Economic profit for firms in perfectly competitive markets

In this video, we're going to dig a little bit deeper into the notion of perfectly competitive markets. So, we're going to think about under what scenarios a firm would make an economic profit or an economic loss in them.

Now, as a reminder, these perfectly competitive markets are something of a theoretical ideal. There's few markets in the real world that are truly perfectly competitive. Some might get close, but most markets are someplace in a spectrum between perfectly competitive and, at the other extreme, say something like a monopoly.

But here, we're talking about perfect competition. In perfect competition, the firm's products aren't differentiated. There's no barriers to entry or exit. In that situation, the market supply and demand curves are going to define the price in the market, which are also going to define the marginal revenue for these firms.

They're all going to be price takers. They're going to be passive in terms of price; whatever the market price is, that's the price that they are going to sell their products for. Their decision is really what quantity to produce and sell and whether to enter or exit the market.

So, let's look at that a little bit. These are just your classic supply and demand curves you might see for a market. The first few units in the market have a huge marginal benefit, so people are willing to pay a lot. But then, each incremental unit, the marginal benefit is a little bit lower and lower and lower, and that's why we have that downward-sloping demand curve.

On the supply curve, the first unit in the market might be fairly inexpensive to produce, but then the marginal cost gets higher and higher. Where they meet, where supply and demand meet, that tells us the equilibrium price and equilibrium quantity in the market. We can show that with that line.

Let's just say that the equilibrium price is ten dollars. As I just mentioned, that's going to have to be the price that all of the firms—and these might not be all of the firms in the market—but all of the firms in the market, if we're talking about a perfectly competitive market, would just have to take that price.

Given that, what quantity would firms A, B, and C produce? And which of these firms would be profitable or not? I encourage you to pause the video and think about those two questions. If you could just answer which of these firms would be profitable or not, and we're talking about economic profit in this context.

All right, well, let's look at firm A first. For any of them, it is not rational to produce a quantity where the marginal cost is higher than the marginal revenue that the firm is getting. Remember this line right over here; this line right here, which is the price line, is also price which is equal to marginal revenue.

For that extra unit, if you can't sell it for more than you're producing, then you wouldn't produce that extra unit. So, it's rational for them to produce more and more until right at the point that marginal cost is equal to marginal revenue, which is equal to the market price that they are just going to take.

So, it's rational for this firm to produce this quantity right over here. Now, is this firm going to be profitable or not? Well, this quantity—what's its average total cost? Well, its average total cost is right over there. For every unit, it's going to make the difference between the price or the marginal revenue it's getting and its average total cost.

One way to think about the profit of this firm is, and we're talking about economic profit, it's going to be the area of this rectangle right over here. Let’s say if the average total cost at that quantity is, let's say, that this is eight dollars, then this height of the rectangle is ten minus eight.

The height right over here—let me do this in a different color—this height right over here is two dollars, and then the width is going to be the quantity of that firm. So, let's say the quantity of that firm is ten thousand units a year. The area right over here would be two dollars times ten thousand; it would be twenty thousand dollars.

Twenty thousand dollars per time unit; if we're talking all of this to say per year. Now, let's go to firm B. Using that same analysis, is firm B making an economic profit or is it not making an economic profit? Well, firm B is once again going to be a price taker.

So, the price right over here, the equilibrium price in the market is going to be equal to the price that that firm has to take, which is going to be its marginal revenue curve. That's why it's a flat marginal revenue curve because no matter what quantity they produce, they're going to get that same price.

It wouldn't be rational for them to produce a quantity where marginal cost is higher than marginal revenue, and so they would produce right over there. Now, what is their economic profit at this quantity? This is quantity of the second firm, firm B.

I'll write like that. Maybe that is firm A, and maybe this is also. It looks about the same. I'll make them a little bit different. Let's say that's 9500 units per time period. Here, the average total cost at that quantity is equal to the marginal cost, which is equal to the marginal revenue.

At that quantity, whatever that ten dollars they're getting per unit, they're also spending on average ten dollars per unit. Another way to think about the area of that rectangle is going to be zero because it has no height. This situation right over here, the firm has zero economic profit—zero dollars of economic profit.

Then, last but not least, let's think about firm C. Pause this video and think about what its economic profit would be. Well, like we've seen, it would be rational for it to produce the quantity where marginal cost is equal to marginal revenue, which is equal to the market price.

So, it would produce this quantity right over here, and let's say that that quantity is 9000 units. What's its average total cost then? So, at 9000 units, its average total cost—let's say that is twelve dollars right over there.

So, what's its economic profit? For every unit it's selling, it's getting ten dollars and it's costing twelve dollars on average to produce it. It's taking an economic loss of two dollars per unit. This height right over here is two dollars times the units—times nine thousand.

You're going to have two times nine thousand. You're going to have an 18,000—not economic profit, but economic loss. One thing to think about is why would any firm be in this situation? It's important to think about things in the short run versus the long run.

In the short run, we've talked about this analysis right over here where a firm can decide what quantity it would produce that is rational. Its fixed costs are fixed in the short run; we’ve studied that in multiple videos. But in the long run, its fixed costs aren't fixed.

The firm could decide to enter or exit the market. For firm C, while they've already put in those fixed costs, it is actually rational for them to do it because they're actually able to make their marginal revenue they get up to that quantity.

They're at least able to more than cover their marginal cost, and then they're able to take care of some of their fixed costs. But they're still not able to run an economic profit. So, in the long run, it wouldn't be rational for this firm to stay in the market; they would likely exit the market.