BackShort Run and Long Run Entry/Exit Rules in Perfect Competition
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Short Run and Long Run Entry/Exit Rules in Perfect Competition
Introduction
This guide summarizes the key rules for firm behavior in perfectly competitive markets, focusing on the distinction between short run and long run decisions regarding production, entry, and exit. Understanding these rules is essential for analyzing firm profitability and market dynamics.
Short Run Decisions
Short Run: Produce or Shut Down?
In the short run, firms must decide whether to continue producing or temporarily shut down. The decision depends on the relationship between price and average variable cost (AVC).
Produce if P ≥ AVC: The firm covers its variable costs and contributes to fixed costs, so it should continue operating.
Shut down if P < AVC: The firm cannot cover its variable costs and will minimize losses by shutting down temporarily.
Key Point: Average Total Cost (ATC) does NOT matter for short-run shutdown decisions; only AVC matters.
Formula:
Produce if
Shut down if
Example: If a firm's AVC is $10, the firm should continue producing in the short run.
Long Run Decisions
Long Run: Enter or Exit the Market?
In the long run, all costs are variable, and firms can freely enter or exit the market. The decision depends on the relationship between price and average total cost (ATC).
Enter if P > ATC: New firms will enter the market if they can make a profit.
Exit if P < ATC: Existing firms will exit the market if they are making losses.
Key Point: Average Variable Cost (AVC) does NOT matter in the long run, because all costs are variable and the distinction between fixed and variable costs disappears.
Formula:
Enter if
Exit if
Example: If a firm's ATC is $15, new firms will be attracted to enter the market.
Profit Maximization Condition
Where to Produce?
Regardless of the time frame, firms maximize profit by producing the quantity where marginal cost (MC) equals price (P).
Profit maximization rule:
Example: If the marginal cost of producing one more unit is $20, the firm is maximizing profit at that output level.
Summary Table: Short Run vs. Long Run Rules
Decision | Short Run Rule | Long Run Rule |
|---|---|---|
Produce? | Produce if | Enter if |
Shut Down/Exit? | Shut down if | Exit if |
Profit Maximization | Produce where | |
Zero Economic Profit in the Long Run
In the long-run equilibrium of a perfectly competitive market, firms earn zero economic profit. This occurs because:
Entry of new firms (when ) drives prices down.
Exit of firms (when ) drives prices up.
Eventually, , and firms earn just enough to cover all costs, including opportunity costs.
Formula:
Example: If the market price, marginal cost, and average total cost are all $25$, firms earn zero economic profit in the long run.
Key Terms
Average Variable Cost (AVC): Total variable cost divided by output; relevant for short-run shutdown decisions.
Average Total Cost (ATC): Total cost divided by output; relevant for long-run entry/exit decisions.
Marginal Cost (MC): The increase in total cost from producing one more unit of output.
Economic Profit: Total revenue minus total cost, including opportunity costs.
Super Simple Summary
Short run (produce vs shut down):
Produce if
Shut down if
Long run (enter or exit market):
Enter if
Exit if
Always (short + long):
Profit maximization happens where
