PROFIT MAXIMIZATION AND COMPETITIVE SUPPLY
1. Why would a firm that incurs losses choose to produce rather than shut down?
Losses occur when revenues do not cover total costs. Revenues could be greater than
variable costs, but not total costs, in which case the firm is better off producing in the
short run rather than shutting down, even though they are incurring a loss. The firm
should compare the level of loss with no production to the level of loss with positive
production, and pick the option which results in the smallest loss. In the short run,
losses will be minimized as long as the firm covers its variable costs. In the long run,
all costs are variable, and thus, all costs must be covered if the firm is to remain in
2. The supply curve for a firm in the short run is the short-run marginal cost curve (above
the point of minimum average variable cost). Why is the supply curve in the long run
the long-run marginal cost curve (above the point of minimum average total cost)?
In the short run, a change in the market price induces the profit-maximizing firm to
change its optimal level of output. This optimal output occurs when price is equal to
marginal cost, as long as marginal cost exceeds average variable cost. Therefore, the
supply curve of the firm is its marginal cost curve, above average variable cost.
(When the price falls below average variable cost, the firm will shut down.)
In the long run, the firm adjusts its inputs so that its long-run marginal cost is equal
to the market price. At this level of output, it is operating on a short-run marginal
cost curve where short-run marginal cost is equal to price. As the long-run price
changes, the firm gradually changes its mix of inputs to minimize cost. Thus, the
long-run supply response is this adjustment from one set of short-run marginal cost
curves to another.
Note also that in the long run there will be entry and the firm will earn zero profit,
so that any level of output where MC>AC is not possible.
3. In long-run equilibrium, all firms in the industry earn zero economic profit. Why is this
The theory of perfect competition explicitly assumes that there are no entry or exit
barriers to new participants in an industry. With free entry, positive economic profits
induce new entrants. As these firms enter, the supply curve shifts to the right,
causing a fall in the equilibrium price of the product. Entry will stop, and
equilibrium will be achieved, when economic profits have fallen to zero.
4. What is the difference between economic profit and producer surplus?