The diagram above represents the equilibrium position of a firm in a perfectly competitive industry. Study it carefully and answer the questions that follow...

Answer Details

(a)(i) Equilibrium output and price

A firm in a perfectly competitive market maximises profit where \(MC = MR\) with \(MC\) rising. On the diagram the rising part of the \(MC\) curve cuts the \(AR = MR\) line at an output of 50 kg and a price of $20. So the firm is in equilibrium at \(Q = 50\) kg and \(P = \$20\).

(a)(ii) Profit in equilibrium

At \(Q = 50\) kg, average revenue \(= \$20\) and average total cost, read off the \(ATC\) curve, \(= \$12\).

\[\text{Profit per unit} = AR - ATC = \$20 - \$12 = \$8\]

\[\text{Total profit} = (AR - ATC)\times Q = \$8 \times 50 = \$400\]

(a)(iii) Type of profit

Since \(AR > ATC\), the firm earns supernormal (abnormal) profit of $400. In perfect competition this survives only in the short run; in the long run new firms are attracted in, supply rises, price falls to the level of \(ATC\), and only normal profit remains.

(b)(i) Why the AR function is horizontal

The firm is one of very many small sellers of an identical product, so it is a price taker. It cannot influence the price and can sell any quantity it wishes at the single ruling market price of $20. Because every extra unit is sold at that same unchanged price, \(AR = MR = \) price, and the curve is a horizontal straight line.

(c) Two ways MC and ATC are related

1. The \(MC\) curve cuts the \(ATC\) curve at the lowest (minimum) point of \(ATC\); on this diagram that is at about $10 and 40 kg.
2. When \(MC < ATC\), the \(ATC\) is falling; when \(MC > ATC\), the \(ATC\) is rising. Marginal cost pulls the average down while it lies below it and pushes the average up once it lies above it.