Question

A perfectly competitive firm currently producing 100 units of output has ATC= $6 and AFC = $4. The market price is $3 and is equal to MC. Is the firm currently operating in the short-run or the long-run? Explain why. Discuss if the firm is currently maximizing profits (or equivalently minimizing losses)? Explain if shutting down the business in this current situation would be beneficial for the firm. If firms break even in the long run and earn zero economic profits, would they stay in the business? Explain why.

Answer 1

The shortrun market price of a perfectly competitive market may fluctuate above and below the unit cost (ATC). But in longrun the market price is equal to average total cost. The equality of market price with ATC comes from the free entry and exit of the firms. If the market price in shortrun in greater than the unit cost, the existing firms will earn positive economic profit. Then new firms will enter into the industry in longrun and the supply curve shifts to the right, price falls. The entry of new firms will continue till the price falls and equate with unit cost. On the other if the market price is such that the existing price is below the unit cost, the existing firms incur losses. Some firms will leave the industry in longrun. The exit of the firms reduces the market supply and price increase. The exit of the firms will continue till the market price equals the unit cost. Once the price equate with ATC there is no tendency on the part of new firms to enter into the industry or the existing firms to leave the industry.

The current market price is $3 and ATC is equal to $6. It means that the firms are incurring loss of $3 per unit and they are in shortrun. The loss indicates that the firms are in shortrun. When the firms incur losses, they will try to minimize losses by reducing the level of output. The firms are now minimizing the loss by reducing the volume of output.

A firm in shortrun decides to shut down when the market price falls below the average variable cost. If the market price is above the average variable cost the firms will stay in business by suffering losses in shortrun. The reason is that the firms have already incurred expenditure on fixed capital like plant and machinery, tools and equipment, insurance policy etc. If production stops the firms have entirely to loss these expenditures. If the firm continues in production the firms can recover its fixed cost and a part of variable cost.

AVC= ATC-AFC= $6-$4=$2. Here the market price is $3, thus the firm can recover its variable cost fully ($2) and part of fixed cost ($1) while continuing production. If the firm shut down production under loss suffering situation, it fully loss its fixed cost. Thus in shortrun if the market price is above the AVC it is a wise decision on the part of the firms to continue in production. Shutting down in this situation of not beneficial for the firms.

The longrun situation of a market under perfect competition is that all firms are in breakeven (P=ATC). The firms earn normal profit. The firms will stay in business by earning normal profit in longrun. In longrun the firms can recover their entire cost fully and also earns a normal profit which is sufficient for a firm to remain in the industry. Thus firms would stay in industry in longrun.