Economics Online Tutor

Perfect Competition: The
Individual Firm
In economics class, the most noticeable distinguishing characteristic of
an individual firm in perfect competition is the shape of the demand curve
it faces. The demand curve is a horizontal line set at the market price.

Even though the market demand curve is downward sloping, each
individual firm is too small to influence the market price. Since the firm is
a price taker, and must accept the market price instead of setting its own
price, the demand curve is set at the market price.

The individual firm will set its quantity of output at the level that will
maximize profits at the given market price.

Note: the following discussion assumes some knowledge of terminology
defined in the section entitled
"Revenue, Costs, & Profit".
Why is the individual firm in perfect competition a price taker?

Refer back to the characteristics of perfect competition as a market structure: many sellers, identical
products, ease of entry, and perfect information.

If an individual firm tries to sell at a price higher than the given market price, it would lose its
customers. Given these characteristics, the customers would buy from the sellers who are selling at
the lower market price. The firm that sets a price that is above the market price will sell nothing.

An individual firm also would not set a price that is below the market price. The individual firm can set
its quantity at an output level that maximizes profit. It can sell all that it wants at the market price. It
would have no reason to sell the same quantity at a lower price. Besides, a lower price would mean
that the profit maximizing output level would be lower, not higher. This is because of the shape of the
marginal cost curve.

In any market structure, profit is maximized at the output level where marginal revenue (MR) is equal
to marginal cost (MC). The relevant portion of the marginal cost curve is the upward-sloping portion
above average variable cost.

The marginal revenue curve is identical to the horizontal demand curve. This is because a price taker
will accept the same price regardless of the level of output.

In perfect competition, then, price equals marginal revenue. Since profits are maximized when
marginal revenue is equal to marginal cost, the profit maximizing equation for a perfectly competitive
firm becomes:

P=MR=MC

Perfect competition is the only market structure where this equation holds true.



The shutdown rule:

Why is the relevant portion of the marginal cost curve above average variable cost (AVC) instead of
average total cost (ATC)? After all, if a firm doesn't cover total costs, it suffers a loss.

This is because fixed costs cannot be avoided in the short run.

Fixed costs do not exist in the long run. In the long run, average variable cost equals average total
cost, and the firm will produce only if it can cover all costs.

But in the short run, with the existence of fixed costs, average variable cost will be below average
total cost. If the market price (same as marginal revenue) is between AVC and ATC, the firm will suffer
more losses by shutting down than it would if it continued to produce. This is because fixed costs do
not vary with the level of output. They have to be paid whether the firm produces or not.

Fixed costs become irrelevant to the decision of whether to shut down or not. For example, suppose
the market price is $1.00, the current output level is 1,000, fixed costs are $500, and variable costs are
$0.75 per unit.

At this output level, total revenue is $1,000. Variable costs are 1,000 x $0.75, or $750. With fixed costs
at $500, total cost is $1,250. The firm is losing $250 by producing this level of output ($1,000 minus
$1,250). But if it shut down, it would still have to pay the entire fixed cost of $500. It would lose $500 by
shutting down. Producing and losing $250 is preferable to shutting down and losing $500.
This page, along with additional commentary, was posted on the "Economics
Online Tutor" Facebook page's timeline on July 26, 2012.
The shutdown rule: a competitive firm should shut down in the
short run if it cannot find an output level that will allow it to cover
total variable costs. Otherwise, it should continue to produce.

This makes the minimum point of the AVC curve the shutdown price. The
breakeven price is the minimum point of the ATC curve.

The supply curve for a competitive firm, then, is the portion of the
marginal cost curve that lies above the average variable cost curve.
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