Long Run Economic Profit

Long Run Dynamics in Perfectly Competitive Markets

Overview of Perfectly Competitive Markets

• Definition of perfectly competitive markets.

• Firms are price takers and cannot set prices; they adapt to market prices.

• The marginal revenue curve for firms in such markets is horizontal, reflecting the market price.

Short-Run Conditions

• Firms will decide production quantity based on the relationship between marginal revenue (MR) and marginal cost (MC).

• Rational decision-making occurs where:

  • Produce additional units as long as MR > MC.

  • Stop producing when MR = MC.

• Economic profits are evident when:

  • Price (P) > Average Total Cost (ATC).

  • Calculation of economic profit:

  • Economic Profit = (Price - ATC) × Quantity Produced.

  • Area representing economic profit is visually depicted as a rectangle on graph.

Transition to Long-Run Equilibrium

• If firms in the market earn positive economic profits, it attracts new entrants.

• New firms entering the market results in:

  • Increased supply, shifting the supply curve rightward.

  • Decrease in market price (new equilibrium price).

• Entry of new firms alters the equilibrium price from
  $P<em>{1}$ to $P</em>{2}$, which reduces the marginal revenue for all firms.

New Production Decisions for Firm A

• In the new equilibrium, Firm A must reassess production:

  • Continue to increase production as long as MR > MC.

  • As MR falls to the new level, equilibrium is reached at a point where MR = MC, leading to zero economic profit.

• Firm A produces at the point where:

  • ATC = MC = MR, indicating productive efficiency.

• Definition of productive efficiency:

  • Firms produce at the minimum of their average total cost curve.

  • At this point, average total cost is minimized, and marginal cost equals average total cost.

Role of Economic Profit and Market Efficiency

• Initial economic profits spur market entry, pushing prices down.

• Long-run outcome in a perfectly competitive market results in:

  • Zero economic profit for firms (normal profit).

  • Allocative efficiency where marginal benefit (MB) = marginal cost (MC).

  • Absence of deadweight loss in the equilibrium condition.

Potential Over-Entry Scenario

• Hypothetical situation: excessively high supply (Supply Curve 3).

  • Illustrates market response to too many firms entering:

  • Results in a new lower price (P3).

  • Firm A faces even lower marginal revenue (MR3).

• Economic loss scenario:

  • At their production quantity, Firm A now has ATC > MR, resulting in losses.

  • If this situation persists, firms will exit the market, reducing supply back to the left.

• Outcome of exit of firms:

  • Market stabilizes towards zero economic profit, ensuring allocative and productive efficiency—proving the self-correcting nature of competitive markets.

Conclusion

• Perfectly competitive markets are efficient in the long run, characterized by:

  • Zero economic profit.

  • Allocative efficiency with no deadweight loss.

  • Productive efficiency at the minimum of average total cost curves.

• The processes of entry and exit ensure that markets adjust to equilibrium over time, fostering an environment of competitive equilibrium without economic profit.