Question

Use our “firm and market” graphs to walk through the short-run and long-run response of a perfectly competitive industry to a decrease in demand for its product. At the firm level, use these graphs to discuss an individual firm’s level of output and profit, as well how the number of firms in the industry will change. At the market level, discuss how the overall quantity of the good produced and the market price will change.

Answer 1

Competitive market is a market in which there are many firms and product is similar, all firms are price takers and there is free entry and exit for any firm.

This market in the long run only has normal profit. In the short run it may have a abnormal profit or a loss but it achieves the normal profit in the long run.

Profit is maximised when marginal cost= marginal revenue and firm charge that price.

Let us look at the following figure.

Case 1: Firm is having a abnormal profit as the price charged is P1 and average total cost in the market is ATC1 , then looking at this other firms will enter in the market and supply curve in the market will shift to right, it will decrease the prices and this firm will be forced to charge only P3 as a price which is equal to average total cost. Normal profit.

Case 2: Firm is having a loss as the price charged is P1 and average total cost in the market is ATC3 , then looking at this other firms will exit along with many other in the market and supply curve in the market will shift to left, it will increase the prices and firms  will be charging P2 as a price which is equal to average total cost.Normal profit.

Hence in the short run a firm may have loss or abnormal profit but in the long run it achieves only normal profit in the competitive markets.

In monopoly, firm is a price maker and charges price above the average total cost and hence aims at abnormal profits.