Answer to Question #287882 in Microeconomics for Rumi

Question

Does a competitive firm’s price equal the minimum of its average total cost in the short run, in the long run, or both? Explain.

Answer 1

Step 1 -

A perfect competition(PC) market is one with many consumers and sellers producing identical products. As there are many producers in this market, that is why the firms are price takers which means they cannot influence the price within the market. Also, there is a free firm's exit or entry into the market. In this market structure firms only enjoys profits that are enough to stay in the market. As if they try to increase their profits, then new firms will get attracted and will decide to enter the market which will again bring down the profits. Now to maximize the profits, a firm can either increase the price or can increase the quantity sold at the existing price level. But in perfect competition firms, it's not possible to increase profits in any of these ways. If the firm tries to gain profits by raising the prices, then consumers will switch to other firms as all the firms will be producing similar goods therefore, the firm cannot set the prices themselves.

Step 2 -

The equilibrium level of price and quantity produced is determined in the market due to the intersection of MR and MC and varies in SR and LR. In SR, the firm will produce quantity produced and output at a point where MR(or price) is equal to MC and MC cuts the MR curve from below. In the long run LR, new firms can enter the market which will erode the profits from the market. Therefore, the LR equilibrium level is determined while adjusting the situations of economic forces. For making decisions the main role is of LR ATC and LRMC. In the LR the prices determine where MC is equal to the minimum of LR AVC. Thus, the price is equal to a minimum of ATC only in LR but not in SR. In the SR, prices will be more than the ATC through which the firm would be capable of making profits or the firm will have a price less than ATC where it will be making losses. But in LR, Prices will always be equal to ATC.