Question

Chapter 12

1) What are the requirements for perfect competition?

2) Define the shutdown point. Explain why the firm shuts down in the short run if the price falls below this point.

3) In the long run, perfectly competitive firms cannot make an economic profit. Why?

4) Describe how economic losses are eliminated in a perfectly competitive industry.

Answer 1

Ans) 1) Perfectly competitive market is where there are many sellers selling homogeneous products. Both buyers and sellers in this market are price takers. Here, prices are decided by the forces of demand and supply. The price is also equal to Marginal revenue and also acts as demand curve for the Perfectly competitive firm.

General characteristics of Perfectly competitive market ÷

• Many sellers.
• Many buyers.
• Homogeneous products.
• Both buyers and sellers are price takers.

2) Perfectly competitive firm produces the quantity where MR and MC curve intersect. If price is above ATC, firms earn positive economic profit. If price is equal to ATC, firms earn zero economic profit. If price is below ATC, firms earn negative economic profit. But in this case, firms do not shutdown immediately. They see whether the price is above or below AVC. If price is above AVC, they continue producing as it will minimise the loss by enabling firms to recover some part of fixed cost.

If price is even below AVC, firms will shutdown because producing further will bring additional loss. How? Assuming that firms will have to pay fixed cost if it shutdown. It will lose AB if it shutdown but if it continues to produce, it will lose AC.

(ATC - AVC = AFC)

ATC

3) In long run, Perfectly competitive firms make zero economic profit. Because if in short run, they are earning positive economic profit, more firms will enter the market, which will increase the supply and reduce the price.

If firms are earning negative economic profit in short run, some firms will exit the market, which will reduce the supply and price will increase.

In either case, price will settle at minimum of ATC, where firms will enter zero economic profit.

4) Economic losses are eliminated by some firms existing the market. Which reduces the supply and increases the price.