Question

(a) Why are firms operating under perfectly competitive market said to be a ‘price taker’? What impact does this have on the firm demand curve?

(4 marks)   

(b) “Firm operating under perfect competition can only earn zero economic profit in the long run" Discuss this statement

(6 marks)

Answer 1

a) A perfectly competitive market is characterized by a large number of firms selling homogeneous product. There are no barriers to entry. Firms can enter and leave the market easily.

In such a market its not possible for a firm to have control over its own . lts a price taker not a price maker .Let's's see the reasons.

> As already stated products are not differetiated and number of competitors is high . output supplied by a firm is small relative to the market.

*.ln addition to that, buyers and sellers have perfect knowledge about prices.

*So if a firm charges a higher price, its demand will fall to zero as the buyers will go for the identical product supplied by its competitor .

* Even if a firm somehow becomes successful in setting a higher price , new firms will enter the market attracted by the higher profits. This would increase supply and price of the firm's product will fall.

Firm being price taker do influence the shape of the demand curve. The firm can sell as much as it wishes, but only at the market price. Therefore, any change in price would lead to infinite change in quantity demanded. In such a situation, demand is said to be perfectly elastic and demand curve becomes a horizontal straight line.

42 po dercond curue X Quality

b) In the long run, a firm can change its plant size or any input used to produce the product.This means that an established firm can leave the industry if it earns below normal profits. This process of entry and exit of firms is the key to long run equilibrium. In the short run,firms enjoy economic profits, as a result, new firms enter the industry and shift the supply curve to right. This increase causes the price to fall. Prices fall until economic profits reach zero in the long run.

Following diagram shows a typical firm in a perfectly competitive market in its long run equilibrium. In the long run, firm faces an equilibrium price of P . Following the MC =MR rule , the firm produces an equilibrium output of Q units. At this output level, firm earns a normal profit ( Zero economic profit.) because marginal revenue ( price) equals the minimum point on the short run average total cost curve and long run average total cost curve., the firm is producing with the optimal factory size.