Question

Draw the following: (a) a perfectly competitive firm that earns profits (b) a perfectly competitive firm that incurs losses, but will continue to operate (c) a perfectly competitive firm that incurs losses and will shut down in the short-run.

Answer 1

Given below are the diagrams:

(a) A perfectly competitive firm that earns profits:

In the diagram Price = Average Cost (AC), which means Total Revenue = Total Cost. This implies the firm is earning Normal Profit here. Any Price above P₁ in the diagram means that the firm is earning super normal profit as the Total Revenue is greater than the Total Cost. In the figure, the equilibrium price is P₁ and the equilibrium quantity is Q₁.

(b) A perfectly competitive firm that incurs losses, but will continue to operate

In the diagram Price < Average Cost (AC), which means Total Revenue < Total Cost. This implies the firm is incurring a loss here. There is a loss here but the loss is less than the Total Fixed Cost (TFC). In the short run, if the price is P₂ the firm will continue production as no production means loss equal to Total Fixed Cost, so, the firm will produce Q₂. Hence, any Price which is below P₁ as shown in the above graph and above P₂ is the point where the firm will continue to operate but will incur losses as here the Total Cost is greater than the Total Revenue.

(c) a perfectly competitive firm that incurs losses and will shut down in the short-run

In the diagram below, the Price is below the Average Variable Cost. Since, the price has fallen below the Average Variable Cost, the firm is going to stop production and it would shut down. So, this is the shut down point and since the firm will not produce any goods, I have not marked the quantity in the graph.

The total cost in the short run is divided into two parts: Fixed Cost and Variable Cost. If the factory is shut down and production is stopped, the variable cost can be avoided but the firm has to bear the fixed cost. So, with the stoppage of production, the loss is equal to the fixed cost. Hence, in the short run, the firm would continue production as long as the loss is less than or equal to the fixed cost.

Loss <= Total Fixed Cost (TFC)

or, Total Cost - Total Revenue <= Total Fixed Cost

or, (Total Fixed Cost + Total Variable Cost ) - Total Revenue <= Total Fixed Cost

or, Total Variable Cost <= Total Revenue

or, Total Variable Cost / Quantity <= Total Revenue / Quantity

or, Average Variable Cost <= Price

or, Price >= Average Variable Cost.

Hence, we find that Price should be more than or equal to the Average Variable Cost for the firm to operate from the following derivation.