Question

a) explain what the law of diminishing(marginal) return means. Does it apply to the short or long run? Is it only present in perfectly competitive markets?

b) how does a firm operating under perfect competition know when it is maximizing its profit-in other words, what is the rule that it follows? explain in detail

c) is the decision that the firm makes in part b a short or long run decision? why? explain the difference between the short and the long rum.

d) neoclassical theory says that in the long run, all firms operating under perfect competition earn zero profits. what is the rationale behind this apparently nonsensical statement? explain

Answer 1

a.... The law of diminishing marginal returns or the law of diminishing returns states that  in the production process , when an additional unit of variable input is increased, its marginal product declines, holding all the other factors constant. This law operates in the short run when a firm can't vary his all factors of production. Example one factor say labor variable and other factors like capital, land etc fixed. This law operates in all the production units ( firms) irrespective of market structures.

b.A perfectly competitive firm maximizes its profit when the following twin conditions are satisfied; 1. MR=MC =P ( Necessary conditions) 2. MC curve should cut MR curve from below (sufficient condition).

A firm operating under the perfect competition market is a price taker firm. Price is set by the market through price mechanism i.e. through interaction of demand and supply curves. So the firm has to only adjust its output to maximize its profit.

c...The equilibrium conditions remains the same under short run or long run conditions. Short run is a time period where a firm can't vary his all factors of production whereas in the long run a firm can vary his all factors of production and so change the size of the company/ plant.

d... In the long run entry and exit of firms are completely unrestricted. When a perfectly competitive market is in equilibrium all the firms operates at P=MR =MC = minimum LATC. If firm's P> LATC then they earn economic profits ( supernormal profit) , consequently new firms enter into the market and economic profit is eliminated. Similarly if some firms get losses due to P <LATC , they will quit the market. Thus all the firms will earn only a normal profit ( zero economic profit) in the long run.