Market Structures
Senior 5 · Economics
Market Structures
Lesson 2 of 5
45 min
Suppose a dry spell elsewhere in the region pushes up the price of Irish potatoes for one season, and growers in the Northern Province earn more than enough to cover all their costs. Next season, farmers who grew beans or maize turn some of their land over to potatoes. More potatoes reach the market, the price falls, and the extra earnings melt away. This lesson explains that sequence with diagrams: what a competitive firm earns in the short run, why it may keep producing at a loss, when it closes, and why, in the long run, abnormal profit cannot last.
Definition
Normal profit: the minimum profit needed to keep a firm in its present industry, equal to what the owner's money, time and skill could earn in their next best use. Economists count it as a cost, so it is included in ATC. When , the firm is earning normal profit.
Abnormal profit (supernormal or economic profit): profit above normal profit, earned when .
Subnormal profit (a loss): earned when , so the firm does not even make normal profit.
In the short run the number of firms is fixed, and each firm produces where . Whether it makes a profit depends on where the market price sits relative to its ATC curve. Profit per unit is , so total profit is a rectangle:
The price P1 is above the lowest point of ATC. At q1, each unit sells for P1 but costs C1 on average, so the shaded rectangle is abnormal profit.
The price P2 is below ATC at every output, so the firm makes a loss, the red rectangle . Yet P2 is above AVC: each unit sold earns more than its variable cost, and the surplus pays part of the fixed costs. Closing would not save the fixed costs (rent, loan repayments, the lease on the land), which must be paid anyway in the short run. So the firm loses less by staying open.
Definition
Break-even point: the output and price at which . The firm covers all its costs, including normal profit, and makes no abnormal profit or loss.
Shutdown point: the output and price at which . Below this price the firm cannot even cover its variable costs, and in the short run it loses less by stopping production and paying only its fixed costs.
The firm's short-run rule can now be stated in full:
| Price compared with costs | Short-run result | Short-run decision |
|---|---|---|
| minimum ATC | Abnormal profit | Produce where MR = MC |
| minimum ATC | Normal profit only (break-even) | Produce |
| minimum AVC minimum ATC | Loss smaller than fixed cost | Produce: losses are minimised |
| minimum AVC | Loss larger than fixed cost if it produces | Shut down |
At every price above the shutdown price, the firm chooses its output by reading across to the MC curve. So the firm's short-run supply curve is the part of its MC curve above minimum AVC, the thick purple section. Adding the supply curves of all firms horizontally gives the industry's short-run supply curve.
Worked example 1: profit, loss and the shutdown test
A firm in a competitive industry has fixed costs of Frw 20,000 a week (illustrative).
(a) The price is Frw 500 and the firm's best output is 800 units, where ATC is Frw 420.
(b) The price falls to Frw 250. The best output is now 500 units, where ATC = Frw 275 and AVC = Frw 235.
Check the fixed costs: AFC Frw, and Frw. If the firm shut down it would still pay these, a loss of Frw 20,000. Producing is better because : each unit contributes Frw towards fixed costs, Frw in total, and , the loss found above. Decision: keep producing in the short run.
Worked example 2: reading the four prices
A firm's lowest average variable cost is Frw 220 and its lowest average total cost is Frw 280 (illustrative). State what it earns and what it does at each price.
| Price (Frw) | Comparison | Result |
|---|---|---|
| 350 | above minimum ATC (280) | Abnormal profit; produce |
| 280 | equal to minimum ATC | Break-even: normal profit only |
| 250 | between 220 and 280 | Loss, but produce in the short run |
| 200 | below minimum AVC (220) | Shut down |
So the break-even price is Frw 280 and the shutdown price is Frw 220.
In the long run all factors are variable and, under perfect competition, firms are free to enter or leave. That changes the story.
In long-run equilibrium every firm earns exactly normal profit, and
Definition
Productive efficiency: producing at the lowest point of the ATC curve, so the output is made at the least possible cost per unit.
Allocative efficiency: producing where , so the value consumers place on the last unit (its price) equals the cost of the resources used to make it. Society gets the mix of goods it values most.
A perfectly competitive firm in long-run equilibrium achieves both.
| Advantages | Disadvantages |
|---|---|
| Productive efficiency: goods are made at the lowest average cost | Firms are small, so they cannot reap large economies of scale |
| Allocative efficiency: P = MC, so resources go where consumers value them most | With only normal profit in the long run, firms have little to spend on research and new technology |
| Consumers pay the lowest long-run price; no one can exploit them | Identical products give consumers no variety |
| Resources move quickly to industries whose products are wanted (entry and exit) | Unstable incomes for producers when prices swing, as farm prices do |
| No waste on competitive advertising, since products are identical | Wasteful duplication of small units; may ignore external costs such as pollution |
Warning
Shut down is not the same as leave. A firm that shuts down in the short run stops producing but keeps its land and machines, and still pays fixed costs; it may reopen when the price rises. A firm that exits in the long run sells off its assets and leaves the industry. In the long run there are no fixed costs, so a firm must cover ATC, not just AVC, or it will leave.
Important
Discuss. Farmers in a fertile valley each grow the same variety of tomato. When prices are high one season, the extra earnings disappear within two seasons. Use the long-run diagram to explain why. Then suggest one reason why, in a real Rwandan market, some growers might keep earning more than others for longer.
EconplusDal, "Perfect Competition" (about 13 minutes). An A-level walk-through of the short-run and long-run diagrams. Pause at each diagram and check that MC cuts ATC at its lowest point, as in the drawings above.
Practice
Sources and credits
Written by Ganzaa: the text, the four diagrams (computed from one cubic cost function so that MC passes through the lowest points of AVC and ATC), the tables, the worked examples and the practice items. The potato season and all prices and costs are illustrative.
