Question

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

Short answer

In a perfectly competitive industry, firms' profits tend to vanish in the long run due to the absence of entry barriers, identical and substitutable products, and increased market supply. Firms initially may earn positive economic profits, but the entry of new firms will drive prices down, leading to a long-term equilibrium where they earn only normal profit, covering their explicit and implicit costs. This equilibrium results in effectively zero economic profits for firms in the industry.

Step-by-step solution

Define a perfectly competitive industry

A perfectly competitive industry is characterized by a large number of small firms, the absence of barriers to entry, the products being identical and substitutable, and firms being price takers. This means that each firm cannot influence the market price by changing its own output and has to accept the market price determined by supply and demand forces.

Introduce the concept of economic profit

Economic profit is different from accounting profit. Economic profit takes into account not only explicit costs (operating expenses, taxes, etc.) but also implicit costs (opportunity costs of resources used). If a firm's total revenue exceeds its explicit and implicit costs, it earns a positive economic profit, which represents a return above the normal rate of return or opportunity cost.

Explain how profits occur in the short run

In the short run, some firms in a perfectly competitive market may earn positive economic profits due to factors like lower production costs, better access to resources, or effective business strategies. Other firms will earn a normal profit, which means that they're just covering their explicit and implicit costs but not earning any surplus.

Discuss barriers to entry and the role of market forces

As mentioned earlier, a perfectly competitive industry has no barriers to entry. This means that new firms can freely enter the market if they believe that there's an opportunity to make profits. As more firms enter the market, the increase in supply will drive the market price down, given that the products in the market are identical and substitutable. Consequently, the profits of existing firms will decrease.

Explain the long-term equilibrium and vanishing profits

In the long run, profits will vanish due to the market forces and free entry of new firms. When positive economic profits exist, more firms will enter, increasing supply and pushing the market price down, which reduces economic profits. This entry process will continue until the market reaches a long-term equilibrium, where firms earn only normal profit, covering their explicit and implicit costs. At this point, economic profits are effectively zero. In conclusion, profits for firms in a perfectly competitive industry tend to vanish in the long run as market forces, driven by the absence of barriers to entry and identical products, push prices down through increased supply. This ultimately leads to a long-term equilibrium where firms earn only normal profit.