The Determination of Price and Output by a Competitive Firm in the Short-Run

The short run equilibrium is characterised by two basic features. First, the average and marginal cost curves are U-shaped. Second, entry or exit of firms is insignificant so that abnormal profits or losses persist in short run. The short run average and marginal cost curves, with their typical U-shapes caused by the inability of the firms to increase some of their fixed factors further, contribute to sustain abnormal profits or losses.

They are denoted as SAC (short run average cost), SAVC (short run average variable cost) and SMC (short run marginal cost) instead of the general notation of AC, AVC and MC. Under these two features, the equilibrium of a competitive firm in short run, thus, may involve either abnormal profits or losses or even normal profits as shown in Figures 7.5, 7.6 and 7.7.

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A common case of short run equilibrium of a competitive firm is one in which the firm suffers loss and is contented only with the recovery of the total variable cost. The level of output at which it just recovers it corresponds to the lowest point on the short Run Average Variable Cost curve, as shown in Figure 7.7.

Thus, in short run, the loss making competitive firm does not stop its operations just when the horizontal demand curve faced by it slides below its SAC. Instead, it continues to operate so long as it recovers its total variable cost. The limiting level to which the market price can fall without causing the firm to close down is, thus, the level of the lowest point, G, on the average variable cost curve. This point is known as the shut down point.


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