Question

Why will profits for firms in a perfectly competitive industry tend to vanish in the long run?

Short answer

Profits for firms in a perfectly competitive industry tend to vanish in the long run because when firms initially earn profits, it attracts new entrants to the market. This increases competition and supply, driving down the market price, and reducing individual firm profits. The process continues until the market reaches a long-run equilibrium where firms are making zero economic profit, ensuring that firms in a perfectly competitive market earn only normal profits in the long run.

Step-by-step solution

Understanding Perfect Competition

A perfectly competitive market is a market structure characterized by a large number of small firms producing a homogeneous product, with no barriers to entry or exit. In such a market, firms are price takers which means that they cannot influence the market price. They also have perfect knowledge of the market and aim to maximize their profits given the constraints.

Short-Run Equilibrium

In the short-run, firms can make a profit, break even, or incur losses depending on their cost structure and the market price. If market price is above the average total cost (ATC) at the profit-maximizing level of output (where marginal cost equals the market price), the firm will earn a profit. If market price equals the ATC, the firm will break even, and if market price is below the ATC, the firm will incur losses.

Profits Attract New Entrants

When firms in the perfectly competitive market make a profit in the short run, it serves as an incentive for new firms to enter the market. Since there are no barriers to entry, new firms can enter the market and produce the same homogeneous product, adding more competition for existing firms.

Adjustments in Supply and Price

As new firms enter the market, the supply of the product increases, which drives down the market price due to the increased competition. This, in turn, reduces the profit margin for each individual firm, as their revenue decreases with the reduced market price while their cost structure remains unchanged.

Long-Run Equilibrium

This process continues until the market reaches a long-run equilibrium where firms are making zero economic profit (i.e., they are covering their opportunity costs but not making above-average returns). At this point, there is no economic incentive for new firms to enter the market or for existing firms to exit. The market supply and demand forces work together to ensure that firms in a perfectly competitive market earn only normal profits in the long run. In conclusion, profits for firms in a perfectly competitive industry tend to vanish in the long run due to the characteristics of perfect competition, such as no barriers to entry, homogeneous products, and firms being price takers. As firms initially earn profits, it attracts new entrants to the market, increasing competition and supply, which drives down the market price and reduces individual firm profits. This continues until a long-run equilibrium is reached where firms are earning zero economic profit.