Question

Some of the 200 firms in market X, a perfectly competitive market, are incurring losses. How will these losses influence (a) exit out of the market, (b) the supply of the good produced in the market, and (c) the price of the good? Explain your answers.

Short answer

Losses incurred by a number of firms in a perfectly competitive market causes those firms to exit the market. This, in turn, reduces the overall supply of the good or service in the market, which leads to an increase in its price.

Step-by-step solution

Analyze the effect on market exit

In a perfectly competitive market, if a firm is making losses, it implies that the price of the good or service it sells is lower than its average total cost. As this is not sustainable in the long run, firms making losses will gradually exit the market.

Analyze the effect on supply

When firms exit the market, this reduces the overall supply of the good or service being produced. That is because there are fewer suppliers to meet the existing demand.

Analyze the effect on price

As firms exit and overall supply decreases, the price of the good or service in the market will increase. This is due to the principle of supply and demand, which maintains that a decrease in supply will lead to a price increase when the demand stays the same.

Key concepts

Market Exit

In a perfectly competitive market, the concept of market exit is inevitable when firms are unable to cover their costs. When some firms in the market start incurring losses, it signals that the price of their product is less than the average total cost (ATC) of production.

This disparity means they are not breaking even and, over time, leads to a situation where maintaining business becomes unsustainable. Consequently, these loss-incurring firms will make the decision to exit the market.

Market exit is crucial as it reflects the self-correcting nature of a perfectly competitive market. This process cleanses the market of underperforming firms, paving the way for more efficient players to thrive.

Supply and Demand

In the realm of supply and demand, the exit of firms plays a significant role. When firms exit due to losses, the overall market supply diminishes. There are fewer companies producing and offering their goods, thus leading to a reduced supply.

With supply being invertedly dependent on prices, it follows the basic economic principle: when the supply decreases, prices are likely to increase, assuming demand stays constant. Consumers will therefore find the good scarcer, driving up its value in the market.

The supply and demand mechanism ensures the market equilibrium adjusts to changes, supporting the overall efficiency of a perfectly competitive landscape.

Profit and Loss

The concepts of profit and loss are central to understanding market dynamics. In a perfectly competitive market, firms are in a constant struggle to maximize profits and minimize losses.

Profit occurs when the price at which goods are sold exceeds the average total cost of production. Conversely, losses arise when prices fall below the average total cost, as seen in the scenario in market X.

When losses occur, they signal to firms that their resources may be more profitably employed elsewhere. This results in market exit for those unable to adjust costs downward or increase revenues. Over time, remaining firms may achieve normal profits, where price equals ATC, ending the incentive for market exit or entry.