Question

1. Illustrate and discuss the following factors related to the new equilibrium :

a.Why is the economic profit possible?

b. Can the economic profit be permanent? Explain why or why not.

c.How many consumers is the firm selling to (in other words, what is its market)?

d. What is the economic profit in the long run?

Answer 1

a. Perfect competition is a market where large number of sellers and large number of buyers. The buyers and sellers dealing in homogenous product. The buyers have no special preference for the product of a single seller. No buyer or seller is able to influence the market price. The price is determined by the market forces of demand and supply. Each seller or buyer in this market is a price taker. The shortrun is a very short period which is not enough for the entry of new firms or the exit of old firms from the market. So the supply is limited to the extent that the firm can earn profit if the market price rises above their average unit cost. If the market price is above the unit cost the firm earn positive economic profit. On the other hand if the market price is below the unit cost the firm will suffer loss. All firms are operating under full capacity and this inability of supply to increase in proportion to increase in price gives positive economic profit to the firms under perfect competition.

b. The economic profit is not permanent under the perfect competition. This will disappear in longrun with the entry of new firms or the expansion of existing plant size by the existing firms and thus all firms will earn only zero economic profit in longrun. If the market price is above the average unit cost of the firms, they will earn positive profit in shortrun. Attracted by this profit new firms will enter in to the market or the existing firm expands their plant size in longrun and the increase in supply drop down the price. Thus in longrun all firms are earning only zero economic profit. The movement of supply in longrun in accordance with the rise in price eliminates the positive profit of the firms. Thus positive economic profit in shortrun is not permanent.

c. The number of buyers is so large under perfect competition. The number of buyers is so large but they are small buyers in the sense that they cannot influence the market price by their own action. Thus the market under perfect competition is characterized by large number of buyer and large number of sellers.

d. The free entry and exit of firms in longrun under perfect competition gives only zero economic profit to the firms operating in this market. The entry of new firm expands the volume of output in the market and thus the marker price decrease. The existing firm can adjust their plant size when the price increases. Thus the supply is elastic in longrun. This elastic supply gives only a chance of zero economic profit or normal profit in longrun in a market of perfect competition.