Perfect competition: short-run and long-run equilibrium
Many firms sell an identical product at the market price. In the long run, free entry and exit leave only normal profit at minimum average cost.
Features of perfect competition
- A very large number of buyers and sellers; each is too small to affect the price.
- A homogeneous (identical) product, so buyers do not care whose product they buy.
- Free entry and exit of firms in the long run.
- Perfect knowledge of prices and technology among buyers and sellers.
- Perfect mobility of factors of production and no transport costs.
- Result: each firm is a price taker and faces a horizontal demand curve at the market price.
Short-run equilibrium of the firm
The market price is set by industry demand and supply. The firm can sell any amount at that price, so P = AR = MR. It maximises profit where P = MC with MC rising. Whether it makes a profit depends on where price is compared with ATC: above ATC gives supernormal profit, equal gives normal profit, below gives a loss. In the short run, a loss-making firm keeps producing as long as price covers average variable cost, because its fixed costs must be paid anyway. The firm's short-run supply curve is its MC curve above minimum AVC.
Worked example: profit, loss and shutdown
Use the bakery's costs (TFC Rs. 10,000; TC for 1-6 batches: 14,000; 17,000; 19,000; 22,000; 27,000; 34,000; MC: 4,000; 3,000; 2,000; 3,000; 5,000; 7,000; minimum AVC Rs. 3,000; minimum ATC Rs. 5,400). Find the best output and result at market prices of Rs. 6,000, Rs. 4,000 and Rs. 2,500.
- P = 6,000: MC ≤ 6,000 up to the 5th batch (MC 5,000); the 6th costs 7,000. Q = 5. Profit = 30,000 − 27,000 = Rs. 3,000 (supernormal).
- P = 4,000: MC ≤ 4,000 up to the 4th batch (MC 3,000); the 5th costs 5,000. Q = 4. Profit = 16,000 − 22,000 = −Rs. 6,000.
- At P = 4,000, shutting down would lose the whole fixed cost, Rs. 10,000. Producing loses only Rs. 6,000, because revenue (16,000) covers TVC (12,000). Stay open in the short run.
- P = 2,500: this is below minimum AVC (3,000). Best producing loss is Rs. 11,500 (at 1 or 3 batches: e.g. 7,500 − 19,000), worse than the shutdown loss of Rs. 10,000. Shut down.
Rs. 6,000: produce 5, profit Rs. 3,000. Rs. 4,000: produce 4, loss Rs. 6,000 (better than closing). Rs. 2,500: shut down, loss limited to Rs. 10,000.
Short-run outcomes for a competitive firm
| Price compared with costs | Result | Decision |
|---|---|---|
| P > ATC | Supernormal profit | Produce where P = MC |
| P = ATC (minimum) | Normal profit (break-even point) | Produce where P = MC |
| AVC < P < ATC | Loss, smaller than fixed cost | Keep producing in the short run |
| P < minimum AVC | Loss greater than fixed cost if it produces | Shut down (shutdown point) |
Long-run adjustment through entry
Losses work in reverse: firms exit, supply falls, price rises until the survivors earn normal profit.
Worked example: the long-run price
If every bakery has the cost structure above, what will the market price settle at in the long run, and what will each firm earn?
- Long-run equilibrium needs P = minimum ATC, which is Rs. 5,400 at 5 batches.
- At P = 5,400 and Q = 5: TR = 5,400 × 5 = Rs. 27,000.
- TC at Q = 5 = Rs. 27,000. Economic profit = 27,000 − 27,000 = 0.
Price settles at Rs. 5,400; each firm makes 5 batches and earns only normal profit (zero economic profit).
Why economists praise perfect competition
Thousands of tea smallholders and vegetable farmers come close to perfect competition: each sells a near-identical product and must accept the price set at the Colombo Tea Auction or the wholesale market. No single grower can raise the price, so cutting cost is their only way to earn more.
Short answer: “What is the shutdown point of a competitive firm?” The price equal to minimum average variable cost; below it the firm loses less by closing than by producing.
Structured question: “Using a cost table, find a competitive firm's output and profit or loss at given market prices, and say whether it should shut down.” Produce where P = MC; compare P with ATC for profit and with AVC for the shutdown decision. E.g. P = Rs. 4,000: Q = 4, loss Rs. 6,000 < fixed cost Rs. 10,000, so stay open.
Essay: “Explain the short-run and long-run equilibrium of a firm under perfect competition.” List the features, show P = AR = MR, explain SR profit, loss and shutdown with diagrams, then LR entry and exit leading to P = MC = minimum ATC and normal profit.
Short run: cover AVC to stay open. Long run: cover ATC to stay in. Long-run equilibrium: P = MR = MC = minimum ATC.