5.2 — Perfect Competition in the Short Run

How Firms Make Production Decisions

In the short run, firms in perfect competition have to decide how much output to produce while at least one factor of production remains fixed. Because firms cannot instantly expand or shrink their operations, their main decision is how much to produce at the current market price.

Perfectly competitive firms are price takers, meaning they accept the market price and have no control over it. This makes output decisions far more important than pricing decisions.

Key Short-Run Assumptions

Perfect competition in the short run operates under several important assumptions:

  • Many buyers and sellers exist

  • Products are identical

  • Firms cannot influence price

  • Entry and exit are not immediate

These assumptions explain why firms focus entirely on cost and revenue relationships rather than marketing or pricing strategies.

A Perfect Competitor’s Demand Curve

The demand curve faced by a perfectly competitive firm is horizontal at the market price. This means the firm can sell any quantity of output at that price, but none at a higher price.

If a firm raises its price even slightly, consumers will buy from competitors instead. Because products are identical, buyers have no incentive to stay loyal to a higher-priced seller.

This horizontal demand curve reflects the complete lack of pricing power held by individual firms.

 

Revenues for a Perfect Competitor

Revenue relationships in perfect competition are simple and predictable:

  • Average revenue remains constant at the market price

  • Marginal revenue is also equal to the market price

  • Each additional unit sold adds the same amount to total revenue

Because of this, marginal revenue, average revenue, and the demand curve are all represented by the same horizontal line on a graph.

This simplifies decision-making and makes cost analysis the primary focus for firms.

The Profit-Maximizing Rule

Firms maximize profit by producing the level of output where marginal revenue = marginal cost. (MR=MC)

This rule guides all short-run production decisions:

  • When marginal revenue is greater than marginal cost, increasing output raises profit

  • When marginal revenue is less than marginal cost, increasing output lowers profit

The profit-maximizing output is therefore the point where producing one more unit no longer adds to profit.

Possible Short-Run Outcomes

In the short run, a perfectly competitive firm may experience one of three outcomes:

  • Economic profit when price is greater than average cost

  • Break-even when price equals average cost

  • Economic loss when price is less than average cost

Losses do not immediately force firms out of the market because fixed costs must be paid whether or not production occurs.

The Breakeven Point

The breakeven point occurs when total revenue = total cost. At this level of output, firms earn zero economic profit but cover all costs, including opportunity costs.

Graphically, this point appears where the price line intersects the average cost curve.

 

The Shutdown Point

The shutdown point is the lowest price at which a firm will continue operating in the short run. It occurs when price = minimum average variable cost.

If price falls below this level, the firm minimizes losses by temporarily shutting down production rather than continuing to operate.

 

 

A Perfect Competitor’s Supply Curve

In the short run, a perfectly competitive firm’s supply curve is its marginal cost curve above the shutdown point. Below this point, the firm supplies zero output.

This explains how individual firm supply decisions combine to form the market supply curve.

Why the Short Run Matters

Short-run analysis explains why profits and losses can exist temporarily in competitive markets. It also sets the foundation for understanding how entry and exit change markets over time, which leads into long-run perfect competition.