Question

a) The owners of firms in the real world would generally expect (in the long run at
least) to have some positive of profits on their accounting statements. However, in
economic models we usually assume that firms will be willing to operate for zero
economic profits even for the long term. Explain why this is the case.


b) Explain why the profit maximising price and quantity for a price-setting firm (in a
market where it can only set one price) will result in an outcome that can be
considered Pareto inefficient.

Answer 1

a) The total profit of the owner of a firm consists of economic profit and earning from the capital. In economic models, the firm operates at zero economic profit as a positive economic profit draws in more competition and makes it impossible to earn a profit. So, with free entry and exit, we will have zero profit in the long run. In reality, the owner of the firms is also the owner of the capitals employed in the firm. Thus though the economic profit of the firms is zero, the accounting profit is positive, since as the owner of capital, the producer is having an income. Accounting profit = economic profit + earnings from capital. Economic profit is just the residual income, that is, the profit the owner gets after payments to factors of production. SOnce economic profit is not the only source of income, firms will be willing to supply at zero profit.

b) A Pareto efficient outcome occurs when none of the individuals can be made better off without aking one person worse off. In a market setup, price and quantity are decided through the interactions of many buyers and sellers, each guided by their own self-interest. If the price increases, the producers will be better off but the consumers will suffer. If the price decreases, consumers will be better off but the producers will suffer. So, the market outcome is the best possible solution possible. It is a Pareto-efficient outcome.