Market Supply and Demand Curves
The market supply and demand curves are fundamental components of economic visualization. They are used to represent the relationship between the quantity of goods that producers are willing to supply at various price levels (the supply curve) and the quantity of goods consumers are willing to purchase (the demand curve). When plotting these curves on a graph, the point where they intersect identifies the market equilibrium, which shows the equilibrium price and quantity.
In a perfectly competitive market for kitty litter, as shown in the exercise, the supply and demand curves help to pinpoint the long-run equilibrium for the industry. This equilibrium illustrates that the quantity supplied by the industry as a whole matches the quantity demanded by the consumers, leading to a stable market price, at which all market exchanges occur.
Marginal Cost (MC)
Marginal cost (MC) is crucial to understanding business production decisions. It represents the change in total cost when producing one additional unit of a good. In the context of perfect competition, firms will typically adjust their output so that the marginal cost equals the market price.
For the individual kitty litter firm portrayed in the exercise, the MC curve intersects both the average total cost (ATC) and average variable cost (AVC) curves at their lowest points. This happens at the ideal level of production that minimizes cost and coincides with the market price in long-run equilibrium.
Average Total Cost (ATC)
Average Total Cost (ATC) is the sum of all production costs divided by the number of units produced. In the context of long-run equilibrium for a perfectly competitive market, the ATC includes both fixed and variable costs.
The significance of ATC is observed when the industry's price, which is also the firm's marginal revenue (MR), equals the ATC at its minimum point. This implies that each firm is making 'normal profit', where total revenues are exactly the same as total costs, ensuring that the business can sustain operations but without economic profit.
Average Variable Cost (AVC)
Average Variable Cost (AVC) reflects the variable costs per unit of output, which are costs that change with the level of production. Examples can be raw materials or labor directly involved in the creation of a good – in our case, kitty litter.
Understanding AVC is essential for firms making short-term production decisions, because it influences how they adapt to changes in market price. When discussing long-run equilibrium, firms operate at a point where price is above AVC, ensuring they can cover these costs and contribute to covering fixed costs as well.
Marginal Revenue (MR)
Marginal Revenue (MR) is the additional revenue a firm gains from selling one more unit of its product. In perfect competition, MR is equal to the price of the product because each unit sold adds exactly the price amount to total revenue.
In the case of the kitty litter market, the MR for the firm is represented as a horizontal line because the firm, being a price taker, can sell any amount of product at the market price. The firm will continue to produce up to the point where MR equals MC to maximize profits, which in long-run equilibrium means just earning a normal profit.
Normal Profit
Normal profit occurs when a firm’s total revenue is equivalent to its total costs, accounting for both explicit and implicit costs. This level of profit does not provide excess returns over the opportunity cost of capital but does ensure that the business remains viable.
In the context of the kitty litter industry, normal profit means that while the entrepreneur has covered all production costs and earns a return equal to what could be made elsewhere with the same risk, there's no incentive for additional firms to enter or leave the market because there are no extra profits to be had. Thus, normal profit signals a stable long-run equilibrium in a perfectly competitive market.
Industry Entry and Exit
Industry entry and exit are natural responses to the profitability of a market. When firms in an industry earn above-normal profits, new entrants are attracted to the market, increasing supply and therefore decreasing the market price until only normal profits are achievable.
Conversely, if firms are making losses (revenues are below their ATC), some will exit the industry, effectively reducing supply and increasing price till only normal profits are made. This process of entry and exit continues until long-run equilibrium is achieved, where no firm has an economic incentive to either enter or leave the kitty litter market.
Market Preference Shifts
Market preference shifts refer to changes in consumer tastes or demand for a product. In the case of the kitty litter market, a shift towards dog ownership would decrease demand for kitty litter. The demand curve in the market would shift leftward, leading to lower prices and reduced quantities sold.
Overtime, this shift impacts industry dynamics. The lower price can enforce some firms to incur losses, prompting them to exit the market. This exit reduces market supply, and prices may eventually stabilize, but at a new, lower level of output. The remaining firms adjust to the new equilibrium, continuing to earn a normal profit, albeit with a smaller market size.
