7.3 Perfect competition

Question 1

What are the assumptions made of perfect competition?

Answer 1

1. There is a large number of firms
2. All firms produce homogenous or identical products.
3. There is free entry and exit into the market.
4. perfect information
5. perfect resource mobility

Question 2

Why is there normal profit in the long run.

Answer 2

Profitable:
1. Since the industry is profitable, new firms will be attracted to enter the industry since they like to earn supernormal profit.
2. As more firms enter the market, supply will increase, hence reducing the price of the good.
3. When the price of the good decreases, the firms, as price takers, will now have to sell the good at a lower price until it continues to fall to the minimum average cost. This leads to normal profit.

Unprofitable:
1. Since the industry is unprofitable, firms will be attracted to exit the industry since they do not like to earn subnormal profit.
2. As more firms exit the market, supply will decrease, hence increasing the price of the good.
3. When the price of the good increases, the firms, as price takers, will now have to sell the good at a higher price until it continues to rise to the minimum average cost. This leads to normal profit.