Question

Suppose Michael’s friend James makes the following statement, “Economic theory states that in a purely competitive market, profits should be zero in the long-run, but Michael’s friend, Johnson, who owns a pizza restaurant indicates that if he really made zero profit, he wouldn’t be able to support his family and would shut down. So if profits tend to zero, small businesses like Johnson’s restaurant will have to close down. Assume the pizza market is purely competitive, using your knowledge, evaluate James’s statement. Is his analysis correct? 3b. Explain the difference between a firm in a purely competitive industry shutting down and a firm exiting a purely competitive industry because they are incurring negative profits.

Answer 1

When the price in pizza restaurant is exactly at the zero-profit point, then it is making zero profits. When price falls in the zone between the shutdown point (i.e. price per unit > or equal to average variable cost (AR = AVC)) and the zero-profit point, then pizza restaurant suffer losses however will continue to operate in the short run, because it is covering its variable costs. The firm will need topay for the fixed costs. Thus Michael’s friend, Johnson should continue producing at the zero-profit level.

When market demand falls, marginal revenue declines below marginal cost, which results firms to suffer temporary losses, because they are requited to reduce their prices below their ATC, leading less efficient producers to exit the market. A perfectly competitive firm will shut down if its price is less than average variable cost