Question

Firm X operates in a perfectly competitive market. It is making a supernormal profit in the short-run. Explain clearly and logically what will happen to this firm in the long run. You will need to use a diagram.

Answer 1

The above diagram shows the short run equilibrium in which the firm is having super-normal profit ( abnormal profit).

In a perfect competitive market firm can make super normal profit only in the short run. When the average revenue exceeds the average cost, super-normal profit is made. In this type of market situation, firms are price takers, thus they are essentially facing infinite demand at the market price which means that the average revenue is not only equal to marginal cost but is also constant and equal to market price. On the other hand cost are kept as low as possible to avoid being priced out of the market. Thus super-normal profit is obtained only in short run where there are fewer firms.

The above diagram shows the long run equilibrium in which the firm is having normal profit.

The super-normal profit which is obtained by the firm in the short run acts as an incentive for new firms to enter the market, which increase the industry supply and reduces the market price for all firms until only normal profit is made. The minimum point of AC curve is the optimum output produced at that point of productionand the output produced at that point is the optimum output. New firms entering the market will reduce the market price which will make the firm to have a normal profit as in perfect competition the firms are price taker. Thus, a firm will only make normal profit in the long run.