Question

Suppose a perfectly competitive market is originally in equilibrium. Due to a negative demand shock, the

market price falls below the ATC curve of Firm A, one of the many firms selling in the market. What will

Firm A do in the short-run? What about the long run? Illustrate your answers graphically

Answer 1

In this case as the negative demand shock causes the price to fall below ATC, then the firm will carry on producing in the short run as long as the price is above average variable costs. So in the figure below as long as P>minimum AVC the firm will carry on producing in the short run. If price falls below minimum average variable cost in the short run however as given by P2 below, then the firm will shut down even in the short run. In the long run the firm will shut down even at P1, when its not making normal profits. In the short run it wil shut down only at P2 but not at P1.