Perfect Competition

Long-Run Equilibrium

Under perfect competition, in the long run the cost of production will approach the lowest possible cost per unit, profits and losses will tend toward zero, and prices will fall to the point of generating maximum efficiency in the market.
In the long run, in a perfectly competitive market, profits for all companies tend toward zero because supernormal profits lead to an influx of new competitors looking to claim some of that profit for themselves. Increasing supply in the market drives down prices to the point where the market is no longer attractive to new competitors, and prices will stabilize at that equilibrium point. However, companies can maximize their individual profits by calculating the quantity of output that will cause marginal cost and marginal revenue to be equal.

Over the long run (a span of time long enough for firms to freely enter or leave the market with no barriers or to change their output level), another assumption of perfect competition is that profits will tend toward zero. To understand why profits will tend toward zero under this system, it is first necessary to understand the difference between explicit costs and implicit costs and the type of profit with which each is associated.

An explicit cost is a cost involving a payment. Explicit costs are paid by a firm directly, such as costs paid to suppliers of materials, to its labor force, and to landlords, as well as taxes, tariffs, and other fees. Depreciation of assets, or a decrease in value of assets, is also counted as an explicit cost of doing business. The amount left over from total revenue once explicit cost is subtracted is known as accounting profit and is the profit reported by a firm when paying taxes or reporting to shareholders.

An implicit cost is a cost that does not require the buyer to pay cash, or that cannot easily be assigned a monetary value. Implicit costs are incurred by a firm through the loss of opportunity to generate revenue in other ways, such as using the firm's assets to do other kinds of business and management's opportunities to make money doing other kinds of work. These opportunity costs are included along with explicit costs in the calculations that give rise to economic profit, which is the type of profit considered in analyses of perfect competition.

The concepts of economic profit and opportunity cost demonstrate why, in a situation of perfect competition, profits must tend toward zero in the long run. If producers in an industry are earning greater economic profits than those in another industry, producers in the second industry are paying an opportunity cost by not producing goods in the first industry. Because perfect competition assumes there are no barriers to entry, producers in the second industry are likely to enter the market in the first industry. As producers enter the first industry, they will increase the supply in the first industry and reduce profits correspondingly. An increase in supply reduces the market price so that profits, being equal to (PATC)×Q(\mathrm P\;-\;\mathrm{ATC})\;\times\;\mathrm Q , will go down for each individual firm, where P is price, ATC is average total cost, and Q is quantity sold. This process will continue until there are zero economic profits, because with zero economic profits, there is no longer motivation for new producers to enter the first industry.

Meanwhile, in the second industry, supply will have dwindled as producers left for more fertile economic ground. Perfect competition assumes that demand is constant, so price (and therefore economic profits) will increase in the second industry until the point of zero economic losses is reached. With zero economic losses, producers will no longer be motivated to leave the second industry.

Exit and Entry in the Long Run

Because there are no barriers to entry or exit from markets under perfect competition, firms tend to move to the markets in which they can maximize profit. The eventual effect of this freedom of movement is to move toward an equilibrium state where neither profit nor loss is earned by production and sales of goods or services.
In perfect competition, all participants in a market know all the prices being charged for goods and services in that market as well as the profits being earned. With a lack of any barrier to entering or exiting markets, such as an Internet provider that can offer services easily in both Chicago and Philadelphia, firms are free to move to where they can maximize economic profit and minimize economic loss. Over time, this freedom of movement will act to reduce both economic profit and economic loss to zero. Exit and entry in the long run reflect the movement of companies into markets and the long-term equilibrium state. For example, suppose that in a particular market, some producers are manufacturing candy bars and some are manufacturing frozen juice pops. In this fictional market, the producers of candy bars are making an economic profit and the producers of frozen juice pops are taking an economic loss. Suppose the candy bar firms are producing an output of 10,000 candy bars at a market price of $1 each and an average cost of $0.75 each, so that total profit equals $2,500 ([$1price$0.75averagecost]×10,000unitsofoutput)(\lbrack\$1\;\mathrm{price}\;-\;\$0.75\;\mathrm{average}\;\mathrm{cost}\rbrack\;\times\;10,000\;\mathrm{units}\;\mathrm{of}\;\mathrm{output}) . The juice pop makers are producing an output of 10,000 juice pops, with an average cost of $0.50 each, but their market price is only $0.45. Therefore, the juice pop makers are taking an overall economic loss of -$500 ([$0.45price$0.50averagecost]×10,000unitsofoutput)(\lbrack\$0.45\;\mathrm{price}\;-\;\$0.50\;\mathrm{average}\;\mathrm{cost}\rbrack\;\times\;10,000\;\mathrm{units}\;\mathrm{of}\;\mathrm{output}) .

Observing this situation, some clever juice pop makers decide to leave their industry and get into the candy bar business because candy bar firms seem to be doing pretty well by comparison. Assume firms that have been producing a total of 2,000 juice pops leave juice pop production for candy bar production, and with no economic barriers or additional costs, they are able to manufacture the same number of candy bars as they did juice pops.

These firms are now producing 2,000 candy bars, so there is now a total of 12,000 candy bars being produced and sold. This greater supply causes the price of candy bars to fall to $0.75. The average cost of candy bars is still $0.75, so zero economic profit is being made.
When the market price is $1.00 as determined by the market equilibrium (the place where supply S1 crosses demand D in the market), firms make a profit because this price (which is also marginal revenue, MR), is above their average total cost (ATC). Other firms see that profit is being made, which causes them to enter the market. This shifts supply right (S2), which moves the equilibrium point down the demand curve until it reaches $0.75, the new price. At this point, firms make normal profit, or zero profit, and no new firms will enter the market.
Meanwhile, over in the juice pop business, now only 8,000 juice pops are being made. This reduction in supply moves the market price up to $0.46 per juice pop. Losses are still being incurred in the juice pop business, but now at only $0.04 per juice pop instead of $0.05, a reduction in losses of a full 20%. The theory and conditions of perfect competition hold that this migration of producers from less profitable situations to more profitable ones will continue until profits on the one hand and losses on the other are both reduced to zero. The candy bar market further highlights the process of exit in the short-run. Some time in the future, the market price becomes $1.00, but the cost structure has changed, and average total cost is now $1.25 due to rising input costs. In this case, firms in the candy bar market are incurring short-term economic losses. Firms will begin to exit the market to reduce losses or search for profits elsewhere. Firms will exit, which reduces supply of candy bars in the market, and thus increases the market price. These exits will occur until the market reaches long-run equilibrium, where price equals average total cost and firms are making zero economic profit. In this new example, the equilibrium market price is $1.25 and average total cost is $1.25.
When market equilibrium (at the place where supply S1 crosses demand D in the market) sets the price at $1.00, firms suffer a loss because this price (which is also the firm's marginal revenue, MR), is below their average total cost (ATC). Some firms will leave the market to avoid taking losses. This shifts supply left (S2), which moves the equilibrium point up the demand curve until it reaches $1.25, the new price. At this point, firms make normal profit, or zero profit, and no more firms will leave the market.