Firms in Perfect Competition

December 18th, 2007 | markets -

(a)A perfectly competitive firm uses one variable and one fixed factor of production to make a single product. The price of the fixed factor rises by 10%, the price of the variable factor by 5% and the price of the good by 5%. In the new situation will the firm produce more, less or the same amount as it did before? Show your reasoning.

In long Run equilibrium, firms in perfect competition

Produce where MR=MC. This is the level of profit maximisation
Make Normal Profit AR=ATC

A rise in the variable factor by 5% will increase the marginal cost of production by 5%. But if the price rises by 5%. The AR and MR will increase by 5%.

Therefore, price will rise, but output should stay the same.

However, if the price of fixed factor rises by 10% there will be a bigger increase in the average total cost. If the firm was making normal profit, it will now make a loss. Because costs have increased more than price.
Therefore, in the long run, some firms in perfect competition will go out of business. Causing the supply of firms to fall and price to rise. This means that the AR of firms will increase and there will be an increase in production, by existing firms.
This really needs a diagram of perfect competition for individual firms and the market.

(I think this is what happens, but, it is not something I usually teach)