Question

Product A is sold in a perfectly competitive, constant-cost industry.

Draw a side-by-side graph for product A showing the market in long-run equilibrium with an individual firm earning normal profit. Label each of the following:
The market's equilibrium price (PE) and quantity (QE)
The firm's profit-maximizing quantity (QE)
How would it affect the quantity demanded if the government imposed a price floor below PE?
The price of B, a complement for product A, decreases. Illustrate on your graph from part (a) the result of this in the short run.
Label the new market price (P2) and new market quantity (Q2).
Shade completely any profit or loss for the firm.
The price of B decreased by 10 percent, while the quantity demanded of A changed by 15 percent. What is the cross-price elasticity of A and B?
What happens to the productive efficiency of the firm in the short run as a result of the change described in part (c)?
What will happen to the price of A in the long run? Explain.
In long-run equilibrium, the individual firm produces 50 units of A. At that level of output, its total cost is $200. What must be the market price?
The whole market from part (g) clears at a quantity of 2,000 units in the long run. If the constant long-run supply would intersect the y-axis at $3 and the demand curve intersects the y-axis at $5, what is the consumer surplus?

Answer 1

In a perfectly competitive market, firms earn normal profit by selling at the market price, which equals average cost in long-run equilibrium. A complement's price decrease temporarily increases demand and price for product A but normal profit prevails long-term. Consumer surplus is the area under the demand curve above market price.

In a perfectly competitive market, firms must accept the market price determined by overall demand and supply. Such firms face a perfectly elastic demand curve, meaning they can sell any quantity at this price. Profit is calculated as Total Revenue - Total Cost, with both depending on the quantity produced and the market price.

In long-run equilibrium, firms in a perfectly competitive market earn normal profit, which occurs when total revenue equals total costs. Normal profit is a situation where economic profit is zero, and it provides the minimum return necessary to keep factors of production in their current use.

If the government imposed a price floor below the equilibrium price (PE), it would not affect the quantity demanded as the market price would still determine the sales. Additionally, the decrease in the price of a complement (B) will increase the demand for product A in the short run, increasing both the market price (P2) and the quantity (Q2). This effect would likely erode in the long run as new firms enter the market due to the absence of barriers to entry.

The cross-price elasticity of A and B is calculated as the percentage change in quantity demanded of A divided by the percentage change in price of B. Given a 15 percent change in quantity demanded of A and a 10 percent change in the price of B, the cross-price elasticity is 1.5. This indicates that A and B are complements, as expected.

With regards to consumer surplus in a perfectly competitive market for product A, assuming the market price is such that the firm produces 50 units at a total cost of $200, the market price needs to be $4 per unit to ensure normal profit. In such a case, if market quantity is 2,000 units and the supply intersects the y-axis at $3, while demand intersects at $5, consumer surplus can be illustrated as the area between the demand curve and the supply curve, up to the equilibrium price level.