Question

This question asks you to analyze how the ideal conditions that influence the motives and decision-making of firms in Pure Competition cause differences in the efficiency outcomes and total profit levels that occur in the short run and the long run.

1. Make a distinction between accounting profit and economic profit. Then explain why a purely competitive firm who earns a Zero Total Economic Profit is actually earning a normal profit, as viewed by economists.
2. In the short run, explain how a single firm in a purely competitive market could be either earning normal, below-normal or above-normal total economic profit, as a result of the level of the equilibrium product price in the entire industry at that moment.
3. Explain how the conditions of rational decision-making, perfect information and free-entry and free-exit of firms in a purely competitive market causes all firms in the industry to end-up earning a normal total economic profit in the long-run. Also explain why zero total economic profit is also the maximum total profit available in the long run for a purely competitive firm.
4. When a purely competitive firm earns a normal economic total profit in the long run, it produces a quantity Q of its final product where $Price = $Marginal Cost and also $Price = Minimum Average Total Cost. Why are these price and cost equalities considered to be beneficial for the entire economy?
5. In the short run, if a purely competitive firm is producing Q where $Price = $Marginal Cost and simultaneously $Price = $Minimum Average Variable Cost, then explain why this firm is operating at output level known as the “Shutdown Point”. (Hints to remember help answer this question: For any given Q level, AVC is always less than ATC; Also, a positive contribution margin will exist as long as $Price > $Average Variable Cost at a given Q level).

Answer 1

First of all we have to understand the key feature of perfect competition and pure competition.

1. Large number of buyers and sellers: There are large numbers of buyers and sellers present in the perfect or pure competition market. The number is so large( actually not in figures) that an individual buyer or seller can not influence the price of the commodity. Therefore all firems under pure or perfect competition are price takers.

2. Homogenius Product: Products are indentical in all aspects that is size ,shape , colour, quality tec. Therefore no individual buyer would be ready to pay different prices.

3. Free entry and exit of firms: This is the most important key feature of perfect or pure coimpetitive firms. Firms are free to enter or leave the industry any time. Generally when a firm wants to leave? When it is in loss as exit is free they can move out but it will lead to less supply and other firems would be more comfortable to remain in the market. Similarly when firms want to remain in the maarket? When they are earning super normal profit.it will definitly attract new firms to enter in the industry. AS entry is free it will lead to more supply and more competition in the market.so profit will reduce. The gist of the story is all firms will earn normal profit inthe long run.

Above three feature are the features of pure competition. Other than this there are some features like no transportation cost, buyers and sellers have perfect knowledge,perfect mobility of resources etc.

Now million dollor question is where a perfect or pure competitive firm should stay? What is the producer's equlibrium? Where is the maximum profit? It is for short run or for long run?

For all these questions to answer just imagine a vegetable market where large number of sellers are present , Product is almost indetical( dont go for new , old , frozen etc) so no individual buyer or seller can influence the price. If they do so they will be out of the market.( we can see in profit maximising condtion). So wehre is equlibrium. Remeber an equilibrium is the postion of rest where a firm wants to saty. So where it is ? It is that point wehre a firm earns the maximum profit.

There are two approaches to see this producer's equilibrium.

1. MR-MC approach

2. Tr -TC approach

We will go by MR -MC approach. But before seeing the condtions of producer's equlibrium. Let us discuss few terms.accounting profit, economic profit, super normal profit, normal profit , zero eonomic profit . There are basically two types of costs which are very important for producers. One is Explicit cost (hiring factors of production like land , labour, capital etc) and implicit cost( with in the organisation like own use of factors like vegetable seller himself is sitting in the market, he is having his own purchased shop etc) Whem we deduct total cost means all explicit cost from total revenue we get accounting profit or in simple words mentioned in the accouting book. But what we ignore here that the implicit cost .Sellers himself is sitting , having his own shop and above all the opportunity cost ( cost of foregone alternative or next best possible use of resource.Like a seller is sitting in such area which is more accesssible. .So reach to the economic profit we have to see these cost also. People generally feel that all selleres are seeling the same product at same price will earn normal profit. Its not like that MR. beans is very kind , generous in his talking, sitting next to the entrance,i will attract more to him and will buy from him. Even i know prices are same every where. i will buy from him and obviously he will earn more than the normal profit which is called super normal profit. That is another issue that more firms will attract and all firms will earn normal profit in the long run as entry is free.

So basically there are two conditions to see profit maximisation for a purely competitive firm.

1. MR= MC

2. MC must rise ot rising portion of MC curve will lead to profit maximisation.

IN the short run few firms may be in loss too as they are not cost efficient so they earn below normal profit which is actually loss which forces to move out. Other firms earn normal profit TR-TC and but its not maximim . Cost efficient firms will earn above normal profit.

Zero economic profit is actually is the maximum total profit for all firms in the long run. It is because opportunity cost might be high or all firms are just managing economic profit .

Now which is shut down point. If firms are not able to manage their average vaiable cost they are forced to hut down. Graphically AVC curve is above price line that is loss. If it just touching the price line MR and MC curve are also cutting from that point it is shut down. Firms would be able to recover their losses from fixed factors of production like land , machinary etc.