Question

Draw a graph showing a firm that is making a profit in a perfectly competitive market. Be sure your graph includes the firm's demand curve, marginal revenue curve, marginal cost curve, average total cost curve, and average variable cost curve, and make sure to indicate the area representing the firm's profit.

Short answer

The graph consists of a horizontal demand and marginal revenue curve, and 'U' shaped Marginal Cost, Average Total Cost, and Average Variable Cost curves. The profit area is the rectangle formed between ATC and the demand curve (price) at the quantity where MC=MR.

Step-by-step solution

Set Up the graph

Start by drawing the vertical and horizontal axes. Label the vertical axis as 'Price/Cost' and the horizontal axis as 'Quantity'. This will serve as the foundation of the graph.

Draw the Demand Curve and Marginal Revenue Curve

In a perfectly competitive market, the demand curve faced by the firm is perfectly elastic, which is a horizontal line at the level of the market price. Draw a horizontal line in the middle of the graph representing this. Additionally, for a perfectly competitive firm, the marginal revenue is equal to the market price, so the marginal revenue curve coincides with the demand curve.

Draw Marginal Cost, Average Total Cost, and Average Variable Cost Curves

The Marginal Cost curve should be drawn as a line starting from the bottom of the graph, increasing as we move rightward along the x-axis. It forms a 'U' shape. Above this, draw the Average Variable Cost curve and then the Average Total Cost curve. Both are 'U' shapes, but AVC is below the ATC.

Indicate the Profit Area

In a scenario where the firm is making a profit, the Price should lie above the ATC. To find the profit region, extend a vertical line from the intersection point of MC and MR to the ATC and the demand curve. The area of the rectangle formed between ATC and the demand curve (price), with width equal to the quantity of output, represents the firm's profit.

Key concepts

Demand Curve

The demand curve in a perfectly competitive market is a critical concept for students to understand. Imagine a vast marketplace where numerous sellers offer the same product—say, fresh strawberries. No single seller has the power to influence the price because there are so many competitors, and the product is identical no matter from whom you buy. In such a market, the demand curve faced by an individual firm is perfectly elastic—that means it's a straight, horizontal line. This reflects that the firm can sell as much as it wants at the market price, but cannot charge a different price.

On our graph, this curve lies horizontally at the level where the price is determined by the interplay of the total market supply and demand. For students, visualizing this horizontal line is key—it represents that the price remains constant, no matter the quantity sold by the single firm.

Marginal Revenue

Now, let's talk about marginal revenue, which is the extra income a firm gets from selling one more unit of a good. In the context of a perfectly competitive market, an essential insight for students is that the marginal revenue is actually the same as the market price for each additional unit sold.

Why? Because each firm in a perfectly competitive market is a 'price taker,' which means it can't set its own prices—those are determined by the overall market. So, the graph shows the marginal revenue curve coinciding exactly with the demand curve. Each time a firm sells another strawberry, it brings in revenue exactly equal to the market price. To students, I always underline that in this special market setting, the demand curve and the marginal revenue curve are twins, lying right on top of each other.

Marginal Cost Curve

Moving onto the marginal cost curve, it's important to capture its 'U' shape. This is because costs typically first decrease and then increase with the output level. At the beginning of production, firms are usually less than fully efficient, so costs decrease as workers and machinery are better utilized. But, after a certain point, costs start to climb as resources become overused or scarce.

In our graph, the marginal cost curve starts at the graph's origin and swoops downward, then climbs as it moves right—forming that iconic 'U'. It's crucial for students to recognize where the marginal cost curve intersects with the marginal revenue (aka demand curve) because that point determines the most profitable output level for the firm.

Average Total Cost

Average total cost (ATC) is the average expense per unit of production, including all fixed and variable costs. As with marginal costs, it's represented with a 'U' shape on the graph. Starting higher on the left, it goes down as production becomes more efficient, reaching a minimum, and then increases once more at higher levels of output due to diminishing returns.

Important to students is knowing that when this curve sits below the demand curve (price), the firm is covering all its costs and making a profit on each item sold. The ATC helps in identifying the break-even price and visualizing profitability. If the market price is above the ATC at the optimal production level, it's 'happy days' because the firm is earning profits, and that's an exhilarating feeling for any business.

Average Variable Cost

Lastly, understanding the average variable cost (AVC) puts students on solid ground comprehending a firm's cost structure. Variable costs change with the level of output, like materials and labor, as opposed to fixed costs, which remain constant like rent. The AVC curve is also 'U'-shaped and lies below the ATC curve because it doesn't consider fixed costs, only variable ones.

It's essential to point out to students that where the AVC curve lies in relation to market price impacts a firm's decisions about production in the short term. If the price dips below the AVC, it's usually a signal to shut down operations temporarily, as the firm would not even be covering its variable costs. However, if the price is above the AVC (and even more so if above the ATC), it signifies the firm can profitably produce at least in the short term.