Question

Discuss the equilibrium of a firm under perfect competition in the long run.

Hint:

In the long run, firms in a perfectly competitive market enter and exit freely, leading to zero economic profit and efficiency in resource allocation.

Answer 1

In the long run, a firm under perfect competition achieves economic equilibrium where the firm maximizes its profits (or minimizes losses) by adjusting all its inputs, including fixed factors of production. The equilibrium is characterized by the following features:
1. Profit Maximization: In perfect competition, firms are price takers, meaning they accept the market price determined by the forces of supply and demand. The firm produces at the level where marginal cost (MC) equals marginal revenue (MR), and since price equals marginal revenue in perfect competition, this condition becomes \( P = MC \). Firms will increase output as long as the marginal revenue from the sale of an additional unit exceeds the marginal cost of producing it. 2. Zero Economic Profit (Normal Profit): In the long run, economic profit (profit beyond the normal rate of return) tends to be zero. If firms in the industry are making an economic profit in the short run, new firms will enter the market, increasing supply and driving the price down until firms are no longer earning above-normal profits. On the other hand, if firms are making losses, some will exit the market, reducing supply and increasing the price until firms are once again earning zero economic profit. This condition is known as the long-run equilibrium in perfect competition. 3. Productive and Allocative Efficiency: In the long run, firms achieve productive efficiency, meaning they produce at the lowest possible cost, represented by the minimum point of the average cost (AC) curve. At this point, firms are utilizing resources in the most efficient manner, minimizing waste. Firms also achieve allocative efficiency, where the price consumers are willing to pay equals the marginal cost of production, \( P = MC \). This ensures that resources are allocated to their highest valued uses, and there is no excess or shortage in the market. 4. No Incentive to Enter or Exit the Market: Once a firm reaches long-run equilibrium, there is no incentive for new firms to enter or existing firms to exit the industry. The price remains stable, and firms are earning only normal profits, which is the level required to cover the opportunity cost of resources. 5. Constant Costs Industry: In a perfectly competitive market, the long-run equilibrium typically assumes constant costs, meaning that as the industry expands, the cost of production for each firm remains the same. If the market were to experience increasing or decreasing costs, the equilibrium would shift. The long-run equilibrium for a firm under perfect competition is depicted where the MC curve intersects the AC curve at its minimum point. This is the most efficient production level, where the firm produces the output at the lowest cost, while also earning zero economic profit in the long run.