i) Explain why the short-run MC curve of each business does not shift but that the short run AC curve of each business shifts downwards. Draw a diagram to illustrate the change in the cost structure. Explain why, in the short run, there is no change to the market supply and each business now makes economic profit.
Marginal cost is the change in total cost divided by the change in output (MC = ΔTC/Δ q), therefore marginal cost is only related to variable costs and is independent of fixed costs. Average total costs equals the total costs divided by the output thus a decrease in total costs will cause a decrease in average total costs. In the short-run a decrease in the cost of capital (a fixed cost) will cause the average total cost to decrease but marginal costs will remain unchanged because the other variable factors are unaffected.
In the short-run a company can only change its variable inputs, with fixed inputs staying the same. This means that in the short-run no new firms can enter the market thus the market supply will not change. Assuming that this exogenous change does not affect demand then the market equilibrium point will not change thus the price for the product will also not change. With the firms average total cost decreased and the price of the product staying the same, the firm will make an economic profit on each unit sold.
Explanation of Figure 1 –
Due to the reduced cost in capital ATC curve will shift down and slightly to the left to form ATC*. MC is not affected by fixed costs and so remains the same. In the short-run there will be no new entrants into the market thus supply stays the same and so does the price, P. It now costs the firm P* to produce a single unit of output and the firm is selling each unit at P, therefore making an economic profit within the rectangle P,A,B, P* (where A is the profit maximising output and B is the new ATC at the output Q).
(ii) Now consider the long run. Each firm will seek,... [continues]
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