Question

Why will profits for firms in a perfectly competitive industry tend to vanish in the long run? Would this be true of losses also? Why or why not?

Answer 1

Answer - When a perfect competitive firm earns an economic profit in short run, other firms gets attracted by seeing the profit of the firms in the market and tends to enter the market to make profit like the other firms as in perfect competition market there is no restriction in entry and exit. As there is more and more firms entering the market, every firm tries to decrease its price to pull the customers towards themselves. This decreasing of price by the sellers pulls the price of goods and services down to their cost as there is tough competition in the market. So in the long run, sellers have to sell their product at their cost where the sellers incur neither profit nor loss and the profit which the sellers made in the short run vanishes in the long run.

This is not true of losses because the sellers would rather sell it in their cost price than to make loss by selling it below their cost. Thus, sellers pull down the market price till their cost so that they could only cover their average cost by selling their product at cost price.

GRAPHICAL REPRESENTATION

• P = Price
• Q = Quantity
• D = Demand
• MC = Marginal Cost
• ATC = Average Total Cost
• AR = Average Revenue
• MR = Marginal Revenue

EXPLAINATION OF THE DIAGRAM ABOVE.

In the above diagram it is shown that, in the long run for a firm in perfect competitive market earns a zero economic profit. We see that the price line intersects the ATC at the lowest or at the minimum point. If the price level is above the lowest point of ATC, the firm would incur a economic profit and if the price level is below the lowest point of ATC the firm would incur a loss. Thus, as the firm incurs zero profit or in a position of no profit no loss, the price line is exactly at the minimum point of ATC, where the firm only covers only its average cost.