Question

1. Does earning a normal profit or when economic profit = 0 mean a firm is not earning a profit? Explain.

2. Why can there be excess profits in the short run but not in the long run?

Thank you!

Answer 1

Earning a normal profit or zero economic profit doesn't mean that firm is not earning a profit. At this point where average revenue equals the average costs of production the firm earns normal profits. The cost of production includes a normal return to cost of production and entrepreneurship. That is the cost of production includes the return to entrepreneurship which is profit. Therefore we say that even if the firm is earning zero economic profits or is at break even, it is still earning a normal profit.

In the long run if a firm earns excess profits, the industry will attract new firms and will lead to more supply in the market. This will lead to fall in the price to the extent that all economic profits are removed. Similarly if there are losses being suffered by the firms in the industry, it will lead to exit of some firms. The exit will lead to decrease in supply and increase in price. The process will go on until the price equals the average costs of production. In the long run therefore the firm will operate at normal profits level.