Explain why in competitive markets there can be profit or producer surplus in th

Question

Explain why in competitive markets there can be profit or producer surplus in the short run but not the long run. Include the idea of "economic rent" for exceptionally productive inputs. Then imagine a firm with the same cost structure but in each of the four very distinct market structures: (1) Purely Competitive, (2) Monopolistically Competitive, (3) Oligopoly, and (4) Monopoly. Using the concepts of consumer surplus and producer surplus, explain the long run outcome in each market structure and how consumer surplus, producer surplus and dead weight loss changes.

Explanation / Answer

It is because

monopolistically competitive firms have market power, they will produce less and charge more than a firm would under perfect competition. This causes deadweight loss for society, but, from the producer's point of view, is desirable because it allows them to earn a profit and increase their producer surplus.

Because of the possibility of large profits in the short-run and relatively low barriers of entry in comparison to perfect markets, markets with monopolistic competition are very attractive to future entrants.

Perfectly competitive markets exhibit the following characteristics:

In the long run

There is perfect knowledge, with no information failure or time lags. Knowledge is freely available to all participants, which means that risk-taking is minimal and the role of the entrepreneur is limited.

There are no barriers to entry into or exit out of the market.

Firms produce homogeneous, identical, units of output that are not branded.

Each unit of input, such as units of labour, are also homogeneous.

No single firm can influence the market price, or market conditions. The single firm is said to be a price taker, taking its price from the whole industry.

There are a very large numbers of firms in the market.

There is no need for government regulation, except to make markets more competitive.

There are assumed to be no externalities, that is no external costs or benefits.

Firms can only make normal profits in the long run, but they can make abnormal profits in the short run.

However, in the long run firms are attracted into the industry if the incumbent firms are making supernormal profits. This is because there are no barriers to entry and because there is perfect knowledge. The effect of this entry into the industry is to shift the industry supply curve to the right, which drives down price until the point where all super-normal profits are exhausted. If firms are making losses, they will leave the market as there are no exit barriers, and this will shift the industry supply to the left, which raises price and enables those left in the market to derive normal profits.

Related Questions

Navigate

• Browse (All)
• Browse E
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.