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Firms' Short & Long-Run
Decisions

Learn how firms decide whether to produce in the short run and whether to enter or exit a market in the long run using cost and revenue analysis.

AP Microeconomics

What Is the Short Run vs Long Run?

Short Run
At least one input is fixed (e.g., factory size, lease). Firms can only adjust variable inputs like labor and materials.
Long Run
All inputs are variable. Firms can change plant size, technology, and even decide to enter or exit the market entirely.

Key Cost Concepts for the Firm

\( TC \)
Total Cost: \( TC = TFC + TVC \). Sum of all fixed and variable costs.
\( ATC \)
Average Total Cost: \( ATC = \frac{TC}{Q} \). Per-unit cost of production.
\( AVC \)
Average Variable Cost: \( AVC = \frac{TVC}{Q} \). Per-unit variable cost only.
\( MC \)
Marginal Cost: \( MC = \frac{\Delta TC}{\Delta Q} \). Cost of one more unit.

Revenue and Profit Defined

A firm's total revenue is \( TR = P \times Q \). Its profit (or loss) is:

In a perfectly competitive market, the price is set by the market, so \( P = MR = AR \). The firm is a price taker.

The Profit-Maximizing Rule

Price / Cost Quantity ATC AVC MC P = MR Q*

At \( Q^* \), the firm produces where \( P = MC \). The gap between \( P \) and \( ATC \) at that quantity determines profit or loss per unit.

Short Run: Shut Down or Produce?

Even when making a loss, a firm may continue producing in the short run. The key question: can the firm cover its variable costs?

1
If \( P \geq AVC \): Continue producing. Revenue covers variable costs and contributes to fixed costs. Losses are smaller than if the firm shut down.
2
If \( P < AVC \): Shut down. Revenue doesn't even cover variable costs. The firm loses less by shutting down and only paying fixed costs.

Three Short-Run Scenarios

Price / Cost Quantity ATC AVC MC P₁ (Profit) P₂ (Loss, produce) P₃ (Shut down) AVC min
\( P_1 > ATC \)
Firm earns economic profit.
\( AVC < P_2 < ATC \)
Firm has a loss but still produces.
\( P_3 < AVC \)
Firm shuts down.

The Firm's Short-Run Supply Curve

A perfectly competitive firm's short-run supply curve is the portion of its \( MC \) curve that lies at or above the minimum of \( AVC \).

Price Quantity AVC Supply (MC) Shut-down point Not supplied

Long Run: Entry and Exit

In the long run, all costs are variable and firms can freely enter or exit the market.

1
If \( P > ATC \): Firms earn economic profit → new firms enter → supply increases → price falls → profits shrink.
2
If \( P < ATC \): Firms suffer economic losses → some firms exit → supply decreases → price rises → losses shrink.
3
If \( P = ATC \): Firms earn zero economic profit → no incentive to enter or exit → market is in long-run equilibrium.

Long-Run Equilibrium

Price / Cost Quantity ATC MC P* Q* \( P = MC = ATC_{\min} \) Zero economic profit

Short Run vs Long Run: Key Distinction

Short Run Long Run
Fixed Costs Yes (sunk) No (all variable)
Key Decision Produce or shut down Enter or exit market
Decision Rule Compare \( P \) to \( AVC \) Compare \( P \) to \( ATC \)
Critical Point \( P = AVC_{\min} \) \( P = ATC_{\min} \)
Economic Profit Can be +, 0, or − Driven to zero
Number of Firms Fixed Changes with entry/exit

How to Analyze a Firm's Decision

1
Identify the time frame. Are there fixed inputs? If yes, it is the short run.
2
Find profit-maximizing quantity. Set \( MR = MC \) (or \( P = MC \) for perfect competition).
3
Short run: Compare \( P \) to \( AVC \). If \( P \geq AVC \), produce at \( Q^* \). If \( P < AVC \), shut down.
4
Calculate profit/loss. \( \text{Profit} = (P - ATC) \times Q \).
5
Long run: Compare \( P \) to \( ATC \). Profits → entry. Losses → exit. Zero profit → equilibrium.

Example 1: Profitable Firm

A firm in a competitive market faces \( P = \$12 \). At its profit-maximizing output of \( Q = 100 \), \( ATC = \$9 \) and \( AVC = \$7 \).

Example 2: Loss but Still Producing

The market price drops to \( P = \$8 \). At the new \( MR = MC \) output of \( Q = 80 \), the firm has \( ATC = \$10 \) and \( AVC = \$6 \).

Example 3: Shut Down

Now the price crashes to \( P = \$4 \). The firm's \( AVC_{\min} = \$6 \) and \( TFC = \$500 \).

Common Mistakes

✕ Confusing Shut Down with Exit
Shut down is a short-run decision (stop producing, still pay fixed costs). Exit is a long-run decision (leave the market entirely).
✕ Using ATC for Shut-Down Rule
The short-run shut-down rule compares \( P \) to \( AVC \), not \( ATC \). A firm can operate at a loss if \( P > AVC \).
✕ Zero Economic Profit = Failing
Zero economic profit means the firm covers all costs including opportunity costs. It is still earning a normal accounting profit.

Question 1 of 5

A perfectly competitive firm will shut down in the short run when:

Question 2 of 5

In long-run equilibrium for a perfectly competitive market, which condition holds?

Question 3 of 5

A firm has \( P = \$15 \), \( ATC = \$18 \), and \( AVC = \$12 \) at its profit-maximizing output. In the short run, this firm should:

Question 4 of 5

If existing firms in a competitive market are earning economic profits, what will happen in the long run?

Question 5 of 5

A firm's short-run supply curve is: