PCM - Perfect Competition: Short Run v. Long Run Lesson

Perfect Competition: Short Run v. Long Run Lesson

Market Structures Video

Before we discuss specific variations, view the video below to familiarize yourself with the basic market structures. To make the video full screen, click the double arrows at the bottom right corner of the object.

Characteristics of Perfect Competition

The journey through the various structures of product markets is an exploration of the varying degrees of competition. In this lesson, we will explore the perfectly competitive market. It is the foundation of economic theory.

Market v. the Firm in Perfect Competition

A perfectly competitive market is constructed like any other market. It will consist of a downward sloping demand curve and an upward sloping supply curve. The graph for the perfectly competitive firm differs greatly from the graphs for firms in other market structures. 

Why is the firm's demand curve horizontal?  

The firm's demand curve is horizontal because the firm is considered a price taker. Due to a large number of small producers and consumers and standardization of the product, the market sets the price of goods and services in perfect competition. A given firm is insignificant in the market and has no control over price. It just takes the market price as given. Theoretically, it can sell as much as it wants at the given market price.

Demand, Marginal Revenue, and Profit Maximization Video

To make the video full screen, click the double arrows at the bottom right corner of the object.

If the firm can sell "as much as it wants," how is that determined?

Remember, every action taken by the firm is done in an attempt to maximize profit. The general profit maximization rule is that a firm will produce every unit of a good for which the marginal revenue is greater than, up to the point of being equal to, the marginal cost.

Profit Maximization Rule for ALL Firms: Produce every unit of a good for which MR ≥ MC

Remember, profit is the difference between revenue and costs. As long as the extra revenue generated by selling another unit of a good is greater than the extra cost associated with producing that unit, profit will increase. Firms will seek to produce up to the point of equality of MR and MC because it signifies profit has been maximized. Production past that point will result in MR being less than MC (this would be a negative marginal profit) and total profit would decrease.  

Because marginal revenue equals price in perfect competition, this general rule can be refined to create a special profit maximization rule that applies only to perfect competition. A perfectly competitive firm will produce every unit of a good for which the price is greater than, up to the point of being equal to, marginal cost.

Profit Maximization Rule for ONLY Perfect Competition: Produce every unit of a good for which P ≥ MC

Why are Price and Marginal Revenue equal to each other in perfect competition? 

First, let's recall what we know about revenue:   

Total Revenue (TR) = Price x Quantity Sold or TR = P x Q.

Average Revenue (AR) = Total Revenue / Quantity Sold or AR = TR/Q.

If you solve for Price in the Total Revenue formula above, you would find P = TR/Q. Therefore, Price (P) and Average Revenue (AR) are the same number.  

Now let's consider marginal revenue. Marginal revenue is the additional revenue generated by the sale of an additional unit of output. It is viewed as the change in total revenue divided by the change in output. So, MR = ∆TR/∆Q. Because price does not have to decrease in order to sell more at a perfectly competitive firm, every additional unit of output is bringing in the same additional revenue as previous units. That additional revenue is the price the good sells for. Take a look at the mathematical example in the chart below.

Price	Quantity	Total Revenue P x Q	Average Revenue TR/Q	Marginal Revenue ΔTR/ΔQ
$5.00	1	$5.00	$5.00	$5.00
$5.00	2	$10.00	$5.00	$5.00
$5.00	3	$15.00	$5.00	$5.00
$5.00	4	$20.00	$5.00	$5.00

The demand curve is drawn based on data related to price and quantity. The average revenue curve is drawn based on data related to average revenue and quantity. The marginal revenue curve is drawn based on data related to marginal revenue and quantity. Because the data is the same, all three curves are equivalent to each other. That is, D = AR = MR.  

It is important to note that, in the case of perfect competition, total revenue (TR) is constantly increasing across all ranges of production. This is because price does not have to be lowered to sell more units. If you plotted the total revenue curve, it would be linear and positively sloped across all ranges of production.

Combining Cost and Revenue Curves

For all quantities between the origin and point 1, economic profit is negative (loss). Over this range of production, the total cost curve lies above the total revenue curve. That means TR < TC and, therefore, TR - TC equals a negative value (a loss). At point 1, the firm is breaking even. TR=TC and, therefore, TR - TC equals 0. For all quantities between point 1 and point 2, TR is greater than TC. Therefore, TR - TC yields a positive number (+ economic profit). Profit is maximized at the quantity where TR and TC are separated by the greatest vertical distance. Point 2 represents another breakeven point for the firm. For all quantities to the right of point 2, TC is greater than TR again and the firm will be incurring an economic loss.

Given the market equilibrium, the firm perceives its demand curve to be perfectly elastic (infinite). Therefore, the firm's demand curve is drawn as a horizontal line at the given market price. If the market price is such that P(=D=AR=MR) is also equal to MC and ATC, as seen at Point A, the firm is breaking even and economic profit is equal to 0. Any changes in the market that produce a price higher than that at Point A would result in the firm earning a positive economic profit (because AR > ATC...so average profit would be positive). Any changes in the market that produce a price lower than that at Point A would result in the firm incurring an economic loss (because AR < ATC...so average profit per unit would be negative).  

When a firm is earning a loss, it must determine if it should continue to operate. Remember, even if a firm ceases operation in the short run, it still must cover its fixed costs (those are the costs that can't be changed in the short run). By continuing to operate, the firm will also have variable cost to consider. In essence, when a firm is earning a loss, profit maximization becomes a question of loss minimization. If the price is greater than AVC, a firm can operate and cover all of its variable costs and some of its fixed costs. By doing so, it would minimize its losses. The shutdown point for a firm is when P=AVC, represented by Point B. At all prices/quantities below this point, the firm would not earn enough revenue to even cover the variable costs associated with operating. So it would be losing money equal to a portion of its variable costs plus all of its fixed costs.

Changes in Costs at the Firm

These graphs show a typical price-taking firm in a perfectly competitive market. At the current price, the firm is maximizing profit (P = MC) and the maximized level of profit is zero (P = ATC). Important points to note about the firm's graph:

• Point A represents the breakeven point (P = ATC) for the firm. Prices above Point A will result in positive profit. Prices below Point A will result in losses.
• Point B represents the shutdown point (P = AVC) for the firm. At prices below this point, the firm is not earning enough revenue to cover its variable costs of producing. Loss = fixed costs + variable costs.
• The firm will earn a loss but should continue to operate as long as the price is between Point A and Point B. It will be able to cover all of its variable costs and a portion of its fixed costs.  

Shut Down Rule Video

To make the video full screen, click the double arrows at the bottom right corner of the object.

Changes in the Market

Changes in market demand can also impact profit at a perfectly competitive firm. In the graph shown above, a decrease in market demand has occurred. In response to the decrease in market demand, the market price has fallen to Pm1. The perfectly competitive firm perceives its new demand curve at Pf₁ (D₁, MR₁, AR₁). Because the price has changed, the firm must determine its new profit maximizing level of output. It does so by equating P and MC. The new profit maximizing level of output is Qf₁. However, at Qf₁, the firm is now earning a loss. This is because P < ATC at Qf₁. If the graph contained an AVC curve, it would be possible to tell if the firm should continue to operate through the loss or shutdown in the short run. Remember, the decision to operate through the loss or shutdown would be based on a comparison of P and AVC at the profit maximizing level of output.  

Of course, if market demand had increased, the firm would see its individual demand curve shift upward and it would begin to earn a profit. 

Adjusting to Long Run Equilibrium

Why will perfectly competitive firms earn zero economic profit in the long run?

Profit and loss act as incentives in the market. When firms are earning positive economic profit in the short run, as the firm does when its costs decrease in the example below, there is an incentive for other firms to enter the market in the long run. Remember, entry can only occur in the long run because it requires the manipulation of all factors of production. When firms enter the market, market supply increases (shifts right), driving market price down. As market price decreases, the firms in the market take the new price as given and perceive their individual demand curves to shift downward. As the curves shift down, profits at existing firms will begin to decrease. Firms will continue to enter the market until economic profits reach zero. That is, until P=MC=minATC. This is referred to as long run equilibrium (LRE, for short).

When costs decrease from MC to MC₁ and ATC to ATC₁, the firm adjusts its profit maximizing level of output to equate P and MC. The existing firms will produce Qf₁ units of output. At Qf₁ units, the price (represented by Point B) is greater than ATC₁. Therefore, the firm is earning a positive profit. This is an incentive, in the long run, for firms to enter the market. Market supply increases, driving the price down, until firms reach LRE where P_f2 = MC₁ = minATC₁ (Point C).  

**Side note: Decreasing costs at the firm, will correspond to a downward sloping long run industry supply curve; increasing costs at the firm, will correspond to an upward sloping long run industry supply curve (see the previous module).  

When firms are earning a negative economic profit, also known as a "loss", there is an incentive for firms to exit the market in the long run.   The example below deals with a decrease in demand that causes firms to incur a loss. In the long run, as firms exit the market due to this loss, market supply decreases (shifts left), driving the market price up. As market price rises, the firms remaining in the market take the new price as given and perceive their individual demand curves to shift upward. As the firms' demand curves shift upward, losses at the existing firms will begin to decrease. Firms will continue to exit the market until economic profits reach zero. Again, this occurs at P = MC = minATC.

Demand decreased to D₁. The firm assumes the market price of Pm1 as its new price (P_f1). It adjusts production to its profit maximization level (where the new price, P_f1, equals MC). This occurs at a quantity of Q_f1. At Q_f1, P_f1 < ATC and the firm is earning a loss. In the long run, the loss will result in firms leaving the industry. This is seen by the market supply curve shifting left (to S₁). Price rises as supply decreases and losses at remaining firms begin to decrease. The exit will stop when the price returns to its original level, Pm and profits at the firm return to 0. At this point, the remaining firms are in a position of long run equilibrium (P=MC=minATC).

**Side Note: In this scenario, the long run industry supply curve would be horizontal to represent a constant cost industry (see the previous module).

Short-run to Long-run Perfect Competition Video

To make the video full screen, click the double arrows at the bottom right corner of the object.

When economic profit is zero, the market is in a state of "long run equilibrium." Long run equilibrium occurs where P = MC = minATC. In long run equilibrium, the conditions for both allocative and productive efficiency are met. That is, P = MC (allocative efficiency) and P = minATC (productive efficiency). 

IMAGES CREATED BY GAVS (Image 1 from freepik.com and modified by GAVS)