Question

Draw a supply and demand diagram showing the market equilibrium price and quantity.

Now draw a diagram showing how a perfectly competitive firm might make a loss at this market price.

Identify the firm’s quantity supplied, average total cost, and total losses.

Finally, use the market supply and demand diagram to show what would happen to bring this market to long run competitive equilibrium.

Answer 1

Below is a market where demand and supply curves intersect to determine market price and quantity. At the equilibrium price, a single firm is making economic losses (measured by the difference between average cost and price). This may have happened because the new demand is lower than the original demand and so at new price, firms are making losses. This new price is P1 and firms are forced to produce q1 units. ATC is equal to P0 and total losses are shown in black

In the long run loss making firms will leave the market which means supply curve will shift left. Price will again reach P0 but market quantity is reduced to Q2. Each firm will again produce q0 at a price of P0 but now there will be fewer firms. There are no economic profits / losses in new log run equilibrium