In perfect competition, there are a large number of small firms producing homogenous products, in other words, products produced by one firm is identical to the products produced by other firms in the market. There are also a large number of buyers within the market where they have perfect information about the products. Therefore, no individual trader is able to influence the market price. The market price is thus determined by the operation of the market. Firms in the perfect competition are able to enter the market if they think it’s a profitable step, and they can exit from the market without any obstacle. In short-run, the firm in the perfect competition act as a “price taker”, and has to accept whatever price is set in the market. The firm faces a perfectly elastic demand curve for its product, as shown in Figure 1. In this figure P1 is the price set in the market, and the firm cannot sell at any other price. If the firm tried to set above P1 it will sell nothing, as buyers know that there is no quality difference between the product as produced by other firms in the markets. Also, there is no incentive for any firm to set a price below P1.
As the firm choose to produce at the profit maximum point, the firm needs to set output at a level where marginal revenue is equal to marginal cost. Figure 2 illustrates this by adding the short-run cost curves to the demand curves. The firm faces constant average revenue and marginal revenue, as the demand curve is horizontal and will choose output at q1, where MR=MC. Consider the industry as a whole; the demand curve is conventionally downward sloping, as shown in Figure 3. On the supply side, the supply curve is the sum of each firm operating in the market, the result is the industry supply curve S1, as shown in Figure 2. The price will then adjust to P1 at the intersection of demand and supply. The firms in the industry will supply Q1 output.
In Figure 2, the firm maximises profits by accepting the price P1 as set in the market and producing up to the point where MR=MC, which is at q1. However, now the firm’s average revenue is greater than its average cost. The firm is thus making super-normal profits at this price and the amount of total profits being made is shown as the shaded area adP1b on Figure 2. In short-run, the firm may also earn sub-normal profits, which is shown in Figure 4. When the average cost curve is located above the horizontal demand curve, the firm is producing at the profit maximising point where MR=MC, and the firm is producing q2. At this point, the firm’s average revenue is less than its average cost. The firm is thus making sub-normal profits at the price P2 and the amount of total sub-normal profits being made is shown as the shaded area abP2d. In long run, all factors of the firm can be varied, therefore new firms can enter and existing firms can leave the industry. When a large number of new firms are attracted into the industry by super-normal profits, then this will shift the industry supply curve to the right in Figure 5 from S1 to S*. New firms will then continue to enter until any super-normal profit is competed away, that is only normal profit is earned.
When firms earned sub-normal profits, a large number of firms would therefore leave the industry, shifting the supply curve to the left in Figure 5 from S2 to S*. Hence, the price will be risen, and earning normal profit. In summary, the long-run profit maximising equilibrium will only occur when there are no...