(b) With the aid of diagrams, explain equilibrium positions of a perfectly competitive firm in the: (i) short-run: (ii) long-run
(a) The three characteristics of perfect competition are:
- Large number of buyers and sellers: In a perfectly competitive market, there are a large number of buyers and sellers. No single buyer or seller can influence the market price.
- Homogeneous products: In a perfectly competitive market, all products are identical or homogeneous, meaning that there is no differentiation among the products sold by different firms.
- Free entry and exit: Firms are free to enter or exit the market without any barriers to entry or exit. This means that there are no legal or economic barriers that prevent new firms from entering the market or existing firms from leaving the market.
(b) In a perfectly competitive market, a firm's equilibrium position is determined by the intersection of the firm's marginal cost (MC) curve and the market price (P).
(i) Short-run equilibrium: In the short-run, a perfectly competitive firm will produce at the point where its marginal cost (MC) curve intersects the market price (P), as shown in the diagram below:
In this diagram, the short-run equilibrium for the firm occurs at point E, where the MC curve intersects the market price line P. At this point, the firm is producing Q units of output and is earning a profit (represented by the shaded rectangle). If the market price were to decrease, the firm may operate at a loss or shut down in the short-run.
(ii) Long-run equilibrium: In the long-run, firms are able to enter or exit the market freely. If firms in the market are earning a profit, new firms will enter the market, increasing the supply of goods and driving down the price. Conversely, if firms are operating at a loss, some firms will exit the market, reducing supply and driving up the price. In the long-run, a perfectly competitive firm will produce at the point where its long-run marginal cost (LMC) curve intersects the market price (P), as shown in the diagram below:
In this diagram, the long-run equilibrium for the firm occurs at point E, where the LMC curve intersects the market price line P. At this point, the firm is producing Q units of output and is earning zero economic profit (represented by the point where the LMC curve intersects the horizontal axis). In the long-run, all firms in the market will be earning zero economic profit, as new firms will continue to enter until the price is driven down to the point where firms are only earning a normal rate of return.