Question

d) New technologies impact a firm by way of costs. Using two new graphs of a perfectly competitive firm’s cost structure and a given market price, compare and contrast the effect on profit maximising level of production, and profits, of each of: i. increased rent on factory premises. (2 marks) ii. increased prices for raw materials. (2 marks)

Answer 1

A perfectly competitive firm maximizes profit (or minimizes losses) when its Price (equal to market price, since such firms are price takers) equals the Marginal cost (MC). The firm makes a profit (loss) if corresponding to the profit-maximizing quantity, Price (demand) lies above (below) ATC curve.

In each of the following graphs, profit is maximized at point A where Demand intersects MC with (market) price P0 and firm output q0. It has been assumed that the firm is currently earning profit, therefore when output is q0, price is above ATC curve. Profit equals area of rectangle P0ABC.

(i) Factory rent being fixed cost that does not change with output, higher fixed cost does not change market price or MC and so, profit maximizing level of price and output combination will stay unchanged. However, higher fixed costs will increase total cost, thus raising ATC and shifting the ATC curve upward to ATC1. Profit will fall. New profit is area of rectangle P0AEF.

P, C MC ATCI

(ii) Raw materials being variable costs, higher price of raw materials will increase both MC and ATC, which will shift the MC curve upward to MC1 and shift the ATC curve upward to ATC1. New equilibrium is at point D where output is lower at q1, and new profit equals area of rectangle P0DEF. Since Area(P0DEF) < Area(P0ABC), profit is lower.

MEMC D A ATCI ATC 9,0