Perfect competition: losses to the long run through exit

Market and firm side by side: losses, firms leaving, and the price rising back to the bottom of ATC.

Britain is losing its dairy farmers.

Each dairy farm is tiny compared with the whole milk market and has to accept the price buyers offer. In the first five months of 2023 the milk price fell by almost 30%, and for many farms it dropped below the cost of producing it. Over that year 350 dairy farmers left the industry. By April 2026 there were 6,850 dairy producers left in Great Britain, the first time the number has fallen below 7,000, and 15% fewer than five years earlier.

Why does a falling price push farmers out, and what happens to the price for the farms that stay?

Sources: AHDB producer surveys, reported by Farmers Weekly (2023 and 2026). Milk is close to perfect competition, but not a perfect fit: farmers sell on contracts to a few large processors.

Think first

Prices for a farm crop fall below what it costs the average farm to grow it.

Nothing else changes. What happens to the price over the next few years?

Farms making losses leave the market in the long run. Market supply falls, so the price rises until the farms that remain just cover their costs. No farm can raise the price on its own: it happens through exit.

Step by step

1. Perfect competition: many small firms, identical products, perfect information and no barriers to entry or exit. On the left, the whole market. Supply and demand set the price.

2. The market price is P1. Carry it straight across to the firm. Each firm is a price taker: it can sell as much as it likes at P1, so its demand curve is horizontal: D = AR = MR.

3. Now the firm’s costs: MC, then ATC with MC cutting it at its lowest point.

4. The firm produces where MC = MR, on the rising part of MC, at q1.

   Check: The price line crosses MC twice. Why does the firm produce at the right-hand crossing?

   Where MC is still falling, one more unit costs less than it earns, so the firm should keep going. Profit is maximised where MC = MR and MC is rising: past that point, every extra unit loses money.

5. Go up from q1 to ATC: at that output, ATC is above the price. The firm makes a loss, also called subnormal profit: the shaded box. In the short run it may keep producing, as long as the price covers its average variable cost, because its fixed costs have to be paid even if it shuts. If the price falls below AVC, it shuts down at once. In the long run it cannot carry on making a loss.

   Teacher tip: Read ATC at q1, the output the firm chooses, never at the bottom of ATC. And keep two tests apart: price = AVC is the shutdown point, price = ATC is break-even (normal profit).

6. With no barriers to exit, loss-making firms leave the industry in the long run. Fewer firms means less supply, so market supply will shift left. But how far? Work backwards from the firm.

   Check: Which assumption of perfect competition lets loss-making firms leave?

   Firms can only leave if nothing stops them, such as sunk costs or long contracts.

7. Exit goes on until the firms that are left have no reason to leave.

   Check: At what price does exit stop?

   At the lowest point of ATC the firms that are left cover all their costs and make normal profit, so nobody has a reason to leave.

8. Exit stops when the price has risen to the lowest point of ATC, because then the firms that are left cover all their costs, including opportunity cost: normal profit. So draw that price first, P2, at the bottom of ATC, and carry it across to the market. Then draw S2 parallel to S1, through the point where P2 meets demand. Drawing it this way round is much easier than guessing where S2 goes.

9. Exit has finished. Now look at the firms that are left, selling at P2.

   Check: In the new long-run equilibrium, which kinds of efficiency does each firm achieve?

   Each firm sets MC = MR, and in perfect competition MR = P, so P = MC: allocative efficiency. P2 is at the lowest point of ATC, so it is productively efficient too.

10. This is long-run equilibrium: if costs are unchanged, the same position you reach from abnormal profit. P = MC, so it is **allocatively efficient**, and each firm is at the lowest point of ATC, so it is **productively efficient**. The industry is smaller: Q2 is less than Q1.

What your diagram must show

• Market D and S1, with P1 carried across to the firm as AR = MR
• Firm MC cutting ATC at its lowest point, with P1 below the lowest point of ATC
• Firm output q1 where MC = MR on the rising part of MC
• Loss box between ATC at q1 and P1
• Supply shifts left from S1 to S2, so price rises to P2
• P2 at the lowest point of ATC, with the firm at q2 making normal profit

A common mistake

They shifted supply right. Firms leaving means less supply, so S shifts left and the price rises. A shift right would push the price even further below ATC.

Exam question

Explain how a perfectly competitive market reaches long-run equilibrium when firms are making losses.

Model answer

At the market price P1, each firm produces where MC = MR, at q1, but its average cost at q1 is above the price, so it makes a loss. It may keep producing in the short run if the price covers its average variable cost, but it cannot do so for ever.

Because there are no barriers to exit, loss-making firms leave the industry in the long run. Fewer firms means less market supply, so the supply curve shifts left from S1 to S2 and the market price rises. As the price rises, the remaining firms’ losses shrink.

Exit stops when the price reaches P2, the lowest point of ATC, where the firms that are left make normal profit and have no reason to leave. In this long-run equilibrium P = MC, so the market is allocatively efficient, and each firm produces at the lowest point of ATC, so it is productively efficient.