Question

Illustrate the short-run equilibrium of a perfectly competitive firm incurring losses. Show the same with the help of a diagram.

Answer 1

In the short run, a perfectly competitive firm can earn supernormal profits if the market price is higher than the average total cost (ATC). Since the firm is a price taker, it accepts the market price and chooses the output, where marginal cost (MC) equals marginal revenue (MR), and under perfect competition, MR = Price.

If the price is above ATC at this output level, the firm earns supernormal profit. The profit per unit is the difference between price and ATC, and total profit is this amount multiplied by the number of units produced. This profit is shown as the shaded area between the price line and the ATC curve in the diagram.

However, this situation doesn’t last in the long run. Due to free entry, new firms enter the market when they see existing firms earning supernormal profits. This increases supply, causing the market price to fall. The entry continues until the price drops to the level of ATC, and only normal profit remains.

So, while a perfectly competitive firm can earn supernormal profits in the short run, it earns only normal profits in the long run due to the entry of new firms.