(a) Stale three characteristics of perfect competition, (b) With the aid of diagrams, explain equilibrium positions of a perfectly competitive firm in the: ...

Answer Details

(a) Three characteristics of perfect competition.

• There are many buyers and many sellers, so no single firm can influence the market price; each is a price taker.
• The product is homogeneous (identical), so buyers have no reason to prefer one seller.
• There is free entry into and exit from the industry in the long run.
• There is perfect knowledge of prices and conditions by buyers and sellers, and free/perfect factor mobility.

(b) Equilibrium of a perfectly competitive firm. In every case the firm maximises profit where marginal cost equals marginal revenue, \( MC = MR \), with MC cutting MR from below. Because the firm is a price taker, \( P = AR = MR \) and the demand curve is a horizontal line at the market price.

(i) Short run. The firm produces where \( MC = MR = P \). At this output the firm may earn supernormal profit (if \( P > AC \)), normal profit (if \( P = AC \)), or a loss (if \( P < AC \)). It continues in the short run so long as price at least covers average variable cost. Diagram: a horizontal demand line \( P = AR = MR \) cutting a U-shaped MC curve; the gap between price and AC at the equilibrium output shows profit or loss.

(ii) Long run. Supernormal profits attract new firms (free entry), which raises supply and lowers price, while losses drive firms out until price rises. Adjustment stops when each firm earns only normal profit, so long-run equilibrium is where \( P = AR = MR = MC = AC \) at the minimum point of the average cost curve. Diagram: the horizontal demand line is tangent to the lowest point of the AC curve, with MC passing through that point.

Examination reminder: stress that only normal profit survives in the long run because free entry and exit compete away any supernormal profit.