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• Fahim Shahrier

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Module 4 Peer Review Explanation

Below are explanations for the questions in the Module 4 Peer Review Assignment.

Prompt Consider a firm facing conventional technology with U-shaped AVC and ATC and MC. The firm wants to maximize profits given an exogenously fixed price of P = $20. Further, suppose the firm correctly determines that its short run profit maximizing output is 1000 given its costs and the fixed price of $20.

Questions 1A and 1B Depict marginal revenue and marginal cost curves that would support the conclusion that the optimal short run output is q = 1000. Be sure to label all important values. Is this a short run equilibrium? Explain. Explanation:

MR = MC is the profit maximizing output, which we know is Q = 1000. We cannot answer whether this is a short run equilibrium because we do not know the size of profits.

Questions 2A and 2B Reproduce your graph from Question 1, but add an average total cost curve to the picture in such a way that the firm is earning zero profits (π = 0). Does your graph depict a short run equilibrium? If so, explain why. If not, explain why not. Explanation:

This is a short run equilibrium.

Questions 3A and 3B Again, reproduce your graph from Question 1. For this question, depict a different ATC curve, one where the firm has negative profits (π < 0) at the profit maximizing output of 1000. Add an additional average cost curve that will allow you to determine whether to shutdown or keep producing at Q = 1000. Should the firm produce Q = 1000 in the short run or should it shutdown, producing Q = 0? Explanation:

Since ATC at 1000 is greater than price, we know profits are negative. The firm cannot change the exogenously given price (20), and it cannot exit in the short run so fixed costs are positive (FC>0). Until the firm can find a buyer for its FC, it should either produce where MR = MC or it should lock its doors, an event called shutdown. Adding the AVC, as shown above, tells us that shutdown would be wrong. Since the price of 20 is greater than the AVC at Q = 1000, the firm is better off by producing 1000. It earns some money above VC, which can be used to partially offset the FC. Algebraically, π = Q[P – ATC]. Since price is less than ATC at Q = 1000, we know that profits are negative. The shaded area indicates the size of profits. It is defined by the rectangle with Q length and [P-ATC] < 0 as its height.