Question

Explain why this statement is false: Competitive firms always earn zero profits in a long run equilibrium because their marginal cost is equal to their marginal revenue at the optimal level of production.

Answer 1

Perfect competition is a type of market structure where there are many buyers and sellers in the market of homogeneous goods. Since there are so many buyers and sellers, no one seller can affect the prices charged by them. Thus the prices are determined by market forces and the firms are price takers. Also, we assume that in perfect competition there is free entry and exit of the firms.

The profit-maximizing condition of a firm is at the point where the marginal revenue = marginal cost. Marginal revenue is the additional revenue generated from an extra unit of output sold. Marginal cost is the additional cost incurred from an extra unit of output produced. If MR>MC, the firm will find it profitable to increase the output level to the point where MR=MC. If MC>MR then the firm will find it profitable to decrease the output to the level where MR=MC. Thus, this point cannot be the one where the firm earns zero economic profit.

We know that in perfect competition there is free entry and exit of the firms. Suppose there are two industries A and B. Initially suppose that industry A is earning economic profits, the firms in industry B will find it attractive to leave industry B and enter industry A for earning profits. Now, what happens is that when some firms exit from B and join A, the supply curve of A will increase and that will lead to lower prices and lower profits. On the other hand, when few firms from B left, the supply curve of B decreased and prices increased which led to higher profits. Now, the firms will keep moving from one industry to another until both the firms earn zero economic profit. Thus, in the long run, in a perfectly competitive market, firms earn zero economic profit.