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Posted on April 13th, 2014, by

Generally, the perfectly competitive market exists when each participant is the “price taker”, and no participant impacts a price of goods it purchases or sells (Sloman 2005, p. 98-99). This paper is meant to discuss how a firm in the perfectly competitive market can make a loss in the short run or long run, and yet remain in the market. Thesis statement: if firm’s average variable expenses are less than marginal revenue at profit maximizing degree of output, an organization will not close in the short-run. Additionally, firms might remain in business for a time in spite of being not too profitable. This situation is possible predominantly for companies with high fixed capital expenses.

Short-run Losses and Shut-down Decisions

Once the company’s standard total cost curl is above the marginal revenue curl at profit maximizing degree of the output, a firm is suffering losses and will have to think about whether to stop own operations (BVTpublishing). In making this decision, an organization will take into consideration the standard variable costs rather than average total costs. The dissimilarity among the company’s average total costs and average variable costs is the average fixed costs (CSUN). A company has to pay fixed expenses (for instance, the purchases of plant space and tools), regardless of whether it creates any output. Thus, the company’s fixed costs are considered sunken expenses and will not have bearing on whether the company makes a decision to stop its work. Therefore, a company will concentrate on average variable costs in determining whether to close.

If the company’s average variable expenses are less than the marginal revenue at profit maximizing degree of output, a company will not shut down in the short-run. The organization is better off continuing the operations as it may cover own variable costs and utilize any remaining revenues to pay off certain fixed costs. That fact that the company is capable to pay the variable costs is all that is important as in the short-run, the company’s fixed costs are depressed; a firm should pay the fixed expenses regardless of whether or not it makes a decision to close. Naturally, the company will not carry on incurring losses for an indefinite period. In the long-run, a company, which is suffering losses, will have to either close or lessen the fixed costs by altering the fixed aspects of manufacture in the way, which makes the company’s operations money-making.

The case where the company is suffering short-run losses but carries on operating is illustrated in Figure 1 (a). At market price, P1, company’s profit maximizing amount is Q1. At this amount, company’s standard total cost curve is above the marginal revenue curve, that is the flat, dashed line indicating price degree, P1. The company’s average variable cost curve, nevertheless, lies below the marginal revenue curve, asserting that a company is capable to cover the variable costs. The losses from the producing amount Q1 at price P1 are given by an area of the shaded four-sided figure, abcd. In spite of these losses, a firm will make a decision not to stop working in short-run as it obtains enough profits to pay for the variable costs. The opposite situation is illustrated graphically in Figure 1 (b) (Cliffsnotes).

Long-run Losses and Shut-down Decisions

The entry and exit of companies, which is totally possible in the long-run, will finally, cause each company’s economic earnings to fall to zero. Thus, in the long-run every organization obtains normal profits. If some companies are obtaining the positive economic earnings in the short-run, in long-run novel companies will enter market and the augmented competition will lessen all companies’ economic earnings to zero. Firms, which are suffering losses in the short-run, will be forced to either make some alterations in the fixed aspects of manufacture in the long-run or select to leave the industry in the long-run (Rittenberg & Tregarthen 2009). A perfectly competitive market accomplishes the long-run equilibrium once all companies are obtaining zero economic earnings and once the amount of companies in the market is not altering.

Reduction of long-run standard total cost: in the long-run, perfectly competitive company may correct the amount it utilizes of all factor inputs, counting those, which are fixed in a short-run. For example, in the long-run, a company may adjust the size of the factory. In making certain adjustments, the organization will seek to lessen own long-run standard total cost. In case if, in a short-run, a company is working below the smallest proficient scale and noticing economies of scale, in a long-run it may adjust its usage of aspect inputs so as to augment the output to the smallest proficient scale degree (Cliffsnotes).

On the other hand, if the organization is noticing the diseconomies of scale as short-run degree of output exceeds the smallest proficient scale, in the long-run the company may adjust its usage of factor inputs so as to lessen the its output to the smallest proficient scale degree. Therefore, in the long-run the company will be working at the smallest point of the long-run average total cost curve (Cliffsnotes). Long-run equilibrium for a firm in a perfectly competitive market is showed in Figure 2.

The income maximizing degree of output, where the marginal price equals the marginal revenue, results in the equilibrium amount of Q units of output. As the company’s average total expenses per unit equal company’s marginal income per one unit, the organization is obtaining zero economic proceeds. Additionally, the company is demonstrated to be producing at the smallest point of the long-run standard total cost curve, at the smallest proficient scale degree of output (Cliffsnotes).

Conclusion

Thus, many firms can remain in the industry for a time even though they are not profitable. It is possible predominantly for companies with the high fixed capital expenses. There is the critical zero income point below which the long run cost cannot remain if companies are to carry on working. So, basically, long run price has to cover out of pocket expenses, for instance, materials, work force, equipment, taxes, together with the opportunity expenses, for example, competitive return on owner’s invested funds.

If firm’s average variable expenses are less than marginal revenue at profit maximizing degree of output, an organization will not close in the short-run. In a long run price will tend toward the decisive point where firms only cover the total competitive expenses. Below the critical price, companies would leave the market till price returns to long run standard cost. Above the price novel organizations would enter the market, in so doing shifting the market price back down to long run equilibrium cost where all the competitive costs are only covered.

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