Question

4.2 Explain using properly labelled diagrams, why a perfectly competitive firm will earn only normal profit in the long-run.

4.3 Explain SEVEN (7) conditions necessary for a perfectly competitive market to exist.

Answer 1

Suppose that there is increase in demand , which causes price to rise from P1 to P2. This causes supernormal profits because P2>AC.

However, the supernormal profit encourages more firms to enter the market.New firms enter which increases supply from S1 to S2 until the prices fall to P1 and there will be only normal profits in the long run. Hence, in the long run all profits are wiped out.

4.3 Seven essential conditions necessary for a perfectly competitive market to exist are:

1. Large number of buyers and sellers.

2. Homogeneous products.

3. Uniform price.

4. Free entry and exit .

5. Perfect knowledge.

6. Perfect mobility.

7. Absence of transport costs.