Question

Will a profit-maximising firm in a competitive market produce a positive level of output in the long run if the market price is less than the minimum of AC? Give an explanation.

Answer 1

It is not possible for a firm to produce positive level of output in the long run if the market price falls short of the minimum of AC. This is because, in the long run there is free entry and exit of firms and all firms earn normal profit. Therefore, any firm making losses in long run will stop production.

Let us understand this concept through an example:

At Oq₁ level of output,

Price charged by the firm = OP.

Revenue generated by the firm (TR) = P × Q

= OP × Oq₁

= area (rectangle Oq₁LP)

Cost of producing Oq₁ level of output (TC) = LAC × Quantity of output

= ON × Oq₁

TC = area (rectangle Oq₁KN)

Profit earned by the firm = TR − TC

= area (rectangle Oq₁LP) − area (rectangle Oq₁KN)

= − area (rectangle NKLP)

Thus, the loss incurred by the firm is equal to the area of the rectangle NKLP.

In the long run, all firms earn zero economic profit, and if any firm earns loss or negative profit, then the firm will shut down its production. Thus, if the firm earns loss, i.e. if price is lesser than LAC at any level of output, it will not be the profit maximising output level of the firm.