Question

Explain why abnormal profits earned and losses incurred by perfectly competitive, profit-maximizing firms cannot be present at long-run equilibrium.

Answer 1

Perfectly competitive firms has the characteristic of free entry and exit of firms. Because of this characteristics , if the abnormal profits are earned by existing firms. Then, new firms will enter the market and this will shift the market supply curve outward and reduce the market price. Because of the same cost structures , this will reduce the profits for each firm. This process will continue up to the point where all firms earn only normal profits and P=MC= minimum long run ATC.

Similarly, if abnormal losses are earned by existing firms. Then, existing firms will exit the market and this will shift the market supply curve inward and increase the market price. And it reduces until the remaining firms earn only normal profits and P=MC=AR=minimum long run ATC.