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I could see that if the price level is say lower than the intersection point , then firms won't be able to operate , but what is wrong with the price level being above the intersection point of the AVC and the MC .

IN that case firms would earn positive profit , although I know that this not happen in a competitive market , but I fail to grasp what stops this from happening ?

That is why won't the competitive market function well enough if the price level would be higher than the intersection point ?

I thought then the positive profits would make the other firms come in , however I could;t quite make the whole connection as to how would it drive the price level down !

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  • $\begingroup$ I think you are confusing the effects of price taking in the short run and effects of free entry in the long run. $\endgroup$
    – Giskard
    Apr 19, 2016 at 8:22
  • $\begingroup$ Relevant to your interests: economics.stackexchange.com/questions/11354/… $\endgroup$
    – Kitsune Cavalry ♦
    May 21, 2016 at 2:21
  • $\begingroup$ (Using fairly reasonable assumptions about cost curves) it is true for marginal producers who are indifferent between entering the market or leaving it because they make no profit either way. It does not have to be true for other existing companies already producing in the market with lower average costs which then profit from the difference between their marginal cost (the market price) and their average cost. But if you make the (in my view unreasonable) assumption that all companies have the same cost curves then they are all marginal producers. $\endgroup$
    – Henry
    Nov 17, 2016 at 1:25

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One of the assumptions of perfect competition is that firms are price takers. Ultimately price is determined by the quantity of goods supplied, and with perfect competition, there are infinite (or an arbitrarily large) number of firms, so a firm that changes their price by itself will simply have no business, since there are cheaper places to buy from. The quantity supplied will also not change, and will leave the prices unchanged.

So what happens if all infinite of these firms tried to unilaterally raise their prices to the same level? This is maybe in some cases a Nash equilibrium, but not a coalition-proof Nash equilibrium. So firms could also unilaterally deviate from the higher price to take the whole market between themselves.

If price (marginal benefit), was suppose, forced to be higher, so that you moved along the marginal cost curve where MC $\neq$ ATC, then the supply curve would shift, because the optimal production quantity would increase for all firms at this price control. And the market would then not clear.

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Because let's say that a firm makes even 1$ profit ... Then another firm can come in a sell the product for only 0.99cts profit ! And so one until the equilibrium is the marginal cost of a product !

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  • $\begingroup$ Just to take your reasoning further , once the other firm starts selling at a lower price , what will happen is that it will get all the customers and would still be able to make profit on each sale ( since the price is a still above the M.C. , but less than the previous price which the firm was selling at ) Right ? @Alexis L. $\endgroup$
    – Noob101
    Apr 19, 2016 at 7:34
  • $\begingroup$ I'm not quiet sur to understand your comment. At a lower price than the MC ? It is against the hypothesis of the entrepreneur being rational. $\endgroup$
    – Alexis L.
    Apr 19, 2016 at 17:06
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    $\begingroup$ Yes, @Suryakant Shrivastava, exactly. If the price is above average cost, then an entrant comes in, increases supply which lowers the price. It he price is still above average cost, then another entrant comes in. Note that there are many simplifying assumptions that you need to make to make these assertions: the marginal cost has to be increasing, there has to be free entry, the incumbents can't be threatening to create a price war that will bankrupt the entrant, etc, etc. $\endgroup$
    – Fix.B.
    May 20, 2016 at 17:01
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The answer to you you question is bertrand model

I will do a simple example.

Suppose there are two identical firm selling an identical phone with MC=200€.

Now firm A want to sell it at 400€ and firm B wants to sell it at 300€.

Now you as a consumer which phone will you buy? Obviously the one produced by firm B, it is the same phone but with 100€ less!

No one will buy from firm A, so firm A in order to make a profit he should at least set it to 300€, this way half of the consumers will buy from firm A and half from firm B (this is an assumption).

Firm A however can make even further profits, if he sets his price to 250, all the consumers will buy from firm A instead of firm B.

By doing this reasoning a lot of times, the prices will converge to the MC.

(Obviously a firm will never set a price below the MC or he will make negative profits)

However a model is a model and don't always reflect reality 100%, in fact we made the assumption of identical firms, also there is a problem with transportation costs, for one one euro less I would rather go to a firm close to me. So depending on the particular market, we don't always reach this equilibrium

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    $\begingroup$ Really only pretty simple (homogenous products) Bertrand models would be considered to have competitive outcomes, which is what the question seems to be focusing on. $\endgroup$
    – Kitsune Cavalry ♦
    May 21, 2016 at 2:11

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