You are a business manager working for a firm in a purely competitive market and
ID: 1210016 • Letter: Y
Question
You are a business manager working for a firm in a purely competitive market and you
just hired a summer intern who does not understand how to derive the firms’ short run
supply curve from the firms’ marginal cost curve. Please explain this to the intern.
a. Please explain to the intern how the short run supply curve derived from the
firm’s marginal cost curve.
i. The following information along with the slides and audio should help
you:
ii. Direct relationship between product price and quantity supplied. When
price goes up, economic profit goes up (assuming production costs remain
the same). If P= min. AVC, the firm would be indifferent to producing or
not producing, but let’s assume the firm does produce. If AVC <P<ATC,
the firm will produce a larger level of output. If P = ATC, the firm willbreak even and achieve a normal profit. If P > ATC, the firm will achieve
economic profit.
iii. Portions of the firms MC curve lying above the AVC curve is also the
short run supply curve. Since the firm will not produce when MC<AVC,
the MC curve above the AVC represents the firm's individual supply curve
since it shows the relationship of a firms output with relative prices
iv. Observe the impact upon profitability as price is increased.
1. Because of the law of diminishing returns, Marginal costs
eventually rise as more units of output are produced.
v. Because marginal costs rise with output, a purely competitive firm must
get successively higher prices to motivate it to produce additional units of output.
b. Please explain to the intern the characteristics of long run equilibrium of a purely competitive firm and how operating in a purely competitive market might impact
the decision-making of the firm. Please include the implications of long-run
equilibrium for productive and allocative efficiency.
Explanation / Answer
The equilibrium of perfectly competitive market in the long run is at a point where P=MC. This means that the competitive firm will produce the quantity corresponding to the equality of P and MC i.e. Marginal costs. The competitive firm will keep on producing until the price is equal to the AVC. That is if P=MC=AVC firm will not shut down. But a point below the min AVC will lead to losses to the extent that the firm will be unable to cover even its variable costs and will therefore shut down. Thus a point P=AVC is known as shut down point. The firm will therefore produce the quantity above the minimuym of AVC along the marginal cost curve.
The characterstics of long run equilibrium of a perfectly competitive firm are
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