Figure 103

Demand Curve for a Single Firm in Perfect Competition

Firms face horizontal demand curves in perfectly competitive markets.

Demand

50 100 150

Quantity per time period (000)

Note: With price constant, P = MR.

at output level Q*, where price (and hence marginal revenue) equals marginal cost, and profits are maximized.

A normal profit, defined as the rate of return necessary to attract capital investment, is included as part of economic costs. Therefore, any profit shown in a graph such as Figure 10.4 is defined as economic profit and represents an above-normal rate of return. The firm incurs economic losses whenever it fails to earn a normal profit. A firm might show a small accounting profit but be suffering economic losses because these profits are insufficient to provide an adequate return to the firm's stockholders. In such instances, firms are unable to replace plant and equipment and will exit the industry in the long run.

In Figure 10.4 the firm produces and sells Q* units of output at an average cost of C dollars; with a market price P, the firm earns economic profits of P - C dollars per unit. Total economic profit, (P - C)Q*, is shown by the shaded rectangle PMNC.

Over the long run, positive economic profits attract competitors. Expanding industry supply puts downward pressure on market prices and pushes cost upward because of increased demand for factors of production. Long-run equilibrium is reached when all economic profits and losses have been eliminated and each firm in the industry is operating at an output that minimizes long-run average cost (LRAC). Long-run equilibrium for a firm under perfect competition is graphed in Figure 10.5. At the profit-maximizing output, price (or average revenue) equals average cost, so the firm neither earns economic profits nor incurs economic losses. When this condition exists for all firms in the industry, new firms are not encouraged to enter the industry nor are existing ones pressured into leaving it. Prices are stable, and each firm is operating at the minimum point on its short-run average cost curve. All firms must also be operating at the minimum cost point on the long-run average cost curve; otherwise, they will make production changes, decrease costs, and affect industry output and prices. Accordingly, a stable equilibrium requires that firms operate with optimally sized plants.

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