Question

Describe the profit maximizing position of a perfectly competitive firm in the long-run. Use a diagram to motivate your answer.

Answer 1

In the long run, economic profits in perfectly competitive markets are driven down to zero. This is because new firms enter the market.

Due to this, firms can only charge a price where P = MC

The firms cannot charge a price higher than the marginal cost of production. If they charge a higher price, all buyers will purchase from other firms. Profit margins are thus zero.

This condition can be shown in the diagram below:

Here, MC refers to marginal cost, AC is average cost or average total cost, AR is average revenue

This graph depicts the long run equilibrium condition in perfect competition. Typical cost curves are shown.

In the long run, the intersection of MC and MR determine the profit maximizing quantity. Here, we must note that though economic profits are zero, accounting profits are still possible.

MC and AC intersect at the point where AC is the lowest. The point of lowest AC is the efficient scale of production. Q at this level is the optimal quantity produced.