How Firm Behave under Perfect Competition in the Short and Long Run

Perfect competition is a market structure characterized by a large number of buyers and sellers of essentially the same product. The firms produce a standardized product and there is a free entry and exit of these firms to and from the industry. The firm in a purely competitive market faces a perfectly elastic demand curve at the price determined by equilibrium in the market (Hirschey 379).

The firm in a short-run supply curve is the short-run marginal cost curve above the minimum point on the average variable cost curve, also known as the shutdown point. In the short run, firms behave differently than in the long-run. It is important to remember that a profit-maximizing firm always produces where marginal cost is equal to marginal revenue. When a firm is small relative to the market, and its product is indistinguishable from the product of other firms, the firm views itself as having no influence on the market price. In perfect competition, if a firm wants to sell any of its output it must sell at the market price, which is referred to as a price taker.

When a market is in equilibrium, the purely competitive firm can sell as much of the product as it wishes. From the firm’s viewpoint, this means it faces a perfectly elastic demand curve. As demand increases, the firm will move up its marginal cost curve. Another increase in market demand would cause the firm to move further up its marginal cost curve. The higher price would lead it to supply more output. However, by doing this the firm is suffering a loss which means factors could earn more in some other use. The opportunity costs are not being met. However, since this is the short run, that means that some factors are fixed. The fixed factors represent the fixed costs and cannot be removed. Fixed costs must be paid in the short run even if the production ceases. We find that the firm will be covering its total variable costs and losing an amount equal to its total fixed costs. It must pay these fixed costs even if it decides to shut down. However, a firm is better off shutting down at this point and only incurring its fixed cost (Heath 825).

Long-run adjustments to changes in market demand are dependent on the cost characteristics of the industry under consideration. Since entry is easy, firms will enter as long as profits are present. If all firms have the same costs and nothing happens to change these costs equilibrium will be restored when the price has been reduced to the original equilibrium price. As a result, economic profits brought about by an increase in demand will bring about new entry. When firms are in the market for the long-run, they have time to adjust to the fixed factors. When a firm is making zero profits and demand is decreased, the industry is out of equilibrium. Just as the profits were the signal for firms to enter, losses are the signal for firms to exit the industry. Entrepreneurs will move their factors to the production of other commodities in order to earn their opportunity cost elsewhere (assuming a perfect competition). Assuming perfect knowledge, the entrepreneurs will know where they can earn their opportunity cost (Cohn 391).

As firms leave the industry, the short-run market supply curve will shift, because it is now derived by adding up fewer firms’ marginal cost curves. Firms will leave the industry until those remaining firms have zero economic profits. This means the equilibrium is restored when the market supply curve shifts so as to restore a price of industry output. As firms enter the industry or exited the industry the prices of the factors of production did not change and as a result the cost curves didn’t change. When this happens, the industry is referred to as a constant cost industry. In a constant cost industry, the cost of the production input does not increase.

This means that a short-run response to a contraction in demand was a decrease in price. An expansion in demand produced a short-run increase in price. The market adjustment, however, returned price to its original level with fewer firms in the case of the contraction and additional firms in the case of the expansion. The long-run supply curve in a constant cost industry is therefore seen to be perfectly elastic, even though the short-run supply curve has a positive slope.

References:

Cohn, Elchanan. “A reexamination of the price effects of a unit commodity tax
under perfect competition and monopoly.” Public Finance Quarterly, (1996): July, pp. 391-396.

Heath, Will Carrington. “Perfect competition and the transformation of economics.” Southern Economic Journal, (1997): January, pp. 825.

Hirschey, Mark. “Managerial Economics.” 10th edition, (2003): pp. 281-314, 379.