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Economics · Ch 10 — The Theory of the Firm under Perfect Competition

Condition 3

10.3.3

Condition 3

4.3.3 Condition 3

The third condition for profit maximisation has two separate parts — one for the short run and one for the long run. Both parts deal with the same basic question: when should a firm shut down rather than produce? The answer depends on whether the market price covers the relevant cost.

Case 1: Short Run — Price must be greater than or equal to AVC

In the short run, a firm has fixed costs that it must pay regardless of whether it produces anything. The relevant cost for the shutdown decision is therefore the average variable cost (AVC), not the average total cost. The rule is: if the market price falls below the minimum of the AVC curve, the firm will produce zero output in the short run.

Why? Consider a firm producing at output level q1q_1 where the market price pp is lower than the AVC. The firm's total revenue at q1q_1 is:

TR=p×q1TR = p \times q_1

This is the area of the rectangle with height pp and width q1q_1 — call it rectangle OpAq1OpAq_1 in the standard diagram.

The firm's total variable cost at q1q_1 is:

TVC=AVC×q1TVC = AVC \times q_1

This is the area of the rectangle with height equal to the AVC at q1q_1 (call that height OEOE) and width Oq1Oq_1 — rectangle OEBq1OEBq_1.

Now, the firm's profit at q1q_1 is:

π(q1)=TR−(TVC+TFC)=(area of OpAq1)−(area of OEBq1)−TFC\pi(q_1) = TR - (TVC + TFC) = \text{(area of } OpAq_1) - \text{(area of } OEBq_1) - TFC

Since pp is less than AVC, the area of rectangle OpAq1OpAq_1 is strictly smaller than the area of rectangle OEBq1OEBq_1. So the difference (TR−TVC)(TR - TVC) is negative — the firm's revenue does not even cover its variable costs.

What happens if the firm produces zero output? Then TR=0TR = 0 and TVC=0TVC = 0, so profit is simply:

π(0)=−TFC\pi(0) = -TFC

The firm loses only its fixed costs. But at q1q_1, the loss is larger:

π(q1)=(area EBAp)−TFC\pi(q_1) = \text{(area } EBAp) - TFC

Since area EBApEBAp is positive (it is the amount by which TVC exceeds TR), the loss at q1q_1 is greater than the loss at zero output. The firm therefore chooses to shut down — produce zero — and exit the market in the short run.

Figure 4.4Price-AVC Relationship with Profit Maximisation (Short Run). A profit-maximising firm produces zero output in the short run when the market price, p, is less than the minimum of its AVC. If the firm's output level is q₁, total variable cost exceeds revenue by an amount equal to the area of rectangle pEBA.
Fig. 4.4 — Price-AVC Relationship with Profit Maximisation (Short Run). A profit-maximising firm produces zero output in the short run when the market price, p, is less than the minimum of its AVC. If the firm's output level is q₁, total variable cost exceeds revenue by an amount equal to the area of rectangle pEBA.

Drawn by us to help you understand the concept clearly, and verified to make sure it's accurate. For exams, practice from your textbook's own diagram.

This figure is the short-run shutdown diagram. It is a single plot with the market price pp on the vertical axis and the firm’s output qq on the horizontal axis. Three curves are drawn: the firm’s short-run marginal cost curve (SMCSMC), its short-run average cost curve (SACSAC), and its average variable cost curve (AVCAVC). The AVCAVC curve is U-shaped, and its lowest point is the minimum of AVCAVC. A horizontal line at price pp is drawn across the diagram. The key feature is that this price line lies below the minimum point of the AVCAVC curve — meaning the price is too low to cover even the variable cost per unit at any output level.

The physical idea is brutally simple: if the price does not cover the average variable cost at any output, every unit the firm produces adds more to cost than to revenue. Producing anything would make the loss larger than the loss from shutting down. The profit-maximising (or loss-minimising) choice in the short run is therefore to produce zero output. The firm shuts down.

The textbook uses this figure to derive the shutdown condition. For any output qq, the firm’s profit is π(q)=pq−TC(q)\pi(q) = pq - TC(q), where TC(q)=TFC+TVC(q)TC(q) = TFC + TVC(q). If the firm produces nothing, revenue is zero and total cost equals total fixed cost TFCTFC, so the loss is exactly TFCTFC. If the firm produces some q>0q > 0, the loss is TFC+TVC(q)−pqTFC + TVC(q) - pq. The firm is better off producing zero whenever the loss from producing is larger than TFCTFC, i.e. whenever TVC(q)−pq>0TVC(q) - pq > 0, or equivalently pq<TVC(q)pq < TVC(q). Dividing by qq gives the condition:

p<AVC(q)p < AVC(q)

If the market price is less than the average variable cost at every possible output, the firm produces nothing. The shutdown point is the minimum of the AVCAVC curve: the firm produces zero whenever pp is below that minimum.

The figure also illustrates the loss from producing at a specific output q1q_1 when pp is below AVCAVC. At q1q_1, total variable cost is AVC(q1)×q1AVC(q_1) \times q_1, which is the area of a rectangle with height AVC(q1)AVC(q_1) and width q1q_1. Total revenue is p×q1p \times q_1, a rectangle of height pp and width q1q_1. The difference — the amount by which variable cost exceeds revenue — is the rectangle with height AVC(q1)−pAVC(q_1) - p and width q1q_1. In the figure, this rectangle is labelled with vertices pp, EE, BB, AA (where pp and EE lie on the vertical axis — EE at the height of AVC(q1)AVC(q_1) — while BB lies on the AVCAVC curve at output q1q_1 and AA lies on the price line at q1q_1). The area of rectangle pEBApEBA equals [AVC(q1)−p]×q1[AVC(q_1) - p] \times q_1, which is exactly the extra loss beyond fixed cost that the firm would incur if it foolishly produced q1q_1 instead of shutting down.

Watch out

A common mistake is to think the firm shuts down only when price is below average total cost. That is wrong for the short run. The firm can tolerate a price below ATCATC as long as it covers AVCAVC, because fixed costs are sunk and must be paid regardless. The shutdown decision hinges on AVCAVC, not ATCATC. …

Watch out

A common mistake is to think that a firm should shut down whenever price is below average total cost. In the short run, the firm can still operate if price covers AVC, because fixed costs are sunk. The shutdown point is the minimum of the AVC curve, not the AC curve.

Case 2: Long Run — Price must be greater than or equal to AC

In the long run, there are no fixed costs — all costs are variable. The firm can choose its plant size and can exit the industry entirely without any sunk costs. The relevant cost for the shutdown decision is therefore the average cost (AC).

If the market price pp is lower than the long-run average cost at the chosen output level q1q_1, the firm will not produce. Consider Figure 4.5 (the long-run analogue of Figure 4.4). At output q1q_1, the firm's total revenue is:

TR=p×q1=area of rectangle OpAq1TR = p \times q_1 = \text{area of rectangle } OpAq_1

The firm's total cost is:

TC=AC×q1=area of rectangle OEBq1TC = AC \times q_1 = \text{area of rectangle } OEBq_1

Since p<ACp < AC, the area of rectangle OEBq1OEBq_1 is larger than the area of rectangle OpAq1OpAq_1. The firm incurs a loss at q1q_1.

In the long run, a firm that shuts down production has zero profit — it has no fixed costs to cover, and it can sell off its capital. So the loss from producing is worse than the zero profit from exiting. The firm will therefore exit the market.

Figure 4.5Price-AC Relationship with Profit Maximisation (Long Run). A profit-maximising firm produces zero output in the long run when the market price, p, is less than the minimum of its LRAC. If the firm's output level is q₁, total cost exceeds revenue by an amount equal to the area of rectangle pEBA.
Fig. 4.5 — Price-AC Relationship with Profit Maximisation (Long Run). A profit-maximising firm produces zero output in the long run when the market price, p, is less than the minimum of its LRAC. If the firm's output level is q₁, total cost exceeds revenue by an amount equal to the area of rectangle pEBA.

Drawn by us to help you understand the concept clearly, and verified to make sure it's accurate. For exams, practice from your textbook's own diagram.

The figure plots the long-run average cost (LRAC) and long-run marginal cost (LRMC) curves of a firm against the market price, with quantity on the horizontal axis and cost/revenue per unit on the vertical axis. The LRAC curve is U-shaped, showing that average cost first falls as output increases (economies of scale), reaches a minimum point, and then rises (diseconomies of scale). A horizontal line is drawn at the market price pp, which is less than the minimum point of the LRAC curve. The firm’s profit-maximising output in the short run would be where marginal cost equals price, but in the long run the firm cannot cover its average costs at any positive output level.

The key physical idea is that in the long run, a firm under perfect competition must earn at least zero economic profit to stay in the market. If the market price falls below the minimum of the LRAC curve, the firm cannot produce any positive output without making a loss. The figure shows this situation: at the output level q1q_1, the firm’s average cost is higher than the price. The total cost of producing q1q_1 units is the rectangle with height equal to the average cost at q1q_1 and width q1q_1, while total revenue is the rectangle with height pp and width q1q_1. The difference — the loss — is the rectangle labelled pEBApEBA in the textbook. Because the price is below the minimum LRAC, the firm’s best decision is to produce zero output in the long run, shutting down entirely.

Important

In the long run, a perfectly competitive firm will produce zero output if the market price is less than the minimum of its long-run average cost curve. This is the long-run shutdown condition.

The textbook uses this figure to derive the condition for long-run equilibrium of a firm under perfect competition. The central result is that in long-run equilibrium, the firm produces at the minimum point of its LRAC curve, where price equals both marginal cost and average cost. The formula for zero economic profit is:

p=LRMC=minimum LRACp = \text{LRMC} = \text{minimum LRAC}

Here, pp is the market price (which the firm takes as given), LRMC\text{LRMC} is long-run marginal cost, and minimum LRAC\text{minimum LRAC} is the lowest point on the long-run average cost curve. At this point, total revenue equals total cost, so economic profit is zero. The figure with price below minimum LRAC shows the opposite case — the firm cannot achieve this condition and must exit the industry. …

Important

The long-run condition is stricter than the short-run condition. In the short run, the firm can survive as long as price covers AVC. In the long run, price must cover AC — otherwise the firm exits.

Summary of the Two Cases

| Time Horizon | Condition for producing | Reason |

|--------------|------------------------|--------| …