BUSS1040 · Economics For Business Decision Making
Perfect Competition
Topic 5 puts the firm into a market where it is a price-taker (P = MR) and profit-maximises by setting P = MC on the rising part of marginal cost. The two examinable decision rules read straight off the Topic-2 cost family: the short-run shut-down rule (produce only if P ≥ AVC) and the long-run exit rule (exit if P < ATC), with free entry/exit driving long-run economic profit to zero at P = min ATC. It is examined as calculation (find q, profit, and the SR/LR decision) plus the recurring 'cover AVC but not ATC' MCQ.
What this chapter covers
- 011. The price-taker: a single firm faces a horizontal demand, so P = MR
- 022. Profit-max rule: produce where P = MC on the upward-sloping part of MC
- 033. The firm's supply curve = MC above the minimum of AVC
- 044. Short-run shut-down rule: produce if P ≥ AVC, shut down if P < AVC
- 055. Long-run exit rule: exit if P < ATC (revenue cannot cover total cost)
- 066. Profit = TR − TC = q(P − ATC); the profit/loss box on the diagram
- 077. Long-run equilibrium: free entry/exit drives economic profit to zero, P = min ATC
- 088. Positive profit ⇒ not yet in long-run equilibrium (entry will erode it)
Perfect competition: output, profit and the SR/LR decision
- 2 marksProfit-max where P = MC: 36 = 4 + 4q ⇒ 4q = 32 ⇒ q = 8.
- 2 marksCheck the shut-down rule: AVC at q = 8 = 4 + 2(8) = 20. Since P = 36 ≥ AVC = 20, the firm covers its variable cost and produces in the short run.
- 2 marksProfit = TR − TC = 36×8 − (64 + 4×8 + 2×64) = 288 − (64 + 32 + 128) = 288 − 224 = +64.
- 1 markEconomic profit is positive (+$64), so the industry is NOT in long-run equilibrium: new firms will enter, raising supply and lowering price until profit is driven to zero.
Key terms
- Price-taker
- A firm so small relative to the market that it cannot influence the price; it faces a horizontal demand curve at the market price, so price equals marginal revenue (P = MR).
- Profit-maximising rule (P = MC)
- A competitive firm maximises profit by producing the quantity where price equals marginal cost on the upward-sloping part of MC. Because P = MR, this is just the general MR = MC rule for a price-taker.
- Firm's supply curve
- The portion of the firm's marginal cost curve that lies above the minimum of average variable cost. Below AVC-min the firm shuts down, so MC there is not part of its supply.
- Shut-down rule (short run)
- Produce if P ≥ AVC; shut down (q = 0) if P < AVC. In the short run fixed cost is paid regardless, so the firm only needs the price to cover variable cost to be worth operating.
- Exit rule (long run)
- Exit the industry if P < ATC, because in the long run all costs are avoidable and a firm that cannot cover total cost makes a loss it can escape by leaving.
- Long-run zero-profit equilibrium
- With free entry and exit, economic profit is competed away to zero in the long run, leaving P = minimum ATC. Positive economic profit attracts entry; losses cause exit, until profit returns to zero.
Perfect Competition FAQ
Why is the rule P = MC rather than MR = MC here?
It is the same rule. Every firm maximises profit at MR = MC. A perfectly competitive firm is a price-taker, so each extra unit sells at the market price — meaning marginal revenue equals price (P = MR). Substituting P for MR turns MR = MC into P = MC. So 'P = MC' is just the general profit-max condition specialised to a price-taker; for a monopolist (Topic 6) MR < P, so the two diverge.
What is the difference between the shut-down decision and the exit decision?
Both compare price to a cost curve, but to different ones and over different horizons. In the SHORT run, fixed cost is sunk (paid whether or not you produce), so you only need to cover variable cost: produce if P ≥ AVC, shut down if P < AVC. In the LONG run, all costs are avoidable, so you must cover total cost: stay in if P ≥ ATC, exit if P < ATC. The tricky in-between case — P covers AVC but not ATC — means produce now (better than shutting down) but plan to exit if the price persists.
If a firm covers AVC but makes a loss, should it produce?
Yes, in the short run. If P ≥ AVC the revenue covers all variable cost plus some of the fixed cost, so producing loses less money than shutting down (where you still pay all of fixed cost). The firm should keep producing in the short run but, if the price stays below ATC, exit in the long run. This 'TR < TC but P > AVC ⇒ stay in SR, exit in LR' case is a very common MCQ.
How is Topic 5 examined?
As calculation plus the long-run-equilibrium logic. Typically: given a cost function and a price, set P = MC for output, test AVC and ATC for the SR/LR decision, and compute profit = q(P − ATC). The conceptual follow-up is almost always about entry/exit: positive economic profit ⇒ entry coming (not long-run equilibrium); P = min ATC ⇒ zero profit ⇒ long-run equilibrium.
Exam move
Make a three-step template for every perfect-competition question: (1) output from P = MC, (2) decision from the cost tests — AVC for short-run shut-down, ATC for long-run exit, in that order — and (3) profit = q(P − ATC). Re-use the Topic-2 cost diagram: mark AVC-min (shut-down point) and ATC-min (break-even / long-run price) and you can answer most MCQs by inspection. Rehearse the entry/exit narrative explicitly, because the marks for 'is this long-run equilibrium?' come from saying that positive profit invites entry until P falls to min ATC and profit is zero. The standard trap to drill is the 'covers AVC but loses money' case — produce in the SR, exit in the LR.
