Question

Suppose that a perfectly competitive market is in long-run equilibrium such that all firms earn zero economic profits. Suppose also that each individual firm reports a yearly profit of $100,000 to the government and its shareholders. Is this situation possible or impossible? Explain your answer in your own words. Hint: Consider total opportunity costs

(b) Consider a perfectly competitive market. As the level of output increases, is the supply curve in the long run in a perfectly competitive market upward-sloping, downward-sloping, or horizontal? Explain your answer in your own words. Hint: Consider the level of long-run equilibrium price in a perfectly competitive market

(c) Suppose that a perfectly competitive market is in long-run equilibrium such that all firms earn zero economic profits. Suppose that the government would like to increase the profitability of firms in the market and imposes a subsidy such that equilibrium quantity and equilibrium price increase. Would you expect the level of allocative efficiency to increase, decrease, or remain constant? Explain your answer in your own words.

Answer 1

Q6.a) An individual firm earning $100,000 as normal profits is perfectly possible in the case of perfect competition. Zero economic profit is different from zero accounting profit. It should be taken into account before thinking of an answer to this question that economic profits include both explicit and implicit costs in contrast to accounting profit which takes into account only explicit costs. Inclusion of implicit costs also means that certain level of normal profit is also included and zero economic profit doesn't mean no profit for the firm. If the firm earns no profit, then there is no incentive for it to operate. Hence, in the long earn run, even if it is said that a perfectly competitive firm earns zero economic profit it doesn't mean it is not getting anything, it still earns the normal profit which is already included as an implicit cost.

b) The answer to this question can be best done when certain assumptions are stated. It is because the supply curve in the long run for a perfectly competitive market can be upward-sloping, downward-sloping as well as horizontal line parallel to x-axis.

If we are assuming a constant cost industry, then the supply curve will be horizontal line parallel to the quantity axis as is the usual case.

If we are assuming a increasing cost industry, then the supply curve will be downward sloping and if the we are assuming a decreasing cost industry, then the supply curve will be upward sloping.

Therefore, the long run supply curve of a perfectly competitive market is dependent on the type of cost the industry is facing.

c) Any form of market intervention as governmental subsidy, or taxes distort the market structure. If a subsidy is provided to the increase the profitability of producers, then it will lead to producers earning higher than normal profits, thus inducing other firms also to enter in the market. This can lead to short run abnormal profits for them and hence a reduction in allocative efficiency.