A purely competitive firm:
a. must earn a normal profit in the short run.
b. cannot earn economic profit in the long run.
c. may realize either economic profit or losses in the long run.
d. cannot earn economic profit in the short run.
The correct answer and explanation is :
The correct answer is:
b. cannot earn economic profit in the long run.
Explanation:
In a purely competitive market, there are a few fundamental characteristics that guide the firm’s behavior in both the short run and the long run. Let’s break these down to understand why option (b) is correct.
- Short-Run vs. Long-Run Dynamics:
- In the short run, firms in a perfectly competitive market can earn economic profits or losses. This is because, in the short run, some factors of production are fixed, and firms have limited ability to enter or exit the market. As a result, firms can earn profits if the price exceeds their average total cost (ATC), or they might incur losses if the price is below their ATC.
- In the long run, however, firms can adjust all factors of production, and importantly, there are no barriers to entry or exit. If firms are earning economic profits, new firms will enter the market because they are attracted by the high potential returns. As more firms enter the market, the supply of the good increases, which leads to a decrease in the market price. This price reduction continues until firms are only earning a normal profit, which means they cover their costs, including a return to the owners for their investment, but do not earn profits above and beyond this. If firms are experiencing economic losses, some will exit the market, reducing supply and pushing the price up until the remaining firms earn a normal profit.
- Normal Profit: In the long run, the equilibrium for a purely competitive firm occurs when price equals the minimum average total cost (ATC). At this point, firms earn only normal profit, which is the return on investment that is sufficient to keep firms in the industry but not high enough to attract new entrants or justify exit.
Thus, in the long run, firms in a purely competitive market cannot sustain economic profits. The market forces of entry and exit drive the market to a point where only normal profits are earned. This is the essence of a perfectly competitive market in the long run, where economic profits are driven to zero.
Why the other options are incorrect:
- a. must earn a normal profit in the short run: Firms can earn either economic profit or economic losses in the short run, depending on market conditions.
- c. may realize either economic profit or losses in the long run: This is incorrect, as the long-run equilibrium in perfect competition results in zero economic profits, not profit or losses.
- d. cannot earn economic profit in the short run: Firms can earn economic profits in the short run if market prices are above their average total costs.