Question

Suppose that a purely competitive firm producing cakes discovers that their P exceeds their MC. Is their output of cakes be too little, too much, or just right to achieve allocative efficiency? In the long run, what will happen to the supply of cakes and the price of cakes? As part of your answer you should mention the two factors that will bring the supply-demand situation back into equilibrium if it becomes known that there is profit in making cakes.    

Answer 1

A purely competitive firm is characterised by many firms selling identical products with no barriers to entry and exit. These firms are price takers and earn only normal profits in the long run. Thus, they operate at a point where Price is equal to the Marginal Cost of production.

If they discover that their P exceeds MC, then their output of cakes is more than the efficient level and they are earning supernormal profits in the short run.

Here, P2 is greater than P1 which leads to overproduction. The firm is earning supernormal profits as shown by the shaded area.

In the long run, two adjustments will take place. One at the firm level and other at the industry level. Because of free entry and exit in the market, super normal profits will draw more firm towards it and now the market is shared by more firms. This reduces market share on an individual firm level and supply increases to cover the increase in demand. The profit is foregone.

Secondly, in the long run, all inputs are variable and firms can vary their factors of production. SO seeing supernormal profits, they'll raise their productive capacity by installing larger plants, thus increasing supply. This will again even out the inccrease in demand and profits will be foregone. Thus, in the long run, firms will earn only normal profits.

In the long run, the supply adjusts to increase to S2, as a result of which price falls back to the efficient level and supernormal profits are wiped out.

Thanks!