Problem 18 Suppose that in a perfectly comp... [FREE SOLUTION]

Chapter 8: Problem 18

Suppose that in a perfectly competitive market, firms are making economic profits. In the long run, we can expect to see a. some firms leave. b. the market price rise. c. market supply shift to the left. d. economic profits become zero. e. production levels remaining the same as in the short run.

Short Answer

Expert verified

In the long run, economic profits become zero (option d).

Step by step solution

Understand Market Characteristics

In a perfectly competitive market, each firm is a price taker, meaning that they cannot influence the market price by their own actions. All firms have identical products, and there are no barriers to entry or exit.

Identify the Short-Run Condition

In the short run, firms are making economic profits. This means that the market price is above the average total cost of production for those firms, allowing them to earn more than the minimum necessary to keep firms in business.

Predict Long-Run Adjustments

When firms in a perfectly competitive market are making economic profits, it attracts new firms to enter the market due to the lack of barriers.

Analyze the Effect of Entry on Market Supply

As new firms enter the market, the market supply increases. An increase in supply, according to the law of supply and demand, causes the market price to fall.

Consider Long-Run Equilibrium

In the long run, the entry of new firms continues until economic profits are eliminated. This results in a situation where the average total cost equals the market price, which means firms are making zero economic profits but still covering all costs, including normal profits.

Conclusion

Based on the characteristics and adjustments in a perfectly competitive market, the correct expectation in the long run is that economic profits become zero, thus option "d" is correct.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Economic Profits

Economic profits in a perfectly competitive market arise when firms earn a return on their investment that exceeds the opportunity cost of capital. This is in contrast to normal profits, which are just enough to cover these costs.
Economic profits occur when the market price is greater than the average total cost of production. In such cases, firms find themselves earning more than the typical return required to remain in the industry.
This situation is initially advantageous for firms, as they can use these profits for reinvestment or other business expansions. However, in a perfectly competitive market, this success is usually temporary due to free market entry and exit.

Market Supply

Market supply refers to the total amount of a product that firms are willing and able to sell at a given price level in the market. In a perfectly competitive market, the supply curve is created by adding the supply curves of all individual firms in the market.
As firms make economic profits, more firms are incentivized to enter the market. This causes the market supply curve to shift to the right because more units of the product are being made available at every price level.
Over time, as market supply increases, the market price tends to drop. This price adjustment continues until firms no longer earn economic profits in the long run, achieving market balance.

Entry of New Firms

The entry of new firms into a perfectly competitive market is driven by the lure of economic profits. When existing firms enjoy economic profits, there are no barriers preventing other new firms from entering the market to capture some of those profits themselves.
New firms increase the quantity of goods available, contributing to an increase in market supply.
This continues until the market becomes overcrowded, pushing economic profits down until only normal profits remain. That is, profits that are just enough to keep the business viable without creating a financial incentive for new entries.

Long-Run Equilibrium

Long-run equilibrium in a perfectly competitive market occurs when firms earn zero economic profits. This means they earn only normal profits, covering all operational costs including the opportunity cost of capital.
In the long run, the market price equals the average total cost for production. This represents a balance where neither profits nor losses occur that are large enough to affect market entry or exit.
The process leads to a stable market environment where supply and demand are balanced, and market forces do not prompt further changes in the number of market participants.

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