The diagram below represents the cost and revenue situation of a firm. Use the information in the diagram to answer the questions that follow. (a) Why would...

Answer Details

Reading the diagram. The vertical axis is Cost/Revenue and the horizontal axis is Output/Sales. The MC curve (dashed) is U-shaped and rises steeply; the AC curve is U-shaped, cut by MC at its lowest point. Three horizontal revenue lines are drawn: \(AR_1=MR_1\) at price \(P_1\) (lowest), \(AR_2=MR_2\) at \(P_2\) (middle) and \(AR_3=MR_3\) at \(P_3\) (highest). The horizontal (flat) AR = MR lines tell us the firm is a price taker. Point A sits at output \(Q_1\) where the \(P_1\) line just touches the bottom of the AC curve; point E sits at \(Q_2\) on the \(P_2\) line where MC cuts \(MR_2\); output \(Q_3\) is further to the right where MC has risen to the \(P_3\) level (point H).

(a) Why the firm would not produce at:

(i) \(Q_1\). At \(Q_1\) the marginal cost (point A, at the level of \(P_1\)) is below the marginal revenue the firm receives at the ruling price \(P_2\); that is \(MC < MR\). Each extra unit beyond \(Q_1\) adds more to revenue than to cost, so profit is still rising. The firm would therefore expand output past \(Q_1\) rather than stop there.

(ii) \(Q_3\). At \(Q_3\) the marginal cost has risen to the \(P_3\) level, which is above the marginal revenue \(P_2\); that is \(MC > MR\). The last units cost more to make than they earn, so they reduce total profit. The firm would cut back from \(Q_3\). Profit is largest only where \(MC = MR\), at \(Q_2\) (point E).

(b) How much profit the firm makes at \(P_1\). The \(AR_1=MR_1\) line at \(P_1\) is exactly tangent to the AC curve at its minimum point A. There average revenue equals average cost:

So at \(P_1\) the firm makes only normal profit (zero supernormal/abnormal profit). Total revenue just covers total cost, including the normal return to the entrepreneur; there is no excess profit.

(c) If price falls to \(P_1\):

(i) Quantity produced. The firm equates \(MC = MR_1\) at price \(P_1\), which occurs at point A. Output \(= \mathbf{Q_1}\).

(ii) Type of profit. The firm makes normal profit only.

(iii) Explanation. At \(Q_1\) the price line \(P_1\) touches the AC curve at its lowest point, so \(AR = AC\) and total revenue equals total cost. The firm therefore just covers all its costs, including the normal profit that is counted as part of cost (the minimum reward needed to keep the entrepreneur in business). Since there is no gap between AR and AC, there is no supernormal profit and no loss. This point A is the firm's break-even point, and in the long run under perfect competition it is the equilibrium position.

(d) Type of market. The firm is operating under perfect competition. The clue is that average revenue equals marginal revenue and both are drawn as horizontal (perfectly elastic) lines (\(AR=MR\)), which means the firm is a price taker that can sell any quantity at the ruling market price.