Short response questions

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
   

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. 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).

2. With the help of a diagram, explain how it is impossible for a firm in perfect competition to earn abnormal profits in the long run.

At first, firms outside of the industry which could also produce the good will start to entry the industry. These small firms are attracted by the chance of making abnormal profits. In the beginning, this will have no real effect. However, the more firms enter the industry; the industry supply curve will start to shift to the right. The firms in the industry are price-takers which leads to a fall in price. The demand curve will shift downwards which means that the abnormal profits will start to be "competed away" and the industry makes normal profits. 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.

A firm in perfect competition is productively efficient if it produces its product at the lowest possible unit cost (average cost). The productively efficient level is where MC=AC. However when a firm is making abnormal profits it is producing at the profit maximizing level of output (MC=MR) and the allocatively efficient level of output (MC=AR). This shows that the firm is not producing at the most efficient level of output (MC=AC).