Perfect Competition in the Short Run

For an industry, the short run is the period of time in which firms are unable to enter or exit the market because they are only able to vary their labor and not their fixed capital. In the short run, it is possible for firms in a perfectly competitive industry to earn economic profits or even operate at a loss as supply and demand for the entire industry's output changes.

Assume that the glazed doughnut industry is perfectly competitive. Imagine that scientists working in New Zealand discover that glazed doughnuts, when consumed with coffee, are extremely beneficial to consumers' health. As a result of this great news, the demand for doughnuts increases. This results in a new, higher equilibrium price. Remember that the market price represents the firm's marginal revenue, so for firms in the doughnut industry, their total revenue has increased by more than their total economic cost. This means that glazed doughnut firms are earning economic profits.

Six months later, scientists in California reveal that the earlier New Zealand doughnut research was flawed and that, in fact, consuming large amounts of glazed doughnuts with coffee might pose a risk to consumers' health. First there is denial, then consumers slowly awake to the reality that they are fifty pounds heavier and finding it difficult to sleep. At this point, the demand for glazed doughnuts decreases below its original equilibrium. For many firms in the doughnut industry, this decrease in the market price means that they are now producing at a short-run loss because their total revenue is less than their total cost of production.

At what point does a firm shut down for good?

Firms will operate, even at a loss, as long as they are able to cover their variable cost. At the point where revenues are less than variable cost, firms must shut down because they are unable to pay workers and keep the lights on.

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