Question

3) Suppose a perfectly competitive firm is earning a positive economic profit. Show this situation in a graph. What will happen to economic profits in the long run? Show this situation in a graph. As profits are driven to zero, what happens to consumer surplus? a. b.

Answer 1

a) When firms in perfectly competitive market was making a positive economic profit, it will attract more firms in the market who will enter the market with hopes to make some economic profit themselves. However, what happens is this free entry of firms in the market will increase the supply in the market, shifting the supply curve to the right. Keeping demand unchanged, this will lead to a fall in price and thus positive economic profits falling back to 0. Graphically, this can be seen as below: MARKET FIRM Price Price АТС P1 P2 Quantity Quantity As it can be seen, a right shift in the supply curve leads to a fall in price from P1 to P2 When price is P1, the individual firm in making positive economic profits equal to the blue colored area. As price falls to P2, p becomes equal to ATC and economic profits become 0 b) Consumer surplus gets maximized as price becomes equal to MO.