In the short-run, there are some firms of average efficiency earning only normal profits just sufficient to induce them to continue to operate in the short-run. These normal profits are included in the costs. Fig. 10.5 illustrates such a case for a competitive firm, which is just able to breakeven (no profit-no loss situation) at point ‘E’.
Here, the AC curve is tangent to the AR curve at the minimum point ‘E’ of the former. This means that the price of the product is equal to its average cost. In other words, total cost is equal to total revenue. Such a competitive firm, which neither makes excess profits nor suffers losses in the short-run, is called a marginal firm.
Fig. 10.5: Short-Run Equilibrium of Competitive Firm Earning Only Normal Profits
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The competitive firm in equilibrium always chooses the output for which price (AR = MR) = MC is above the level of average variable cost (AVC). The short-run equilibrium price of a competitive firm can be equal to or more than it’s AVC, but, cannot be less than AVC.
The minimum price which can induce a firm to produce in the short-run is the one, which just equals AVC. It is also called the shut down point of the competitive firm. The competitive firm closes down the operation, if it is not in a position to cover AVC in the short-run.
When price = MC, the firm would decrease its profits, if, it either increased or decreased its output. For any point to the left of this equilibrium, price is greater than the marginal cost and it pays to increase output. Similarly, for any point to the right of this equilibrium, price is less than the marginal cost and it pays to reduce output.