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.
No, a profit-maximising firm in a competitive market will not produce a positive level of output in the long run if the market price is less than the minimum of AC.
When the market price is lower than the AC at any output level, the firm incurs losses. At output level q₁, the total revenue (TR) equals the area of rectangle OpAq₁ (price × quantity), while the total cost (TC) equals the area of rectangle OEBq₁ (average cost × quantity). Since TC exceeds TR, the firm suffers a loss.
In the long run, a firm has the option to shut down production and exit the market. If the firm shuts down, it earns a profit of zero. Since producing any positive output results in losses while shutting down yields zero profit, a rational profit-maximising firm will choose to exit.
For all positive output levels, if the LRAC strictly exceeds the market price, it cannot be the case that the firm supplies a positive output. The firm will produce zero output when the market price is below the minimum LRAC.
Thus, the long run supply curve of a firm is the rising part of the LRMC curve from and above the minimum LRAC, together with zero output for all prices less than the minimum LRAC.
Explanation
This question tests the student's understanding of the long run supply decision of a firm under perfect competition. The textbook context clearly establishes that in the long run, a firm will exit the market if price falls below minimum AC because it cannot cover its costs. Unlike the short run (where the firm may continue production if price AVC to cover variable costs), in the long run all costs are variable, so the firm has no obligation to stay in the market. The key insight is that the firm compares the loss from production with the zero profit from shutting down, and chooses the latter when price < minimum AC.
Solution Steps
Step 1: Identify that when market price < minimum AC, the firm incurs losses at any positive output level.
Step 2: Compare total revenue (TR) and total cost (TC) - TR < TC when price < AC, meaning the firm suffers losses.
Step 3: Recognise that in the long run, a firm can exit the market and earn zero profit by shutting down.
Step 4: Conclude that a profit-maximising firm will choose to exit (produce zero output) rather than produce at a loss.
Step 5: State that the long run supply curve shows zero output for all prices below minimum LRAC.