Question

Why does a firm under perfect competition earn only normal profits in the long run?

Show how a firm in a perfectly competitive market earns normal profit in the long run.

A perfectly competitive firm always enjoys normal profit in the long run, irrespective of the situation it faces in the short run. Discuss the statement in brief.

Answer 1

A firm under perfect competition reaches long-run equilibrium when it earns only normal profit, i.e., when Total Revenue = Total Cost.

1. Free Entry and Exit:
   • The key feature of perfect competition in the long run is free entry and exit of firms.
   • It ensures that firms cannot earn supernormal profits or incur losses permanently.
2. Role of Short-Run Profits and Losses:
   • Abnormal (supernormal) profits attract new firms into the industry.
   • Losses force existing firms to exit the industry.
3. Effect of Entry of New Firms (Abnormal Profits Case):
   1. New firms enter the market → Industry supply increases.
   2. The supply curve shifts right.
   3. Market price falls, reducing abnormal profits.
   4. Entry continues until only normal profits remain.
4. Effect of Exit of Firms (Losses Case):
   1. Firms exit the industry; industry supply decreases.
   2. The supply curve shifts left.
   3. Market price rises, reducing losses.
   4. Exit continues until remaining firms earn normal profits.
5. Long-Run Equilibrium Condition:
   1. In the long run:
      Price (P) = Average Revenue (AR) = Marginal Revenue (MR) = Average Cost (AC)
   2. Firms earn zero economic profit, i.e., normal profit.