Short Run and Long Run Analysis
In the short run, perfectly competitive firms make production decisions to maximize profit while taking the market price as given. Let's explore how these firms behave when they cannot change all inputs or immediately enter or exit the market.
In perfect competition, individual firms have no control over price. They are price takers because:
Each firm is so small relative to the total market that its production decisions have no noticeable effect on market price. One farm growing wheat cannot influence the global wheat price.
Products are homogeneous—buyers see no difference between sellers. If one firm tries to charge more, consumers simply buy from competitors selling at the market price.
All buyers and sellers have complete knowledge of market prices. Consumers know immediately if a firm charges above market price and will avoid that seller.
If any firm tries to charge above market price, new firms can enter instantly to undercut them. Competition keeps all firms at the same price.
Key Insight: Price takers accept the market price and decide only how much to produce, not what price to charge.
For a perfectly competitive firm, the demand curve is perfectly horizontal (elastic) at the market price. This creates a unique situation where:
Set by the market, constant for the firm
Additional revenue from selling one more unit = P
Revenue per unit sold = P
P = MR = AR = Demand
This equality is unique to perfect competition
Why? Since the firm can sell any quantity at the market price, each additional unit sold brings in revenue equal to the price. The firm doesn't need to lower price to sell more (unlike a monopolist), so MR stays constant and equal to price.
All firms, regardless of market structure, maximize profit by producing where Marginal Revenue (MR) = Marginal Cost (MC). This rule tells firms the optimal quantity to produce.
If MR > MC: The firm earns more revenue from selling one more unit than it costs to produce it. Profit increases by producing more.
If MR < MC: The cost of producing one more unit exceeds the revenue it generates. Profit decreases—the firm should reduce output.
If MR = MC: Profit is maximized. Producing more or less would reduce total profit.
For perfectly competitive firms:
P = MR = MC
Since MR equals price in perfect competition, firms produce where Price = MC
The firm breaks even (earns zero economic profit) when:
P = ATC
(Price = Average Total Cost)
At this point, total revenue exactly equals total cost. The firm covers all its costs (including opportunity costs) but makes no extra profit. It's indifferent between staying in business or exiting—there's no financial incentive either way.
The firm should temporarily shut down (stop producing) in the short run when:
P < AVC
(Price < Average Variable Cost)
If price falls below average variable cost, the firm loses less money by shutting down than by continuing to produce. When shut down, the firm still pays fixed costs but avoids variable costs. It's better to lose only fixed costs than to lose even more by operating.
A typical short-run cost curve graph for a perfectly competitive firm would display:
Shows price levels and various cost measures
Shows units of output produced
MC Curve (Marginal Cost): U-shaped, rising after a certain point. Intersects AVC and ATC at their minimum points.
ATC Curve (Average Total Cost): U-shaped, lies above AVC.
AVC Curve (Average Variable Cost): U-shaped, lies below ATC.
P = MR = AR = D: Horizontal line representing the market price the firm takes.
The profit-maximizing output is where the horizontal price line intersects the MC curve. If this occurs above ATC, the firm earns economic profit (shaded area). If below ATC but above AVC, the firm operates at a loss but continues producing. If below AVC, the firm shuts down.
In the long run, firms can adjust all inputs and freely enter or exit the market. This flexibility creates powerful forces that drive the market toward a specific equilibrium outcome.
The long-run equilibrium in perfect competition is characterized by zero economic profit for all firms. This happens through a natural adjustment process:
If existing firms are making economic profits (P > ATC), these profits act as a signal attracting new firms to enter the market.
Since there are no barriers to entry, new firms join the industry seeking profits. Market supply increases as more firms produce.
Increased supply shifts the market supply curve to the right, causing the equilibrium price to decline. All firms are price takers, so they all face the lower price.
As price falls, profit margins shrink. Entry continues until price equals ATC (P = ATC), meaning firms earn zero economic profit. At this point, there's no incentive for more firms to enter.
If firms face economic losses (P < ATC), some firms will exit the market. This reduces supply, causing price to rise. Firms continue to exit until the remaining firms break even (P = ATC).
Result: In the long run, market forces push toward zero economic profit equilibrium.
At long-run equilibrium, three conditions are met simultaneously:
P = MC (profit maximization)
P = ATC (zero economic profit)
MC = ATC (production at minimum ATC)
This means firms produce at the minimum point of their ATC curve—the most efficient scale of production. Each firm operates at its lowest possible average cost.
Perfect competition in the long run delivers two major benefits to consumers:
Since firms produce at the minimum point of their ATC curve, production occurs at the lowest possible average cost. This efficiency gets passed to consumers through lower prices.
Why it matters: Consumers pay the lowest price consistent with firms covering their costs. Resources are used as efficiently as possible.
Firms produce where P = MC, meaning the price consumers pay equals the marginal cost of production. This achieves allocative efficiency—the socially optimal level of output.
Why it matters: Society's resources are allocated to their most valued uses. The last unit produced provides value to consumers equal to its production cost.
Perfect Competition = Ideal Market Outcome
Long-run perfect competition achieves both productive efficiency (minimum cost) and allocative efficiency (P = MC), maximizing total economic welfare.
A typical long-run adjustment diagram would show two graphs side by side:
The diagram illustrates how market-level changes (entry/exit shifting supply) affect the price individual firms face, ultimately reaching long-run equilibrium where P = minimum ATC.
You've completed Chapter 5 on market structures and perfect competition. Now explore how firms behave in less competitive markets.
Next: Chapter 6 - Demand Differences