In this video we’ll look at the perfectly competitive firm in short-run equilibrium
earning supernormal profits.
We’ll first see how firms in perfectly competitive markets can earn supernormal profits and seek
to understand why they cannot maintain those supernormal profits in the long-run.
While watching this video you should try to follow along with my drawings step by step
so you can become more confident in drawing the diagram for perfect competition and better
understand it.
Take the time to pause the video and draw it along with me.
If you get stuck, leave a comment and we’ll all try to help.
Now let’s get to the diagrams.
Let’s start with the our diagram in long-run equilibrium.
Assume now that there is a sudden increase in demand for widgets.
This shifts the industry demand for widgets to the right, resulting in a higher equilibrium
price of P1 and higher equilibrium quantity of Q1.
The firm’s demand curve now shifts from D to D1 because the price in the market has
risen.
To find the profit maximising level of output we need to find the intersection of MR and
MC.
We drop down to get our production quantity.
We move upwards from this production quantity to the average revenue, or demand curve, to
the sale price.
We also find where the same upward line intersects average costs and follow that to the left
to determine our average cost per unit for this level of output.
Multiplying average revenue, or price, times Q1 gives us our area for total revenue bordered
in blue.
Multiplying average costs by Q1 gives us our total cost bordered in red.
Since total revenue exceeds total cost, this firm is said to earn supernormal profits.
Supernormal profits, or abnormal profits, can only be maintained in the short run.
At this point also, the firm is not productively efficient as it is not operating at the lowest
point of its average cost curve.
However, it is productively efficient as the price consumers are paying is equal to the
marginal cost of production.
Let’s see why they can’t maintain supernormal profits and how the firm returns to long-run
equilibrium.
This level of supernormal profit is going to attract firms into the widget industry.
The lack of barriers to entry means that these profits won’t last for long as new firms
enter the market.
The first thing we need to do to figure out the impact is shift market supply as new firms
enter.
As firms enter the market, this increases the industry supply of widgets, which forces
the market price down from P1 to P* and also pushes down the price the individual firms
must take.
It increases equilibrium output from Q1 to Q2.
Similarly for the firm, this reduces the price they take.
As this happens we have to review our areas for total costs and total revenue.
Again we first locate the point at which MR = MC.
We drop down to the X-axis to find our profit maximising level of output.
Next, we move upwards towards the AC curve and follow that point across to the Y-axis
to determine our average cost per unit.
Similarly, we follow the same line towards our demand curve to determine our average
price per unit.
Our total revenue and total costs in this case are now the same, resulting in normal
profit being earned by the firm.
The supernormal profits have been eroded away by the increased competition in the industry.
By now you should be gaining in confidence with your understanding of perfect competition
in the short-run and long-run.
As we move into our next video we’ll consider firms running an economic loss in the short-run
and what follows in the long run.
If you have any questions or comments, leave them below.
That’s us done for now and I will see you in the next one!