Assume you read in a newspaper that firms who produce baby milk are not doing well due to melamine case. With the theory of perfect competition in mind, what do you expect to happen to the baby milk prices? Will the firms able to make profits in long run?
With the theory of perfect competition, the melamine case will affect the firms in both short-run and long-run. First of all, customers will lose confidence to the baby milk firms and they will stop buying baby milk which contains melamine. The demand of baby milk drop and demand curve will shift to left from D0 to D1 and D1.Both price and quantity have decreased from P0 to P1 and Q0 to Q1 respectively and therefore new equilibrium E1 achieved. In perfect competition, price is equals to marginal revenue (MR) and firm earns profit when marginal revenue is above minimum of average total cost (ATC) curve. But now there is a decrease in price, marginal revenue of the firms will move downward from MR0 to MR1. So now the MR is lower than the minimum of ATC, revenue cannot cover total cost, the firm is making economic loss. Making economic loss will cause the firm to exit the industry. Therefore, zero profit in the long-run. Economic Losses
Short-run competitive equilibrium for a firm and the industry. Industry
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