AQA Specification focus:
‘The formal diagrammatic analysis of the perfectly competitive model in the short and long run.’
In the short run, perfectly competitive firms face fixed resources and may make profits or losses. Their outcomes depend on cost structures, market price, and output decisions.
Short-Run Framework in Perfect Competition
In perfect competition, firms operate under assumptions of many buyers and sellers, identical products, perfect knowledge, and free entry/exit. In the short run, at least one factor of production is fixed, so firms cannot fully adjust all inputs. This creates the context in which profits or losses emerge depending on the relationship between costs and revenues.
Key Revenue and Cost Concepts
Total Revenue (TR): The total income a firm receives from selling output, calculated as price × quantity sold.
Average Revenue (AR): Revenue per unit of output, calculated as TR ÷ quantity. In perfect competition, AR = Price (P).
Marginal Revenue (MR): The additional revenue from selling one extra unit of output. In perfect competition, MR = P because the firm is a price taker.
These concepts interact with cost curves, particularly Average Total Cost (ATC) and Marginal Cost (MC), to determine outcomes.
The Profit-Maximising Rule
Firms maximise profit when Marginal Cost = Marginal Revenue (MC = MR). If MC < MR, producing more increases profit. If MC > MR, reducing output avoids losses.
EQUATION
Profit (π) = Total Revenue (TR) – Total Cost (TC)
TR = Price × Quantity
TC = ATC × Quantity
π > 0 → Abnormal profit
π = 0 → Normal profit
π < 0 → Loss
This rule provides the analytical basis for diagrammatic outcomes in the short run.
Short-Run Profit and Loss Outcomes
In the short run, perfectly competitive firms may experience profits or losses depending on their cost structures and the market price.
1. Abnormal Profit (Supernormal Profit)
If the market price (P) is above the firm’s Average Total Cost (ATC) at the profit-maximising output (where MC = MR), the firm earns abnormal profit.
AR = MR = P > ATC
Total revenue exceeds total cost
Firms benefit from high demand or low costs
This profit is only sustainable in the short run because free market entry erodes it in the long run.
2. Normal Profit
Normal profit occurs when AR = ATC at the output level where MC = MR. Here, the firm covers all explicit and implicit costs, including opportunity cost of capital.
Firm remains in the industry as there is no incentive to exit
Revenue is just enough to sustain operations
Normal profit is considered the minimum return necessary to keep resources in their current use
3. Losses
If AR = P < ATC, firms make losses. However, the decision to continue or shut down depends on Average Variable Cost (AVC).
Shutdown Point: The level of output and price where AR = AVC. Below this point, firms shut down in the short run as they cannot cover variable costs.
If the price falls below the Average Variable Cost (AVC), the firm cannot cover its variable costs and should shut down in the short run.
If P > AVC but P < ATC → firm covers variable costs and part of fixed costs, so it continues operating in the short run.
If P < AVC → firm shuts down immediately as it cannot cover running costs.
4. Short-Run Industry Implications
At the industry level:
Some firms make abnormal profits, some break even, and others incur losses.
The market supply curve reflects the summation of individual firms’ MC curves above AVC.
Market price is determined by the interaction of industry supply and demand.
Diagrammatic Representation
Although diagrams are essential, here the specification requires an understanding of the formal model. The typical diagram includes:
U-shaped ATC and AVC curves due to diminishing returns.
Horizontal AR = MR line reflecting price-taking behaviour.
The MC curve cutting ATC at its minimum point, showing the profit-maximising equilibrium where MC = MR.
Shaded areas representing abnormal profit or loss depending on P relative to ATC.
Efficiency Considerations in the Short Run
In the short run, perfectly competitive firms do not necessarily achieve productive or allocative efficiency.
If abnormal profits exist, P > MC, meaning resources are not perfectly allocated.
If losses occur but firms stay in the market, inefficiencies persist until long-run adjustments restore equilibrium.
Key Points for Students
Perfect competition assumes firms are price takers.
Profit or loss depends on the relationship between market price and ATC at the equilibrium output (MC = MR).
Firms may earn abnormal profits, normal profits, or losses in the short run.
The shutdown point is critical in determining whether firms continue operating under losses.
Short-run outcomes drive the adjustments that lead to long-run equilibrium where only normal profit exists.
FAQ
In the short run, entry into the market is not possible due to fixed factors of production. This allows existing firms to earn abnormal profits if the market price is above average total cost.
In the long run, new firms are attracted by these profits. Their entry increases supply, lowering the market price until only normal profits remain.
Fixed costs, such as rent, remain constant regardless of output, while variable costs change with production levels.
If firms can cover variable costs, they continue operating even if they make losses.
If firms cannot cover variable costs, they shut down immediately.
This distinction is crucial to understanding why some loss-making firms stay open in the short run.
The U-shape of average total cost (ATC) and average variable cost (AVC) reflects diminishing returns in the short run.
A lower ATC relative to price leads to abnormal profits.
A higher ATC relative to price leads to losses.
The position of these curves directly determines whether a firm earns profit, breaks even, or shuts down.
The MC curve shows the additional cost of producing one more unit of output. Firms maximise profit where MC = MR.
In the short run, the portion of the MC curve above the AVC curve represents the firm's supply curve. This highlights how MC both guides profit-maximisation and influences supply decisions.
In the short run, some firms remain in the market even when making losses if they cover variable costs. Industry supply therefore stays higher than if all loss-making firms exited.
This situation can create pressure on prices to remain at a level where only the most efficient firms can survive, setting the stage for long-run adjustment.
Practice Questions
Explain what is meant by the shutdown point for a firm operating in perfect competition in the short run. (2 marks)
1 mark for stating that the shutdown point occurs when price (P) = average variable cost (AVC).
1 mark for explaining that below this point, a firm cannot cover its variable costs and will cease production.
Using a diagram, explain how a perfectly competitive firm may make abnormal profit, normal profit, or a loss in the short run. (6 marks)
Up to 2 marks for a correctly drawn and clearly labelled diagram(s) showing AR=MR, MC, ATC, and AVC curves.
1 mark for explaining abnormal profit: occurs when P > ATC at the profit-maximising output (MC = MR).
1 mark for explaining normal profit: occurs when P = ATC at the profit-maximising output.
1 mark for explaining losses: occur when P < ATC but P > AVC, meaning the firm covers variable costs but not all fixed costs.
1 mark for identifying that if P < AVC, the firm shuts down in the short run.
