Long-run economic profit for perfectly competitive firms | Microeconomics | Khan Academy

Let's dig a little bit deeper into what happens in perfectly competitive markets in the long run.

So, what we have on the left-hand side—and we've seen this multiple times already—are our supply and demand curves for our perfectly competitive market. You can see the equilibrium price right over here, marked with this dotted line. As we've talked about in multiple videos, firms in that perfectly competitive market—the perfectly competitive firms—they just have to be price takers. So, the market price is going to be their marginal revenue curve. It's going to be this horizontal curve, and it would be rational for them to produce the quantity.

So, they're not going to set the price, but they can choose what quantity to produce. It would be rational for them to keep producing while the marginal revenue is higher than the marginal cost, up to and including when the marginal revenue is equal to the marginal cost. So, for this firm, at this current state of affairs, it would be rational for them to produce this quantity right over there.

As we've talked about in other videos, at that quantity they're going to make an economic profit. The way that we can see that is at this quantity; this is the average total cost, and that is your marginal revenue. You are going to get this much per unit, and then you multiply. The height is how much you get per unit, and then you multiply that times the number of units. The area of this rectangle is that positive economic profit that this firm will have.

Now, that's in the short run. But now let's think about what will likely happen in the long run. If folks see other folks making a positive economic profit, remember, economic profit doesn't just account for regular costs; it also includes opportunity cost. So, a lot of people say, "Hey, I would want to put my resources into this market, so that I can make that positive economic profit as well."

But what's going to happen as you have entrance into this market? Well, that's going to shift the supply curve to the right. At any given price, you're going to have more supplies—one way to think about it. So, if that's the supply curve, let's just call that one. Now you're going to have more entrants—more entrants.

What's going to happen? Well, you might get to something like—you might get to a situation like this: actually, let me see if I can draw it well. You might get to a situation like this, where you have more entrants, and you go to supply curve 2.

Now, what's going to be the quantity that firm A produces in that world? Remember, firm A is just one of many firms. Well, in this situation, we have a new equilibrium price. So, if this was P sub 1, now we have this new equilibrium price, P sub 2, which is going to define a new marginal revenue curve for all of the players in this perfectly competitive market. So, the new marginal revenue curve is going to be right over there.

Now, in this situation, what is the rational quantity for firm A to produce? Well, once again, as long as marginal revenue is higher than marginal cost, it makes sense for them to produce more and more and more, up until the point that they are equal. So, now firm A would want to produce less because the market price that it just has to take is less.

But notice what happens: as more and more entrants got into the market, the market price—which also defines this horizontal marginal revenue curve—went lower and lower to the point where firm A, now in this situation, is making no economic profit. At this point, not only is marginal revenue intersecting marginal cost, but that's exactly at the point at which marginal cost is equaling average total cost.

One way to think about it is that in a perfectly competitive firm, they are productively efficient. They are producing the quantity that minimizes their average total cost. We've already talked about that point where marginal cost and average total cost intersect; that's going to be the minimum point for average total cost.

And why is that? Well, while our marginal cost is below average total cost, average total cost is going to get lower and lower and lower. Then, once marginal cost gets higher than average total cost, well, then the average total cost curve will start going curving up.

So, we just saw a situation where we see economic profit. In the short run, in the long run, entrants are going to go into that market, and it's going to reduce the economic profit down to zero. At that point, the firm that has that zero economic profit is productively efficient; they are producing at the minimum point of their average total cost curve.

We've already talked before that this equilibrium point right over here in our market—because our demand and supply curves are the intersection point—is the price that defines our equilibrium price and quantities. We are also allocatively efficient. We've talked about things like deadweight loss in the past; that is not happening right over here. Our marginal benefit is equal to our marginal cost right at that equilibrium price and quantity.

Now, some of you might be saying, "Well, what about the other situation? What about if, for some reason, we were in a—let's call it a supply curve three?" Let's see; people overshot—too many people joined into this market. So, let's say we went to supply curve three.

Well, what's going to happen? Let me label this: this is right over here, this is marginal revenue curve one, which is equal to price one. This is marginal revenue curve two, which is equal to price two, and then this would define—so this right over here would be price three. Price three, which would define marginal revenue curve three.

So, marginal revenue curve three, which is equal to price three—if too many entrants joined into that market, now firm A has a more difficult scenario. They would produce at this quantity—we've talked about many times already—but at that quantity, each unit, their average total cost is higher than that revenue they're getting. So, they're going to be running at an economic loss in the short run.

But what would happen in the long run? Well, firm A in the long run would probably exit the market, and other firms who are running an economic loss would exit the market. So, that would shift the supply curve back to the left, and so we would eventually get once again to that reality where firms have no economic profit in there, and we have a market that is allocatively efficient—no deadweight loss—and firms are producing at the minimum point of their average total cost curve, which is known as productive efficiency or productively efficient.