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Long-run economic profit for perfectly competitive firms

A firm in a perfectly competitive market might be able to earn economic profit in the short run, but not in the long run. Learn about the process that brings a firm to normal economic profits in this video.

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Video transcript

- [Instructor] Let's dig a little bit deeper into what happens in perfectly competitive markets in the long run. So what we have on the left-hand side, and we've seen this multiple times already, is our supply and our demand curves for our perfectly competitive market, and you can see the equilibrium price right over here, marked with this a dotted line, and as we've talked about in multiple videos, the firms in that perfectly competitive market, the perfectly competitive firms, they just have to price takers, so the market price is going to be their marginal revenue curve. It's gonna be this horizontal curve. And it would be rational for them to produce the quantity. So they're not going to set the price, but they can choose what quantity to produce, but it would be rational for them to keep producing while the marginal revenue is higher than the marginal cost up to including when the marginal revenue is equal to the marginal cost. So for this firm at this current state of affairs, it would be rational for them to produce this quantity right over there. And as we've talked about in other videos, at that quantity, they're going to make an economic profit. And the way that we can see that is at this quantity, this is the average total cost, that is your marginal revenue, and so you are going to get this much per unit and then you multiply, so the height is how much you get per unit and then you multiply that times the number of units, so the area of this rectangle is that positive economic profit that this firm will have. Now, that's in the short run, but now let's think about what will likely happen in the long run. If folks see other folks making a positive economic profit, remember, economic profit doesn't just account for regular cost, it also includes opportunity cost, so a lot of you will say hey, I would wanna put my resources into this market so that I can make that positive economic profit as well. But what's gonna happen as you have entrance into this market? Well, that's gonna shift the supply curve to the right. At any given price, you're gonna have more supplies, one way to think about it. So that's a supply curve. Let's just call that one. Now, you're gonna have more entrance. More entrance. And what's going to happen? Well, you might get to something like you might get to a situation like this. Let me see if I can draw it well. You might get to a situation like this where you have more entrance and you got the supply curve two. Now, what's going to be the quantity that firm A produces in that one? Remember, firm A is one of many firms. Well, in this situation, we have a new equilibrium price. So if this was P sub one, now we have this new equilibrium price, P sub two, which is going to define a new marginal revenue curve for all of the players in this perfectly competitive market and so the new marginal revenue curve is gonna be right over there. Now, in this situation, what is the rational quantity for firm A to produce? Well, once again, as long as marginal revenue is higher than marginal cost, it makes sense for them to produce more and more and more, up until the point that they are equal. So now, firm A would want to produce less because the market price that it just has to take is less. But notice what happens as more and more entrants got into the market. The market price, which also defines this horizontal marginal revenue curve, went lower and lower to the point where firm A now in this situation is making no economic profit. At this point, where not only as marginal revenue intersecting marginal cost, but that's exactly the point in which marginal cost is equaling average total cost. So one way to think about it is in a perfectly competitive firm, they're productively efficient. They are producing the quantity that minimizes their average total cost. We've already talked about that point where marginal cost and average total cost intersect. That's gonna be the minimum point for average total cost. And why is that? Well, while marginal cost is below average total cost, average total cost is gonna get lower and lower and lower, and then once marginal cost gets higher than average total cost, well, then the average total cost curve will starting going curving up. So we just saw a situation that even where we see economic profit in the short run, in the long run, entrants are going to go into that market and it's going to reduce the economic profit down to zero and at that point, the firm that has a zero economic profit, they're productively efficient. They are producing at the minimum point of the average total cost curve. And we've already talked before that this equilibrium point right over here in our market, because our demand and supply curves, the intersection point defines the price, our equilibrium price and quantities, we're also allocatably efficient. We've talked about things like dead weight lost in the past. That is not happening right over here. Our marginal benefit is equal to our marginal cost right at that equilibrium price and quantity. Now, some of you might be saying, well, what about the other situation? What about if for some reason we were in a, let's call the supply curve here. Let's say people overshot. Too many people joined into this market. So let's say we went to supply curve three, well what's going to happen? Let me label this. This is right over here, this is marginal revenue curve one, which is equal to price one. This is marginal revenue curve two, which is equal to price two. And then this would define, so this right over here would be price three, price three, which would define marginal revenue curve three. So marginal revenue curve three, which is equal to price three. Well if too many entrants joined into that market, now firm A has a more difficult scenario. They are, would produce at this quantity, we've talked about many times already, but at that quantity, each unit their average total cost is higher than that revenue they're getting. So they're going to be running at an economic loss in the short run. But what would happen in the long run? Well firm A in the long run would probably exit the market and other firms who are running at economic loss would exit the market, and so that would shift the supply curve back to the left. And so we would eventually get, once again, to that reality where firms have no economic profit in there and we have a market that is allocatably efficient, no dead weight loss, and firms are producing at the minimum point of their average total cost curve, which is known as productive efficiency or productively efficient.