In the short run, a perfectly competitive firm operates under certain
conditionsand makes decisions based on its cost structure and market
price. The business considers the market price to be fixed. It has no
control over the price and must sell its output at this price. he firm
aims to maximize short-run profit or minimize short-run losses. It does
this by producing the quantity where marginal cost (MC) equals marginal
revenue (MR). If MC is less than MR, the firm increases production; if MC
is greater than MR, it reduces production. If the market priceis below the
firm's average variable cost (AVC), it will temporarily shut down
production because it cannot cover its variable costs. If the price is above
AVC,the firm continues producing. In the short run, the firm can earn an
economic profit (if price exceeds average total cost, ATC) or incur an
economic loss (if price is below ATC). Economic profit considers both
fixed and variable costs.
- How do firms choose to produce optimal quantity?
- Same rule:
- MR=MC=P
- Or P = MC
- Recall in short run,
- ATC= AFC+ AVC
- Firm choices in short run:
- Profit Maximized: MR=MC
- Firm making profits: P>ATC
- Firm making losses: AVCATC
Short-term equilibrium of competition for (a) a firm and (b)
the industry
Interpretation: Here figure shows this analysis graphically. The individual
supply curves of each of the 1000 identical firms, one of which is shown as
s= MC in graph. With total demand curve D, it yields the equilibrium price
$111 and equilibrium quantity 8000 units. Firm’s demand curve is perfectly
elastic at the equilibrium price, as indicated by‘d’. The industry supply curve
(S) is calculated as the horizontal sum of the individual supply curves (s) of
the 1000 firms. The industry's short-term equilibrium price and output, given
industry demand (D), are $111 and 8000 units. Taking the equilibrium price
as given, the individual firm establishes its profit-maximizing output at 8
units and, in this case, realizes the economic profit represented by the pink
area.
In the long run, a perfectly competitive firm operates under different cond-
itions and makes strategic decisions aimed at maximizing its overall
economic well being. Similar to the short run, the firm continues to take the
market price as given in the long run. It cannot influence or set the market
price. The firm's objective remainsthe same: to maximize profit or minimize
losses. It does thisby producing the quantity where marginal cost (MC) equals
marginal revenue (MR). In the long run, firms in perfect competition earn
zero economic profit. Economic profit includes not only variable costs but
also explicit (accounting) costs and implicit (opportunity) costs. If a firm is
earning an economic profit, it attracts new entrants into the market, increa-
sing competition and driving downprices. Conversely, if a firm is incurring
an economic loss, some
firms may exit the market, reducing competition and driving up prices.
Firms in perfect competition operate at the optimal scale of production in
the long run, where average total cost (ATC) is minimized. This guarantees
effective resource usage.
Perfect competition results in productive efficiency because firms produce at
the minimum point on their ATC curve. This means they produce goods at the
lowest possible cost. Perfect competition leads to allocative efficiency, where
the price of the product equals the marginal cost of production. By doing this,
it is made sure that resources are allocated to maximize society welfare.
- One or more inputs are fixed in the short run.
- It can reduce the firm's flexibility depending on the
- In the long run, a company may change all of its inputs, including the
- Considering that free entry and free exist.
- No additional fees or limitations from the law.
- Same Rule:
- MR=MC, Long-run marginal profit is zero.
- Accounting profit: the difference between a company's direct
- Economic profit: Difference between firms’ revenues and
- Zero and Positive Economic Profits:
- If R> wL+rk, economic profits are positive.
- If R= wL+rk, zero economic profits.
- If R<wl + rk, consider going out of business.
- Long run equilibrium will be occurred when three conditions
- MR= MC
- P=LAC
- QD=QS
Temporary profits and the re-establishment of long-run
equilibrium in (a) represent single firm and (b) the industry.
Interpretation: A favorable shift in demand D1 to D2 will upset the original
industry equilibrium and produce economic profit. But these profits will
cause new firms to enter the industry, increasing supply S1 to S2 and
lowering product price until economic profits are once again zero.
Temporary losses and the re-establishment of long-run
equilibrium in (a) represent single firm and (b) the industry.
Interpretation: An unfavorable shift in demand D1 to D2 will upset the
original industry equilibrium and produce economic losses. But these losses
will cause firms to leave the industry, decreasing supply S1 to S3 and increa-
sing product price until all losses have disappeared.
A competitive firm's long-term
equilibrium position is P=MC.
Interpretation: The equality of price and minimum average total cost indi-
cates that firm is using the most the efficient known technology and is
charging the lowest price P and producing the greatest output Q consistent
with its costs. The equality of price and marginal cost indicates the resources
are being allocated in accordance with consumer preference.
The long-run equilibrium position of a competitive firm: P=MC
Interpretation: The equality of price and minimum average total cost
indicates that firm is using the most the efficient known technology and
is charging the lowest price P and producing the greatest output Q consistent
with its costs. The equality of price and marginal cost indicates the resources
are being allocated in accordance with consumer preference.
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