Question

Explain the concept of Perfect Competition. How is equilibrium of a firm attained in the long run ?

Hint:

The key to long-run equilibrium in perfect competition is the "zero-profit condition." The freedom of entry and exit acts as a powerful force that erodes any supernormal profits or losses, forcing every firm to produce at the most efficient scale (minimum LAC).

Answer 1

Part 1: The Concept of Perfect Competition
Perfect competition is a market structure characterized by the complete absence of rivalry among individual firms. It is a theoretical market model where competition is at its greatest possible level. The key features of a perfectly competitive market are: \begin{enumerate} \item Large Number of Buyers and Sellers: There are so many firms and consumers in the market that no single firm or consumer can influence the market price. Each firm is a "price taker." \item Homogeneous Product: All firms in the industry produce identical products. This means the products are perfect substitutes for each other, and consumers have no preference for the product of one seller over another. \item Free Entry and Exit of Firms: There are no barriers (legal, economic, or technological) to the entry of new firms into the industry or the exit of existing firms. This feature is crucial for the long-run equilibrium. \item Perfect Knowledge: Both buyers and sellers have complete information about the market prices and conditions. \item Perfect Mobility of Factors of Production: Factors of production (land, labor, capital) can move freely from one industry to another. \end{enumerate} A direct consequence of these features is that the demand curve facing an individual firm is perfectly elastic (a horizontal line at the market price), which means \(Price = Average Revenue = Marginal Revenue (P = AR = MR)\).
Part 2: Long-Run Equilibrium of a Firm
In the long run, a firm in perfect competition can adjust all its inputs, and the number of firms in the industry can change through entry and exit. The equilibrium is determined by the interaction of these long-run adjustments. The two basic conditions for a firm's equilibrium are: \begin{enumerate} \item Marginal Cost (MC) must be equal to Marginal Revenue (MR). \item The MC curve must cut the MR curve from below. \end{enumerate} The long-run equilibrium is achieved through the following process: \begin{itemize} \item If firms earn supernormal profits (Price > AC): If existing firms are making profits above the normal level, new firms will be attracted to the industry. This entry of new firms increases the total market supply. The increase in supply will cause the market price to fall. This process continues until the price falls to a level where it is equal to the minimum average cost, and all supernormal profits are eliminated. \item If firms incur losses (Price < AC): If existing firms are making losses, some firms will exit the industry. This exit reduces the total market supply. The decrease in supply will cause the market price to rise. This process continues until the price rises to a level where it is equal to the minimum average cost, and all losses are eliminated. \end{itemize} Therefore, the long-run equilibrium is established at the point where firms are earning only **normal profits**. This occurs at the output level where the price is just sufficient to cover the average cost of production. The conditions for long-run equilibrium are: \[ P = MR = LMC = Minimum LAC \] where LMC is the Long-run Marginal Cost and LAC is the Long-run Average Cost. Diagrammatic Representation: \begin{center} \begin{tikzpicture} \begin{axis}[ axis lines=left, xlabel={Output (Q)}, ylabel={Price, Revenue, Cost}, xmin=0, xmax=10, ymin=0, ymax=20, xtick={5}, xticklabels={$Q^*$}, ytick={10}, yticklabels={$P^*$}, legend style={at={(0.6,0.95)},anchor=north west}, height=8cm, width=10cm ] % LAC and LMC curves \addplot[smooth, thick, blue, domain=1:9] {0.2*(x-5)^2 + 10}; \addlegendentry{LAC} \addplot[smooth, thick, magenta, domain=0:8] {0.4*x^2 - 2*x + 10}; \addlegendentry{LMC} % Price line \addplot[thick, red, domain=0:10] {10} node[right] {$P^* = AR = MR$}; \addlegendentry{} % Equilibrium point \node[circle, fill, inner sep=1.5pt, label=below:E] at (axis cs:5,10) {}; % Dashed lines \draw[dashed, gray] (axis cs:5,0) -- (axis cs:5,10); \draw[dashed, gray] (axis cs:0,10) -- (axis cs:5,10); \end{axis} \end{tikzpicture} \end{center} In the diagram, the firm is in long-run equilibrium at point E, producing output \(Q^*\). At this point, the price \(P^*\) is equal to the firm's marginal cost (LMC) and also equal to the minimum point of its long-run average cost curve (LAC). The firm covers all its costs, including the opportunity cost of the entrepreneur, thus earning only normal profits.