The firms in a perfectly competitive
industry had been earning zero economic profits. However, the firms have recently experienced
a large decrease in the cost of energy that enables them to substantially
reduce the marginal cost and average total cost of producing each unit of
output. The market demand for the
product is pretty elastic. On the other
hand, short-run efforts to increase production run into severely diminishing
returns with respect to the employment of additional variable inputs.
two average total cost curves (ATC) for a typical firm. One curve should represent ATC before the
fall in the cost of energy. The other
curve should represent ATC after the fall in the cost of energy. Assume that
the fall in the cost of energy does not affect the minimum efficient scale (MES)
of production. Draw short-run marginal
cost curves on the same diagram to show both the fall in the cost of energy and
the severely diminishing returns to the employment of additional variable
to the diagram for a typical firm, draw a supply-demand diagram for the
industry. The slope of the demand curve
should reflect the elasticity of demand for the product. The short-run supply curve should reflect the
presence of severely diminishing returns with respect to the employment of
additional variable inputs. The original
equilibrium price in this diagram should line up with the minimum point of the
original ATC curve for a typical firm.
shift demand or supply to reflect the fall in the cost of energy. Note the change in the market
equilibrium. How does the magnitude of
the change in the market price compare to the magnitude of the shift in
ATC? Explain. Do firms now experience short-run economic
profits? In the long-run, can entry of
new firms be expected in this industry? If we have a decreasing-cost industry, show in your diagrams where the cost
curves, the market price, and the equilibrium market quantity end up. Fully explain what has happened. Does the equilibrium quantity end up changing
much in comparison to the magnitude of the overall change in price? Why or why not?
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