Question

In the long run the perfect competitor will (LO5) a) make a profit b) break even c) take a loss

Short answer

In the long run, a perfect competitor will: b) break even This is because, in a perfectly competitive market, firms have enough time to adjust their production levels and enter or exit the market. Profits attract new firms, increasing supply and reducing price, while losses lead to firms exiting the market, decreasing supply, and increasing price. This process continues until all firms just break even, and there are no incentives for new firms to enter or existing firms to exit the market.

Step-by-step solution

Understand Perfect Competition Market Characteristics

In a perfect competition market, there are a large number of small firms that sell identical products or services. The consumers have complete information about the products and there is free entry and exit of firms in the market. In such a market, each firm is a price taker and cannot set the price of its product; it has to accept the market price determined by the forces of supply and demand.

Analyze the Short Run and Long Run Profit Possibilities

In the short run, a perfect competitor may make a profit, break even, or take a loss depending on the relationship between the market price, average total cost (ATC), and marginal cost (MC). If the market price is above the ATC, the firm will make a profit, as the price covers all the variable and fixed costs and provides some surplus for the owners. If the market price equals the ATC, the firm will break even, as the price just covers the total costs (variable and fixed). If the market price is below the ATC, the firm will take a loss, as the price is insufficient to cover the total costs.

Establish Long Run Equilibrium in Perfect Competition

In the long run, firms have enough time to adjust their production levels and enter or exit the market. So, if there are profits in the short run in a perfectly competitive market, more firms will enter the market to take advantage of those profits, which increases the supply and reduces the market price. This process continues until the market price drops to a level where firms just break even, and no new firms have any incentive to enter the market. If firms are taking a loss in the short run, some will exit the market to minimize their losses. This decreases the supply and leads to an increase in the market price. This process will continue until the market price reaches a level where the remaining firms just break even, and no existing firms have any incentive to exit the market. In the long run equilibrium, firms in perfect competition always end up breaking even.

Choose the Appropriate Option

Based on the understanding of perfect competition markets and analyzing short run and long run profit possibilities, we can conclude that in the long run, the perfect competitor will: b) break even

Key concepts

Long Run Equilibrium

In a perfectly competitive market, the concept of long run equilibrium is vital in understanding how firms behave over time. In the long run, all factors of production and costs are variable, meaning firms can adjust their scale of operations, and new firms can enter or exit the market freely.
In such a market, firms aim to find a point where they can operate profitably without attracting new competition. This occurs when firms earn zero economic profit, which means they break even since all their opportunity costs are covered by the revenue. When firms in the market are making profits in the short run, it signals new firms to enter the market, increasing supply and subsequently reducing prices.
On the other hand, if firms are incurring losses, some will leave the market, reducing supply and raising the prices until firms remaining in the market break even. At this point, there is no motivation for firms to either enter or exit the industry, achieving a long run equilibrium. This ensures that any firm that remains in this market in the long run will earn just enough to cover all costs, with no incentive for additional profits or losses.

Price Taker

The role of a price taker is central in a perfect competition market. Here, individual firms do not possess any market power to influence the prices of goods or services they produce. Instead, they must accept the prevailing market price, which is determined by the aggregate supply and demand in the industry.
Since each firm is a small participant among many, changing its prices will not affect the overall market equilibrium. For individual firms:

• They maximize production efficiency where their marginal cost of production equals the market price, meaning any deviation in price would not cover costs efficiently.
• The demand curve faced by each firm is perfectly elastic at the market price. They can sell as much of their product as they want at the market price but cannot charge higher without losing customers to competitors.
• Being a price taker also means staying competitive by minimizing costs and adopting technologies or methods that enhance productivity.

This reinforces the importance of operational efficiency and innovation within competitive markets because firms must focus on minimizing average total cost to stay viable without any pricing power.

Market Entry and Exit

The ease of market entry and exit is a defining characteristic of perfectly competitive markets. This feature ensures that markets can adjust swiftly to changes in product demand and production costs. In the short run, firms may experience profits or losses, attracting or deterring new entrants respectively.
This process of entry and exit aligns market supply with consumer demands efficiently. When firms in the market are enjoying short-term profits, it signals potential newcomers that the industry is lucrative, prompting them to enter. Consequently, the increased supply usually leads to a fall in prices and profits, restoring equilibrium.
Conversely, when firms endure losses, some will leave the industry to prevent further financial damage. This exit reduces market supply, often elevating prices and alleviating losses for those who remain. Thus, market entry and exit are self-regulating mechanisms that ensure resources are allocated to their most efficient uses in the long run. It supports the dynamic nature of perfect competition, facilitating a market environment where resources always move towards the most profitable and productive outcomes.