Question

1. Show what happens to profits and profit maximizing output when price increases. Please start with a firm that is earning positive economic profits.

2. Show what happens to profits and profit maximizing output when price decreases. Please start with a firm that is earning negative economic profits.

Answer 1

Answer 1:

A firm that is earning positive economic profits, an increase in the price of the good will also lead to increase in profits of the firm and this earning of super normal profits will induce other firms to enter the industry and this increases supply of the good leading to fall in the prices until prices fall to the point where the prices are equal to minimum point of Long run Average cost curve of the firm. Thus, the firm will end up earning normal profits in this case.

Answer 2:

If a firm is earning negative profits and the price decreases, the losses of the firm will further increase. Thus, some of the existing firms will exit from the industry leading to fall in supply and price will increase until it reaches the minimum point pf LAC where the firm is earning only normal profits.