Question

******Graphs with clear explanation *********

a) Construct two graphs which show:

                       1. a perfectly competitive firm’s cost structure and profit maximising level of production.

                      2. a market which generates the price faced by the perfectly competitive firm.

b) Represent on your graphs the effects of an increase in consumer incomes, and assume that the product in the perfectly competitive market is a normal good. Show on your graph the perfectly competitive firm’s profit levels.

Answer 1

(a)

In following graph, the left panel depicts the market. D0 and S0 are initial demand and supply curves, intersecting at point A with initial price P0 and quantity Q0. The right panel depicts an individual firm, which, being a price taker, accepts market price P0 as its own price and maximizes profit by equating P0 with its marginal cost (MC) at point B, producing q0 output. Average total cost (ATC) lies below the demand (price) line, assuming firm is making a profit. When output is q0, firm's profit equals area P0BCD.

(b) Higher consumer income increases market demand, shifting D0 rightward to D1, intersecting S0 at point E with higher market price P1 and higher market quantity Q1. Correspondingly, in the short run, the firm equates P1 with its (unchanged) MC at point F with higher output q1. Assuming ATC remains unchanged, profit is higher at area P1FGH.