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 true?
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?
While economic profit is the difference between total revenue and total cost, producer surplus is the difference between
total revenue and total variable cost. The difference between economic profit and producer surplus is the fixed cost of
5. Why do firms enter an industry when they know that in the long run economic profit will be zero?