Question

a）Initially, the market price was p=20, and the competitive firm’s minimum average variable

cost was 18, while its minimum average cost was 21. Should it shut down? Why? Now this

firm’s average variable cost increases by 3 at every quantity, while other firms in the market are

unaffected. What happens to its average cost? Should this firm shut down? Why?

b)Suppose that the demand curve for wheat is Q=100−10p and the supply curve is Q=10p.

The government imposes a price ceiling of p=3

i) Describe how the equilibrium changes.

ii) What effect does this price ceiling have on consumer surplus, producer surplus, and

deadweight loss?

Answer 1

a) At a price of 20 AVC is minimum at 18 so firm should not shut down. It suffers an economic loss because AC is 21 but since P > minimum average variable cost, firm should continue to operate.

Now when AVC is increased by 3 at every unit, its minimum value is now 21 which is less than the price at 20. In this case, firm should shut down since P < minimum average variable cost. Average cost should increase by 3 because AC = AVC + AFC.

b) At a price of 3, qd = 100 – 10*3 = 70 units and qs = 10*3 = 30 units. So the price is now fixed at 3, below the market price of 5, which creates a shortage of 40 units since Qd – Qs = 40 units at P = 3

Consumer surplus is higher. Producer surplus is reduced and there is now a deadweight loss.