Question

Suppose that the owner and CEO of a firm that operates in a PERFECTLY COMPETITIVE market environment comes to see you for help. She has question to ask you as her best Economist friend.

(i)    After talking to another economist friend, Mary, my question, she says, is: “And then this morning Mary said that after the market responds to our current extra-ordinary economic profit, that we may be in a position where our Total Revenue, TR is less that our Total Cost, TC. I said that was awful, we would have to Shut Down! But Mary said, no we won’t because our Total Revenue will still be greater than our Total Variable Cost, TVC. Can you explain WHY this result matters to me and what I should do, please?

Can you please explain the answer thoroughly and in detail for my understanding?

Answer 1

In a perfectly competitive market, all firms produce and sell identical products. Hence as this firm is making an extra ordinary economic profit, this will produce an incentive for other firms to enter the market and eventually, this firm reaches a position, where total revenue becomes less than total cost, hence the firm started to make negative economic profit. But as long as this firm is able to cover up it's variable cost such as wages to workers, this firm should not shut down i.e the shutdown point in case of perfectly competitive market is a point where the marginal cost cuts the minimum point of average variable cost and when price is above this shutdown point, this firm should continue its operation. So as long as the total revenue is above the total variable cost i.e as long as this firm is able to cover its variable cost, this firm should not shut down.Hence in the long run, if this firm is able to earn zero economic profit in the long run, this firm should continue producing but if it's not able to earn zero economic profit in the long run, this firm should exit the market in the long run.