Question

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Firm Aleph operates in a perfectly competitive market in a constant-cost industry and is earning negative economic profit.

Why might Firm Aleph continue to operate despite earning negative economic profit? Explain.

Draw correctly labeled side-by-side graphs for Firm Aleph and the market it operates in. Label the axes and all of the following:
Market price (PE) and market quantity (QE)
The firm's quantity of output (Qe)
The firm's average total cost (ATC)

Completely shade the area of the firm's total revenue.

Identify whether the following increase, decrease, or remain constant as the market moves to long-run equilibrium:
Market equilibrium quantity
Market equilibrium price

Assume the product that Firm Aleph produces has a positive externality. Draw the marginal social benefit (MSB) on the market graph from part (b).

Will the unregulated market produce more or less than the socially optimal quantity?

Shade the area of deadweight loss caused by the externality, when the market is unregulated and in long-run equilibrium.

Answer 1

Explanation:

The graph on the left represents Firm Aleph’s cost curves. The horizontal axis represents quantity (Qe) and the vertical axis represents average total cost (ATC). The graph shows that at Qe, ATC is at its minimum. The graph also shows that at Qe, price (PE) is equal to average total cost (ATC).

The graph on the right represents the market demand and supply curves. The horizontal axis represents quantity (QE) and the vertical axis represents price (PE). The graph shows that at QE, price (PE) is equal to marginal cost (MC). It also shows that at QE, price (PE) is equal to average total cost (ATC).

When the market moves to long-run equilibrium, both market equilibrium quantity and price remain constant3.

If the product that Firm Aleph produces has a positive externality, then there is a difference between private marginal cost (PMC) and social marginal cost (SMC). The marginal social benefit (MSB) curve lies above the demand curve. The socially optimal quantity is where MSB equals SMC. In an unregulated market, however, firms produce where PMC equals demand. Therefore, an unregulated market produces less than the socially optimal quantity3.

Here’s a graph showing marginal social benefit (MSB) on the market graph from part (b):