individual producers like the Healthy Potato firm. Now the average total cost of the Healthy potato firm will be higher than the new price. And this will make the firm earn economic loss in the short run. The firm produces where the marginal cost equals the new decreased price.

Description of the diagram.

Because of the decrease in demand, the demand curve has shifted to the left. And the new equilibrium is where the new demand (D') is equal to the old supply. Point E' shows the new equilibrium. Where the new price is P1 and New quantity is Q1.

This new price is taken by the Healthy Potato firm as given, and it produces where the marginal cost curve intersects the price or marginal revenue. That is quantity is q1.

As the price is lower than the average total cost. Therefore it earns economic losses showed in the red shaded area.

Chain of effects in the long run;

In the long run, as we know that firms are earning economic losses in the short run. Therefore some of the firms existing in the market will exist in the market to minimize their losses. And this will decrease the market supply and shifts it to the left.

The decrease in supply would eventually bring the price back to its original price. And the market achieves its long-run equilibrium at the same price but with a decreased equilibrium quantity  

The Health potato firm takes this increases the price as given and produces where the marginal cost equals the price. As the price rises, the Health potato produces at its minimum average total cost. The exit of firms eats up all the economic loss. In the long, the firm earns zero economic profit and only a normal profit.

Description of the diagram:

As the supply has decreased because of the exiting of firms. Therefore the supply curve will shift to the left. (i.e. S') And the new equilibrium is achieved where new demand (D') is equal to the new supply (S'). The price (P) is retained and the new quantity is lower than the original. i.e. Q₁

This price (P) is taken by the firm, and it again it produces at MC= P =MR and produces at its lowest average total cost, q₁.  And therefore the firm earns zero economic profits. The long run equilibrium is achieved.

Distinguishing between short-run and long-run:

1.) In the short run, firms can earn economic profit and losses. But in the long firms earn zero economic profit and only normal profit.

As in the short run, the price may be below or above the firms' average total cost. But in the long run, the firms produce at their lowest average cost. As in the competitive market, there is free entry and exit of the firm. Therefore when firms in a market are earning losses, the market sees the exit of firms. And when the firms are earning an economic profit, the market sees the entry of firms. This entry and exit result in the firms to again produce at their lowest average total cost and earn no economic profit.

2.) In the short run, the supply doesn't change, but in the long run, supply changes.

In the short run, the supply doesn't have enough time to adjust their suppliers and therefore changes in the demand put the pressure on price. The increase in demand puts upward pressure on prices and a decrease in demand puts downward pressure on prices.

But in the long run, firms adjust their supply according to the change in demand. And therefore the prices get back to the old equilibrium price.

3.) In the short run, there is no entry or exit of firms, while in the long-run firms react and make an exit or entry depending upon the market situation.

4.) In the short run, some of the costs are variable and some are fixed, while in the long all costs are variable.

As a result of the longer period, there is no distinction between average total cost and average variable cost. In the long run, there is only one cost. While in the short run, some cost doesn't depend on the production and therefore there is a distinction between average variable cost and average total cost and that is of average fixed cost.