Question

How does the long run economic profit converges to zero in perfect competition?Explain the process starting from short-term profit or loss.

Answer 1

Initially in the short run,

In perfect competition, in the short run if there is an economic profit. It means that the firm's average cost is less than the market price. And because they could produce the good at a lesser per unit cost than the price they receive for it. It leads them to earn an economic profit.

Firms can earn an economic profit in the short run because of a lower per-unit cost. As profit is the difference between total cost and total revenue. This also means that firms can only earn profit as long as the price is above the average cost. And this can happen in the short run.

In the long-run:

As in the perfect competition, there is a free entry or exit of firms and no transaction cost. Firms produce homogenous products.

Therefore as firms move into the long run, this economic profit attracts other outsiders to enter into this market. As they also want to earn their share of profit. The increase in the number of sellers increases the market supply. And therefore the market supply curve shifts to the right. As the number of sellers in the market has increased, the economic profit is shared by the new entries. And eventually, each seller produces at the lowest average cost. The increased supply lowers the market price and this leads firms to produce at their lowest average cost.

Therefore the firms in the long run earn zero economic profit or only normal profit.

The entry or exit can only happen in the long run. As it takes time for new entries to be attracted to the profit and share the existing economic profit. Therefore firms can earn economic profit only in the short run. While in the long run, the free entry of firms leads to zero economic profit.

Diagrammatic explanation:

Short- run perfect competition:

Initially in the short run firms are earning economic profit because of the lower per-unit cost. The market price is taken by the sellers, which is lower than their per-unit cost. And therefore they earn profit shown by the red shaded area.

Long- run perfect competition:

But as they move in the long run, there is the entry of firms and this leads to the increase in the supply and the leftward shift of the supply curve. (S') This leftward supply decreases the prices to the average cost. And therefore firms produce at the lowest average cost. Which means that they earn zero economic profit.

Economic losses in the short run:

This same process can be seen with the economic losses and in the case of economic losses. There is the exit of firms as they want to minimize their losses. And this leads to a decrease in the market supply which eventually leads each firm to earn zero economic profit.

Process from short run to the long run:

Firms in the short run have a market price above their average cost. And this leads them to economic losses. And the economic losses discourage the existing firms and some of the firms exit the market to minimize their losses. And so the supply of the market decreases. This supply leads to an increase in the market price and eventually firms produces at the lowest average cost and earn zero economic profit.