Question

Problem 1:

a. Draw a situation where a perfectly competitive firm is making a loss, make sure to label loss. When should the firm shut down? (Make sure to include a market diagram).

b. State and draw a graph explaining the long run equilibrium in a perfectly competitive market. Why does the market come to rest at this point? Explain.

Answer 1

a)

AC, ATC AVC

The firm in the perfectly competitive market will produce by setting P=MC at which ATC is more than the price so the firm is making losses, however, since the P>minimum AVC,the firm will continue to produce. The shaded region represents the loss.The firm will shut down when the price falls down below the minimum AVC.

b)

MC ATC AVC

In the long run,since the firms are making losses,some firms will exit the market in the long run which will decrease the supply and increase the price to the minimum of ATC so,the P=MC=ATC in the long run and all the firms will breakeven and earn zero profits in the long run.