Question

Draw a graph showing a firm that is operating at a loss 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 loss.

Short answer

The firm's loss on the graph is represented by the area between the average total cost curve and the demand curve for the quantity being produced.

Step-by-step solution

Draw the Basic Graph

First, draw a graph with two axes. The vertical axis represents cost and price, while the horizontal axis represents quantity.

Plot the Demand and Marginal Revenue Curves

On this graph, draw a horizontal line from the vertical axis which represents both demand and marginal revenue curves in a perfectly competitive market. In this case, these occur at the same price level because each firm is a price taker.

Plot the Marginal Cost Curve

Draw the marginal cost curve. It intersects the marginal revenue/demand line from below. Typically, the marginal cost curve is upward sloping.

Draw the Average Variable Cost Curve

Next, plot the average variable cost curve. It should start from the point where the marginal cost curve intersects the vertical axis, and should initially be downward sloping, then upward sloping, and must lie below the average total cost curve.

Draw the Average Total Cost Curve

Plot the average total cost curve. It should also initially be downward sloping, then upward sloping. This curve lies above the average variable cost curve and will intersect with the marginal cost curve at its lowest point.

Identify the Area Representing the Firm's Loss

Finally, calculate the firm's operating loss by finding the area between the average total cost curve and the demand curve for the quantity being produced. Shade this area to represent the loss.

Key concepts

Demand Curve

A demand curve in a perfectly competitive market is essential to understanding a firm's revenue potential based on price levels and quantities demanded. In a perfectly competitive market, the individual firm's demand curve is typically represented as a horizontal line. This indicates that the firm is a price taker, meaning it has to accept the market price for its product without the ability to influence it.

For any given price, the quantity demanded by consumers is at the equilibrium point of the market's supply and demand. This simplicity allows us to focus on the other costs and revenues affecting the firm's financial outcome. The demand curve also doubles as the marginal revenue curve because additional units sold do so at the same market price, not affecting the overall revenue per unit.

Marginal Revenue

Marginal revenue is the additional income from selling one more unit of a good or service. In a perfectly competitive market, the marginal revenue is constant and equal to the market price, which is also illustrated by the horizontal demand curve.

Understanding marginal revenue helps businesses make crucial decisions about production levels. If the marginal revenue is greater than the marginal cost of producing one more unit, it would be profitable for the firm to increase production. However, in the scenario where the firm is operating at a loss, depicted in our graph, the marginal cost eventually exceeds marginal revenue, indicating that the firm should cut back production to minimize losses.

Marginal Cost Curve

The marginal cost curve is crucial for pricing and production decisions. It displays the change in total cost with the production of each additional unit. Typically, this curve has a 'U' shape due to the principle of increasing marginal returns at lower levels of production followed by diminishing marginal returns at higher levels. The lowest point of the marginal cost curve represents the most efficient output level with the lowest marginal cost.

In our graph, the intersection of the marginal cost curve and the demand/marginal revenue curve indicates the quantity that the firm can offer at the market price. Ideally, the firm aims to produce at a quantity where marginal cost equals marginal revenue; however, if the average total cost at this point is higher than the market price, the firm will incur a loss.

Average Total Cost Curve

The average total cost curve represents the per-unit cost of production, which includes both fixed and variable costs. As production increases, average total costs typically decrease due to economies of scale, reaching a minimum before increasing again with diseconomies of scale.

In the context of a firm operating at a loss in a perfectly competitive market, the average total cost curve lies above the demand curve, indicating that the price they receive for each unit is less than what it costs to produce. Therefore, the firm incurs a loss on every unit sold. The area between the average total cost curve and the demand curve up to the profit-maximizing quantity where marginal revenue equals marginal cost represents this loss on the graph.

Average Variable Cost Curve

The average variable cost curve shows the variable costs per unit of output, excluding any fixed costs. Initially, this curve tends to decrease as output increases due to the spreading out of variable costs over a larger number of units (also known as variable economies of scale), and then it begins to rise after a certain point once diseconomies of scale kick in.

In the graph demonstrating a loss, the average variable cost curve is positioned below the average total cost curve, reflecting the exclusion of fixed costs. For firms, this curve is essential for deciding whether to continue operating in the short term. If the price covers the average variable cost, the firm can cover its variable costs and contributes to fixed costs, even if it's not profitable overall. If it doesn't, the firm is better off shutting down operations temporarily.