Why do firms in perfect competition make zero economic profit in the long run?

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Perfect competition is a theoretical possibility based on the premise that firms and consumers are price-takers. This means that no individual has the ability to influence the price of a good, because what matters is the aggregate supply and demand. In a perfectly competitive market, a long-term equilibrium will be...

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Perfect competition is a theoretical possibility based on the premise that firms and consumers are price-takers. This means that no individual has the ability to influence the price of a good, because what matters is the aggregate supply and demand. In a perfectly competitive market, a long-term equilibrium will be established where aggregate supply equals aggregate demand, setting a quantity and prices. Thus, the market determines prices.

In perfect competition, any firm can enter the market, but eventually supply must equal demand—and in the long run, this supply will be filled only by firms that can operate at the equilibrium price.

These firms all have their own cost functions, and ultimately, they will choose an output quantity at this price that maximizes revenue. This occurs where the marginal cost of producing more equals the marginal benefit. At this point, the firm doesn't want to produce more, or they will begin to lose money, and they don't want to produce less, because below marginal cost = marginal benefit, the marginal benefit is greater (an incentive for more production).

Thus, as marginal benefit = marginal cost at equilibrium, revenues exactly cover the direct costs of production and the opportunity costs, and there is no profit. Because perfect competition holds and firms are price-takers, they don't have the ability to alter price to make a profit in the long run.

In the short run, before the market has equalized and prices are set, firms may be able to generate more revenue than cost, but the aggregate forces will set a price that allows as much purchasing and selling as possible in the long run. Any price high enough for firms to generate profit causes more to flood the market, driving the price down again.

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In an economic free market, perfect competition exists under a specific set of circumstances. All firms must be able to enter the market at no cost, so there is no barrier to entry. There is no government regulation or intervention that has material or artificial impact on the price. Also, consumers must have complete knowledge of the market (both present and future) and complete knowledge of the product.

As such, perfect competition only exists in theory.

Economic profit is the result of all revenue minus all explicit and implicit costs. Explicit costs include wages, equipment, rent, and real estate while implicit costs track items like depreciation and amortization.

In the theoretical perfect competition, there is zero economic profit because there is no opportunity for firms to enter the market. As long as an industry has an economic profit above zero, there is incentive for firms to enter the market. With perfect competition, a new firm is not incentivized to enter the market because it will not be able to gain a competitive advantage over the competing firms. This helps explain why perfect competition only exists in theory because the assumption is that consumers know all information about the product and the future state of the market, so they know the future price points. Consumers of course are unable to know this because the future carries inherent uncertainty.

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Perfect competition exists when the following conditions exist:

  • All companies can enter or exit the market at no cost
  • Price is decided by the price mechanism and not market share
  • Consumers have perfect knowledge of the product, present and future market, and price at all companies
  • Production costs are perfectly mobile
  • There is no government intervention

Perfect competition is theoretical and does not exist in any known competition structure in the modern world.

Economic profit (or loss) describes the mathematical equation of all revenue minus explicit costs (the cost of labor, resources, real estate, etc.) and implicit costs (depreciation of assets, loss of revenue by applying time to one task over another, etc.).

In a perfect competition situation, economic profit would be $0 because there are no opportunities for companies to spend more money than they would make. For as long as the industry is successful, and there is an economic profit above zero, companies will continue to enter the market. As more companies enter the market, the factors above force the pricing to even out until revenue equals cost.

This also explains why perfect competition does not exist in reality. Not only is it impossible to create a a scenario in which customers can have perfect knowledge, but so long as there is money to be made, companies will continue to enter the market. Even when economic loss exists more often than economic profit, companies will compete to benefit from the potential economic profit.

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Firms in perfect competition make zero economic profits in the long run due to freedom of entry by other firms. Economic profit is the difference between the total revenue received by the firm from the sale of goods in demand and the opportunity costs of all goods and services used by the firm. In the short run, economic profit is usually positive because the revenue is more than the opportunity cost. For example, if firms in industry A are making more profits than firms in industry B, firms in industry B are likely to leave and forgo that business in favor of industry A. As more and more firms enter industry A, the market supply curve shifts to the right, reducing the profits and lowering prices. As a result, firms make zero economic profits. In other words, the opportunity costs equal the revenues earned.

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The reason for this can be seen in the definition of economic profit and in the definition of perfect competition.

Economic profit means profit after you pay out your explicit AND implicit costs.  Therefore, zero economic profit does not mean you didn't make any more than you paid out.  It means you made exactly what you paid out (for workers, supplies, etc) PLUS what you yourself could have been making if you were doing some other job.  So you're still making money when you make zero economic profit.

In perfect competition, if a firm is making positive economic profit, then other firms will jump in because they will see there is money to be made.  Firms will jump in until economic profit falls to zero.

 

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