A perfectly competitive firm will shut down in the short run when

Imagine you own a farm and cannot influence the market price of the apples you sell on your farm. You charge the price for your apples the same as the other farmers. If that is the case, your farm is considered to be a perfectly competitive firm.

What is the demand for a perfectly competitive firm? How should you price your products if you own a perfectly competitive firm? What about the total output that you should produce?

Read on to find out the answer to these questions and all there is to know about perfectly competitive firms.

The Demand Curve Perceived by a Perfectly Competitive Firm

To understand the demand curve perceived by a perfectly competitive firm, you need to keep a couple of assumptions in mind. In a perfectly competitive market, many firms are selling the same product.

As there are many firms selling the same product, if one firm decided to increase the price, it would lose all of its customers. On the other hand, decreasing the price isn't possible either. That's due to the cost that firms face if they lower the price further. Hence, firms in a perfectly competitive market are price-takers.

A perfectly competitive firm is a price-taker, which means that it isn't capable of influencing the market price.

How is the price set if the firm doesn't set the price?

In a competitive industry, each company sells just a tiny portion of the total production of the industry as a whole; as such, the amount of output that a company chooses to sell will have no impact on the price that the product is selling for on the market.

The equilibrium between the demand and supply of the industry sets the price that firms take.

The company that takes prices as given is aware that its choice of manufacturing output will have no impact on the price of the product.

Because the firm is a price-taker, the demand curve faced by a perfectly competitive firm is a horizontal line.

As there are many farmers and agricultural companies involved in the agricultural market, agriculture is considered to be one of the closest examples of a perfectly competitive market.

The amount of wheat that a company chooses to plant does not affect the market price of wheat. Instead, the company takes the price from the market.

Fig 1. - Demand for a perfectly competitive firm

Figure 1 above shows the wheat demand among agriculturalists, corresponding to a price of $P1 per bushel of wheat. The quantity of wheat a farmer can sell is shown along the horizontal axis, while the price is represented along the vertical axis.

Fig 2. - Perfectly competitive firm and industry

Figure 2 above shows how the price $P1 is established by the interaction of demand and supply in the agricultural market. On the right-hand side, you have the demand and supply in the industry, which sets the price at P1 and equilibrium quantity at Q1. That is the price that the perfectly competitive firms will have to charge their customers.

The Marginal Revenue Curve Faced by a Perfectly Competitive Firm

Before we dive into the marginal revenue faced by a perfectly competitive firm, let's discuss the concept of marginal revenue.

A firm's marginal revenue is the additional revenue received by the company from an additional unit of production.

If a company increased the production of its goods from 50 units to 51 and the revenues increased from $1,000 to $1,010. The marginal revenue of the 51st item is $10, as the new item produced increased the firm's revenue by $10.

If you want to learn more about Marginal Revenue, check out our explanation!

The marginal revenue of the firm increases and decreases over time. However, in a perfectly competitive market, the marginal revenue that a firm incurs is constant. Why is that?

This is because the market determines the price level at which firms sell, and businesses do not have control over the pricing. In other words, perfectly competitive firms take their price, which is set at the industry's intersection of demand and supply.

So if the price is set, regardless of how many units the firm sells, the marginal revenue will not change. If the price set is 4$, the marginal revenue will remain the same if the firm increases its sales from 50 to 51 units or from 100 to 101.

This means that the marginal revenue of a perfectly competitive firm is equal to the demand curve of a perfectly competitive firm.

It is also important to note that as the marginal revenue increases by the same amount as the price the company charges, the firm's total revenue also increases by the same amount. As the total revenue increases by the same amount that the marginal revenue increases, the average revenue of a firm is equal to the marginal revenue.

Therefore, the marginal revenue faced by a perfectly competitive firm is equal to the demand curve of the firm and the average revenue of the firm.

Short-Run Supply Curve for a Perfectly Competitive Firm

What does a short-run supply curve for a perfectly competitive firm reveal? It reveals how much a firm is willing to produce at each price level during the short run.

A firm that is in a perfectly competitive market will increase the output up to the point where the price equals marginal cost, and the firm will shut down its production if the price falls below the marginal cost.

In perfect competition short-run supply curve is the marginal cost curve just above the average variable cost, but below the price.

Short-run marginal cost is the additional cost incurred by a firm from raising its production by an additional unit.

The short-run average cost is the total cost per unit for a firm.

Short-run average variable cost is the average variable cost per unit a firm faces.

Fig 3. - Supply of a perfectly competitive firm

Figure 3 above shows the supply curve of a perfectly competitive firm. In the short run, the firm will choose to produce when the marginal cost lies above the average variable cost. If the price falls below the average variable cost, the firm will shut down production. In the long run, the firm will choose to supply when the marginal cost is higher than the average total cost.

Profit maximization

Fig 4. - Profit maximization of a perfectly competitive firm

Figure 4 above shows the profit maximization of a perfectly competitive firm.

To maximize profit, a short-run perfectly competitive firm will choose the profit maximization point where marginal cost equals marginal revenue. That's because when marginal revenue is higher than marginal cost, the firm can increase revenue by increasing output.

On the other hand, when marginal cost is higher than marginal revenue, the firm incurs a loss. Therefore, the firm will not produce beyond the point where marginal cost equals marginal revenue.

As the marginal revenue equals the price and average revenue for a perfectly competitive firm, the firm chooses to supply at the point where marginal cost equals the price of a good.

When determining whether or not to manufacture, the company evaluates the price it obtains for the unit compared to the average variable costs it must bear to create the typical unit.

The company would be better off ceasing manufacturing entirely if the price needs to be higher to cover the average variable costs.

If circumstances improve to the point where the market price is higher than the average variable cost, the company may decide to reopen at some point in the future.

Perfectly Competitive Firm Graph

After considering the demand and supply of a perfectly competitive firm, it is time to have a look at the perfectly competitive firm graph.

Fig 5. - Perfectly competitive firm graph

Figure 5 above shows the graph of a perfectly competitive firm. Notice that the price that a firm charges is not decided by the firm but is rather set in the industry’s market.

The price of a perfectly competitive firm is equal to the marginal revenue and the average revenue of the firm.

To maximize its profit, the firm produces a quantity where marginal cost is equal to marginal revenue, which is the price that the firm faces. In the figure above, the firm decides to produce Qm amount of output at the price Pm.

The firm has no incentive to produce at any point where marginal cost is less than marginal revenue, as it can increase its revenue by increasing its total output. On the other hand, the firm has no incentive to produce at any point where marginal cost is above marginal revenue, as it can reduce the cost it incurs by lowering output.

Finally, a perfectly competitive firm will stop its production if the marginal revenue, or price, is below the average variable cost, as the cost prevents the firm from keeping production going.

Perfectly Competitive Firm Examples

There are no real-life examples of a perfectly competitive firm; however, there are examples of firms close to being perfectly competitive.

A company that operates at optimal levels of competition is known as a price taker because it is obligated to sell its products at the price that has been determined to be the market equilibrium.

Suppose a company that is perfectly competitive tries to charge even a little bit more than the price that is already being offered on the market. In that case, the company will be unable to generate any sales.

Additionally, a perfectly competitive firm sells products that are identical to the products offered by its main competitors. However, many real-life firms attempt to differentiate their products to gain more market share.

One example of perfectly competitive firms or businesses is small crop farmers. The typical farmer's market is the closest representation of perfect competition that can be found in real life. The pricing of the practically identical items that small farmers offer is equal.

The entry and exit of farmers is basically free, and it does not affect the price which is set in the agricultural market.

Perfectly Competitive Firm - Key takeaways

• A perfectly competitive firm is a price-taker, which means that it isn't capable of influencing the market price.
• The demand of a perfectly competitive firm is equal to the price.
• The marginal revenue of a perfectly competitive is equal to the demand curve of a perfectly competitive firm.
• In perfect competition short-run supply curve is the marginal cost curve just above the average variable cost, but below the price.

When should a perfectly competitive firm shut down in the short run?

What happens to a perfectly competitive firm in the short run?

What is the shutdown condition in the short run?

When a competitive firm shuts down in the short run it will make a N?