Th3.4: Profit Maximising Equilibrium 2

Question 1

What kind of profits can firms make in the short run?

Answer 1

supernormal profits, losses or normal profits

Question 2

Why can firms only make normal profits in the long run? (this is shown in Graph 35)

Answer 2

the lack of barriers to entry/exit

Question 3

Refer to PP

Look at Graph 35. Firms are assumed to be short run profit maximisers, producing at… and as a result…

Answer 3

producing at MC = MR1 in the short run and as a result they produce Q1 at price P1 and make supernormal profit of the shaded area

Question 4

Refer to PP

Look at Graph 35. However, in the long run… What will this do?

Answer 4

new firms will enter the industry as they know that supernormal profits are being earnt - this will cause demand for the individual firm to decrease and therefore the AR and MR curves will shift left

Question 5

Refer to PP

Look at Graph 35. The firm will now produce where?

Answer 5

where MC = MR2 at P2Q2. at this point AC = AR2 and so the firm is making normal profits

Question 6

If the firm was making a loss…

Answer 6

firms would leave the industry and thus demand for the individual firm would increase as they have less competition - this would lead to normal profits in the long run

Question 7

Refer to PP

Look at Graph 35. What is the first limitation of this model?

Answer 7

that information may be imperfect and so firm will not enter the market as predicted as they are unaware of the existence of abnormal profits

Question 8

Refer to PP

Look at Graph 35. What is the second limitation of this model?

Answer 8

firms are likely to be different in their size and cost structure as well as in their products, which may allow some firms to maintain supernormal profits because firms cannot compete on equal terms