Question

4.2 Explain using properly labelled diagrams, why a perfectly competitive firm will earn only normal profit in the long-run.

4.3 Explain SEVEN (7) conditions necessary for a perfectly competitive market to exist.

Answer 1

1.Suppose a perfectly competitive industry is earning positive profits in the short run.Attracted by this,new firms enters the market.Supply rises.Eventually,there will be excess supply in the market and firms would start incurring losses.Due to this,firms will start leaving the industry.This process would continue till firms remaining in the industry are earning only normal profits.

MC2 and AC2 are when there is excess supply in the market.Since TR(PNQ2O)<TC(C2MQ2O),firms are incurring losses.In the long run,the firms will attain equilibrium as shown in the second figure.

2.Conditions for perfect competition:

1. Large numbers of sellers and buyers:

The industry or market includes a large number of firms (and buyers), so that each individual firm, however large, supplies only a small part of the total quantity offered in the market. The buyers are also numerous so that no monopolistic power can affect the working of the market. Under these conditions each firm alone cannot affect the price in the market by changing its output.

2. Product homogeneity:

The industry is defined as a group of firms producing a homogeneous product. The technical characteristics of the product as well as the services associated with its sale and delivery are identical. There is no way in which a buyer could differentiate among the products of different firms.

3. Free entry and exit of firms:

There is no barrier to entry or exit from the industry. Entry or exit may take time, but firms have freedom of movement in and out of the industry. This assumption is supplementary to the assumption of large numbers. If barriers exist the number of firms in the industry may be reduced so that each one of them may acquire power to affect the price in the market.

4. Profit maximization:

The goal of all firms is profit maximization. No other goals are pursued.

5. No government regulation:

There is no government intervention in the market (tariffs, subsidies, rationing of production or demand and so on are ruled out). The above assumptions are sufficient for the firm to be a price-taker and have an infinitely elastic demand curve. The market structure in which the above assumptions are fulfilled is called pure competition. It is different from perfect competition, which requires the fulfillment of the following additional assumptions.

6. Perfect mobility of factors of production:

The factors of production are free to move from one firm to another throughout the economy. It is also assumed that workers can move between different jobs, which implies that skills can be learned easily. Finally, raw materials and other factors are not monopolized and labour is not unionized. In short, there is perfect competition in the markets of factors of production.

7. Perfect knowledge:

It is assumed that all sellers and buyers have complete knowledge of the conditions of the market. This knowledge refers not only to the prevailing conditions in the current period but in all future periods as well. Information is free and costless. Under these conditions uncertainty about future developments in the market is ruled out. Under the above assumptions we will examine the equilibrium of the firm and the industry in the short run and in the long run.