Last Updated 09 May 2021

Economic Formative Assignment

Category Microeconomics
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In this article, we will consider how a price-taking profit-maximizing business in perfect competition changes according to the change of the fixed factor cost-capital. The short-run marginal cost (MAC) curve of each business remains the same, but the short-run AC curve of each business shifts downwards. Perfect competition is an industrial structure that includes many firms selling identical products to many buyers and has no restrictions for new firms to enter or quit.

We suppose that the market is in equilibrium and each business in this industry is operating at its optimal plant size which is making normal profit. Because there is an exogenous change in this market, that is, the interest rate falls. This change will cause the price of capital decreases. For fixed factor is an input that cannot be increased in supply within a given time period, the price of capital is the fixed factor cost. In the short-run, the marginal cost, MAC, will remain unchanged, the average cost, AC, however, do change, therefore the short-run MAC curve does not shift and the short-run AC curve shifts downward.

The reason why there is no change in marginal cost(MAC) is that the variable cost(PVC) remains the same. For the decrease of interest rate just influences the price of fixed cost, the variable cost will still at the same level, which means, the change in total cost on each unit is the same as before. Marginal cost is the cost of producing one more unit of output. Therefore we can find that a one-unit change in the cost of different outputs equals that before the interest rate changes. Hence, marginal cost keep unchanged and MAC curve does not shift.

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In the meantime, because AC equals fixed cost, AFC, plus variable cost, PVC, and the price of fixed cost decreases, the AC curve will shift downward. Each business makes profits and there is no obvious change to the market supply in the immediate short run. According to the context, each business is making normal profit only before the increase of fixed cost, which means the market price equals minimum average total cost. We can know from the graph. 2. 1, the point that the MAC curve exceeds the MR. curve covers the point of the minimum AC curve.

At this time, the market price can Just cover the total cost. Now, however, for AC falls and the price of good remains the same. In graph A. 2. 2, the AC curve shifts downwards, while the MAC and MR. curves remain the same. As a result, firms can make economic profits. The short-run supply curve shows that all firms in the market can supply how many quantities at each price when the number of firms in the market is the same. In the immediate short run, people cannot react to the change of the cost immediately, so there is no new firm in the market in a short time.

And the quantity supplied by the individual firms changes a little, hence there is no significant change to the market supply. When the change happens, describe how we can get the new equilibrium. In the long run, if the price of a fixed factor decreases, the long-run average cost (LIAR) will shift downward. Hence many firms will increase the input of the capital. We assume that the MESS of each business rises, MESS? minimum efficient scale?is the smallest quantity of output at which long-run average cost reaches its lowest level. That means the LIAR will shift rightwards. The smallest quantity of output will increase when the LIAR at the minimum point.

Graph 8. 1 shows the change. We can know from above that all firms in the market make economic profits, so other firms want to entry this industry or existing firms seek to change their scale of operation, moving towards the new (higher) MESS in order to get more advantages from the market. Both ways give rise to an increase of supply in the long-run market. Therefore the market supply curve shifts rightwards and the market price decline. For the price falls, the marginal revenue (MR.) shifts downward and equals or even below the point of intersection of AC and MAC. Considering the individual firm, the fall of price may make it earn less profit than before or even start making losses. Graph 8. 3 illustrates this situation. Because it is an empirical question, firms, which want to join this industry, may increase excessively. Since more and more firms entry this industry, the price actually falls so far that all firms start making losses.

If this happens existing firms will carry on vowing towards the new (higher) MESS and some firms can not afford the cost so they quit the industry. This will cause the market supply to reduce and the supply curve will shift leftwards in graph 8. 2. Finally, the price of goods in the market will increase somewhat. This change can be shown in graph 8. 3, the MR. the curve will shift upward somewhat. In general, the market supply will increase in terms of before the change of interest rate, and the market price will decrease than before. How the own-price elasticity of demand (PEED) in the market will affect traded quantity ND, therefore, explains that in the new situation the industry will expand or contract in terms of the number of firms.

The own-price elasticity of demand (PEED) is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers' plans remain the same. The price elasticity of demand equals to percentage change in quantity demanded/percentage change in price.

Now we suppose that the PEED is between zero and 1, which means the good has an inelastic demand. From above, we can know that the market supply has increases when the interest rate falls. Since the supply curve shifts rightwards, the traded quantity increases and price falls. As a consequence of PEED, the extent of the increase of traded quantity is small. Especially when the good has a perfectly be the same. In the situation of elastic demand, when the supply increases, the extent of decrease in the price is greater than that of increase in the quantity, and since we know that the MESS rises.

We can assume that the change of annuity supplied is less than the change of MESS, each firm wants to expand their own scale of operation and the production of these firms will increase. Hence the firms will make losses in a short time, and some firms may quit this industry to avoid losses. The result of this kind of situation is that the industry may contract, and the number of businesses will shrink. It) Elasticity demand In the same way if the PEED is greater than I(elastic demand) and the supply shifts rightward, the extent of increase in the traded quantity is large and the price will change a little.

If PEED is perfectly elastic demand, the price will keep unchanged. Since the extent of decrease in the price is smaller than that of increase in the quantity, that means even if the supply increases, the price in the market will change a little. We assume that the change of quantity supplied will be greater than the change of MESS. In this situation, firms may make less loss or even make profits. For this reason, many firms may prefer to entry this industry to get profits. As the consequence, the industry may have grown in terms of the number of businesses.

When the own-price elasticity of demand is 1, the demand is unit-elasticity, which means the percentage change of price will equal to the percentage change of quantity demanded. We can assume that the change of quantity supplied demanded equals to the change of MESS, so the number of firms will stay the same. All in all, however, all the above is Just a surmise. If we want to know the exact change of the number of firms, we must consider in the practice.

Reference

1. Parking, Powell, Matthews (2012). Economics (8th De). Pearson Education. Slogan,J. (2004). Essentials of economics. (3rd De). Pearson Education.

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