Question

1. On September 14, 2019, a drone attack struck two oil factories in Saudi Arabia. The attack has produced significantly higher oil prices. These higher oil prices have forced retail gasoline stations to pay more to refineries to acquire gasoline. For this question, assume the effect of this higher cost for inputs will be to shift the MC and the ATC of each retailer upward by exactly the same vertical amount per gallon. [Hint: this parallel shift in both curves will, then, leave the minimum ATC above the same output as you had shown in question (1) above.] Discuss and depict the movement to a short run equilibrium under these conditions. Be sure to graphically indicate the original and new prices and quantities, the size of the cost increase, the number of firms, and the size of profits.

Answer 1

In following graph, the left panel depicts the market and the right panel depicts the firm.

Initial equilibrium is at point A where market demand (D0) and market supply (S0) intersect with equilibrium price P0 and market quantity Q0. Since market price is the individual firm's price, for the firm, initial equilibrium is at point B where P0 intersects initial marginal cost curve MC0, with firm output q0. Initial profit is the area between initial ATC curve ATC0 and market price P0, equal to area P0BCE.

When input cost increases, MC0 shifts upward to MC1 and ATC0 shifts upwards to ATC1. New MC curve MC1 intersects P0 at point F with lower firm output q1 and lower profit equal to area P0FGH (< Ares P0BCE). Lower profit will decrease the number of firms.