IBonomicsPerfect Competition – Short-Run LossHL
MicroeconomicsA diagram illustrating a perfectly competitive firm's short-run position where price equals average revenue but is below average total cost, resulting in a loss.
Curves and elements
- ar mr
- AR = MR: Perfectly elastic demand curve faced by a price-taking firm.
- mc
- Marginal Cost (MC): The cost of producing one more unit — intersects MR at the profit-maximizing output level.
- avc
- Average Variable Cost (AVC): The firm's variable cost per unit. The firm stays open as long as price > AVC.
- q
- Quantity (Q): The profit-maximizing output where MC = MR.
- p
- Price (P): Set by the market; the firm takes this as given.
- shutdown condition
- Shutdown Rule: The firm continues to operate in the short run if P ≥ AVC, even if it incurs losses.
Key explanations
- 1
In perfect competition, firms are price takers and face a perfectly elastic demand curve (AR = MR).
- 2
The firm maximizes profit (or minimizes loss) where marginal cost (MC) intersects marginal revenue (MR).
- 3
In this diagram, the firm produces at quantity Q, where MC = MR, and sells at price P.
- 4
Since the average variable cost (AVC) is below price, the firm continues to operate in the short run to cover its variable costs.
- 5
However, the average total cost (ATC) is above the price, so the firm is making a loss in the short run.
Example exam question
Using a diagram, explain how a perfectly competitive firm can continue to operate in the short run even while making a loss.
Show example answer
In perfect competition, firms are price takers, so the price is determined by the market and equals AR and MR. The firm chooses output where MC = MR. In this case, although price P is below average total cost (ATC), it is still above average variable cost (AVC). This means the firm is covering all its variable costs and part of its fixed costs, making it rational to stay in business in the short run. If price were to fall below AVC, the firm would shut down immediately.
