Question

Suppose that the defense contracting business is perfectly competitive. In long -run equilibrium the price just covers average production cost, and every contractor makes zero profit. Thus, if the price goes down, even a little bit, due to a decrease in government defense spending, all contractors will go out of business. Discuss this statement.

Answer 1

No, all the defense contractors will not go out of business in just one single day. IN a perfectly competitive market a firm starts its production once there Marginal cost curve crosses its Average variable cost curve. We call this point as Shutdown point.

Below this point, the firm stops production, above this point the firm will continue production though he may be facing a loss unless the price doesn't cross the Average total cost curve. When government decreases the defense spending the prices will fall below the lowest point of Average total cost forcing the firms in the loss. Any firm who has a different cost curve as compared to other i.e. faces more than other firms, is less efficient than other will look to quit the business. This will reduce the number of firms operating in the defense market. This quitting of business will continue to the point where the losses become Zero again. (in a way only more efficient firm whose average cost is fewer remains).

A perfect competition market allows easy exit and entry so, whenever the firm faces loss they will quit only to enter the market back again when the profits are high.