1. With the help of a diagram, explain how it is possible for a firm in perfect competition to earn abnormal profits in the short-run.
The short run is a fixed plant period, which means that a firm is facing fixed costs as well as variable costs. The fixed costs
are the costs of fixed assets a fgbirm uses, such as interest rate or land rent. Variable costs are the costs for each worker (wages). In the short run, firms can't enter or exit a market. Perfect competition is a market structure in which all firms sell an identical product. In a perfect competitive market all firms have a relatively small market share, there are no barriers to entry or to exit the market and they have a small and an equal size. Firms in perfect competitive markets are price takers which mean that they have no say in changing the prices of their product. They have to set the price as the market demands.
It is possible for a firm in perfect competition to earn abnormal profits in the short-run when it is covering more than their total costs, including their opportunity cost. A firm maximizes its profit when the marginal costs equal to the marginal revenue. It is producing at the industry price (P) and it is maximizing its profits by producing at the quantity (q). At q the costs per unit is C whereas the revenue per unit is P. Therefore the average cost is less than average revenue and the firm is making an abnormal profit on each unit (P-C). Because of the attraction of the abnormal profit to other producers, who will then enter the market, making abnormal profits is only possible in the short run. Due to the attraction and the increase in the number of firms in the market, the supply increases and the supply curve shifts to the right (S1). The price decreases from P to P1.
2. With the help of a diagram, explain how it is possible for a firm in perfect competition to earn abnormal profits in the long run.
The long run is also calls "variable plant period", which means that every cost a firm faces, such as rent, wages or interest rate, is variable. There are no fixed costs. Since the long run is the planning period, the costs a firm faces can be changed over time. Small firms which produce the same product outside of the market will start to entry the market because they are attracted by the chance of making abnormal profits. However, the more firms enter the market to make abnormal profits; the market supply for the product will increase rapidly. Therefore the supply curve shifts from S to S1. Since the firms in an industry are price takers, the price for the product will decrease. This leads to a downward shift in the demand curve. This means that the abnormal profits will start to be "competed away" and the firms make normal profits. Since the firms make normal profits, there is no attraction for other firms. Therefore the market will stay at the new equilibrium. Entrepreneurs are satisfied because they are covering all their costs, including opportunity costs.
3. Explain whether or not a firm in perfect competition earning abnormal profits is productively efficient.
However, a firm makes abnormal profits by maximizing its profit. In order to maximize its profits the firm produces at the quantity, where marginal costs=marginal revenue, as well as when the average total cost is less than the average revenue. There are two types of efficiency: Productive efficiency and allocative efficiency. Productive efficiency is when a firm in perfect competition is producing its product at the lowest possible unit cost (P= minimum ATC). The productivly efficient level is where MC=AC. When a firm is producing productively efficient they combine their resources as efficiently as possible, this means that resources are not being wasted by inefficient use. Allocative efficiency is also called the "socially optimum level of output", which means that this is also a point where a firm maximizes its profits. It is being defindes as P=MC=MR. When a firm is allocative efficient it produces the right amount so that the supply equals the demand. However, when the price is greater than the marginal cost, the producers know that demand for the product is higher. When the price is lower than the marginal cost, the product is not as much demanded as being produced. In the end it is clear that a firm in perfect competition is not producing at the most productvley efficient level of output. Hence it produces allocativley efficient.
