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.

Answer 1

1)

A perfectly competitive market has following requirements • • Identical products Large number of buyers and sellers No single seller can manage to charge a higher than market price. Firms are price taker Firms face perfectly elastic demand curve. This means they need to supply whatever quantity is demanded at the given price Firms do not earn any economic profit in the long run Firms and consumers have perfect information and perfect mobility. Price is determined by market demand and supply and the same has to be adopted by each firm Each firm is very small in terms of market share relative to the market •

2)

A company in a perfectly competitive market may be earning a negative economic profit so that the price it faces lies between ATC and AVC. It will continue to produce if the price is greater than AVC even when price lies below ATC Now the only consideration is the AVC. If P > AVC, it will continue to produce as it is able to earn enough to cover its variable cost. If P< AVC, it will stop production as it is not able to earn enough to cover its variable cost. Hence it is wise not to produce and earn a lower loss This implies that a firm will continue to operate in the short run as long as the price is greater than the average variable cost. But when the price falls below the AVC, firm will stop production in the short run. It will stay in the short run but will leave in the long run to avoid any fixed cost.