Question

Explain how a firm in perfect competition incurs loss, in short-run equilibrium.

Answer 1

The situation occurs when the price is so low that it does not cover fully the AFC. The market price is less than AC of production and the firm incurs losses. This situation is graphically illustrated. At price OP determined by the intersection of market demand and supply comes equilibrium is at point E. At point E, MC = MR and MC curve cuts MR from below. Losses are incurred. Losses are calculated as:

AR = MR = P

TR < TC

TR = PEQO

TC = RCQO

LOSS = RCEP

AR = P covers AVC. The firm is not able to completely cover the AFC. The firm still continues to produce even though there are losses because at least the AVC is being covered by the price.