Suppose, at a given time, Sally\'s Smoothie Shack operates in a perfectly compet

Question

Suppose, at a given time, Sally's Smoothie Shack operates in a perfectly competitive market and is producing its profit maximizing level of output. Suppose further that at this level of production, its average fixed cost of producing a smoothie is $1.30, average variable cost is $2.50, and marginal cost is $3.60. At this moment sally is earning _____ economic profits. OVer time, everything else held constant, the quantity of smoothies transacted on the market will _________

a. positive, decrease

b. negative, increase

c. positive, increase

d. negative, decrease

e. zero, remain unchanged.

** explain how you got the answer-- most important!

Explanation / Answer

In perfectly competitive market, price equals marginal cost.

Marginal cost = $3.60

So, price per smoothy is $3.60.

Average fixed cost of producing a smoothie = $1.30

Average variable cost of producing a smoothie = $2.50

Average total cost = AFC + AVC = $1.30 + $2.50 = $3.80

If price is greater than average total cost, firm earns positive profit.

If price is less than average total cost, firm earns negative profit.

At current production of Sally, price ($3.60) is less than average total cost ($3.80).

So, at this moment, Sally is earning negative economic profit.

When firms earn negative profit in perfectly competitive market there is bound to be exit from the market. As firms exit the market, total supply in market decreases leading to decrease in quantity transacted.

So, overtime, everything else held constant, the quantity of smoothies transacted on the market will decrease.

Hence, the correct answer is option (d).

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