explain why a PC firm can only make abnormal profit in the short run but necessarily makes normal profit in long run

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explain why a PC firm can only make abnormal profit in the short run but necessarily makes normal profit in long run

What is perfect competition: a type of structure where all products are homogeneous, large or infinite amount of buyers and sellers. Hence, all firms are price takers.

There is perfect information in this market. Also, there are no barriers to entry.

 

short run is a time period where at least 1 factors of production is fixed. for example land.

Abnormal profits occur in short run when AR>AC.

From the diagram, a firm takes market price in the short run. This price is at P, determined by the market/industry. The firms then allocates where MC = MR, where profit is maximised and they are making abnormal profits (this is because each incremental benefit=incremental cost. The firm has made all excess profits and does not produce more where it will make excess loss).

At this point, the total revenue is represented by PxQ. At the same output, AC<AR. This means that the total cost, which is AC.Q is less than total revenue. The excess revenue is the abnormal profit.

 

IN the long run, as the firms are making abnormal profits, more firms can enter the market because there is low barriers to entry.

therefore they increase supply of the industry, and push price downwards. There is a downward shift of the AR curve.

Assuming that the firms continue to produce where MC=MR, the output is changed from Q to Q1, hence, firms make a normal profit where AC=AR

Price Quantity Diagram

Price Quantity Diagram

In SR; firms takes market price at AR. They allocate at MC=MR, the firms make a abnormal profit. This occurs at AR>AC.

 

In LR; due to absence of barriers entry, new firms enter as they are incentivized by abnormal profits. The supply in the market increases and hence AR shifts down. AR=AC, normal profit

By | 2015-10-28T13:45:12+00:00 October 28th, 2015|Economics resources, Micro: Market Structure|0 Comments

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