Model Answer
0 min readIntroduction
Perfect competition is a market structure characterized by a large number of buyers and sellers, homogeneous products, free entry and exit, and perfect information. In the short run, firms in a perfectly competitive market aim to maximize profits by producing at the output level where marginal revenue (MR) equals marginal cost (MC). The relationship between MR=MC and the average total cost (ATC) determines whether the firm earns normal profit, supernormal profit, or incurs a loss. This answer will graphically demonstrate these three scenarios, focusing on the MR and MC curves without explicitly drawing the ATC curve, but understanding its position relative to the MR=MC intersection.
Graphical Representation of Equilibrium in the Short Run
The fundamental principle governing equilibrium in perfect competition is that firms maximize profit where MR = MC. The following scenarios illustrate the different profit conditions:
(i) Normal Profit
Normal profit exists when the firm earns just enough revenue to cover all its explicit and implicit costs, including the opportunity cost of the owner’s time and capital. Graphically, this occurs when MR = MC = ATC. Since we are not drawing ATC, we infer its tangency to the MC curve at the equilibrium point.
In the diagram above, the firm produces Q1 units of output. At Q1, MR equals MC. The point where MR=MC also corresponds to the minimum point of the ATC curve (even though it's not drawn). This ensures that the firm is earning normal profit.
(ii) Supernormal Profit
Supernormal profit (also known as economic profit) occurs when the firm earns a profit greater than the normal rate of return. This happens when MR = MC > ATC. Again, we infer the position of ATC below the MR=MC intersection.
Here, the firm produces Q2 units of output. At Q2, MR equals MC. However, at this output level, the MR=MC intersection is *above* the ATC curve (inferred). This means the firm’s total revenue exceeds its total costs, resulting in supernormal profit. This situation attracts new entrants into the industry.
(iii) Loss
A firm incurs a loss when its total revenue is less than its total costs. This happens when MR = MC < ATC. The ATC curve is positioned above the MR=MC intersection.
In this case, the firm produces Q3 units of output. At Q3, MR equals MC. However, the MR=MC intersection is *below* the ATC curve (inferred). This indicates that the firm is not covering all its costs and is incurring a loss. In the short run, the firm will continue to produce as long as price (and therefore MR) is greater than average variable cost (AVC). If price falls below AVC, the firm will shut down.
It's crucial to remember that these are short-run scenarios. In the long run, the entry and exit of firms will drive economic profits to zero, resulting in only normal profits being earned.
Conclusion
In conclusion, under perfect competition, a firm’s short-run equilibrium is determined by the intersection of the MR and MC curves. The position of this intersection relative to the (inferred) ATC curve dictates whether the firm earns normal profit, supernormal profit, or incurs a loss. Supernormal profits attract new entrants, while losses lead to exit, ultimately pushing the market towards long-run equilibrium with only normal profits. Understanding these dynamics is fundamental to analyzing market behavior in perfectly competitive industries.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.