Answer to Question #199589 in Microeconomics for Barahama

Question

Perfect competition is a theoretical market structure in which the following criteria are met: All firms sell an identical product. All firms are price takers. Market share has no influence on prices. Given the characteristics described above

i. Describe the factors that drive profits to zero in perfectly competitive markets in the long run. Explain carefully the incentives that drive the market to a long run equilibrium. AP,3 Marks

ii. Why would a firm choose to operate at a loss in the short run? Explain carefully. AP,3 Marks

iii. When do firms decide to shut down production in the short run? Explain carefully.

Answer 1

(i)

In the long run perfect competition market, there is elimination of profit and loss because large numbers of firms are manufacturing large numbers of homogeneous products. There is no barriers on entry and exist of firms, this initiate the firms in the long run to enter the market and invest their resources so that they can also make economic profit. Their entrance increase the supply which reduces the marginal revenue to the point where the economic profit is zero. This is the point where marginal cost is equal to average total cost. The firm at zero profit is they are productively efficient. If other firms continues to enter the market even after zero economic profit, the firms will face economic loss and hence leave the market and market will be back in zero profit.

(ii)

It is not necessary that in the short run firm will earn profit. In this scenario a firm chooses to continue to produce the quantity where average variable cost is less than profit, in this case production at this point is cheaper than not to produce any goods or leaving the market. In this way, firm can minimize its loss.

(iii)

A firm decides to shut down when its revenue cannot make up for variable cost of production. The firm fails to operate the level of output where marginal cost is equal to marginal revenue.