In perfect competition, why do firms earn zero economic profit in the long run?

In perfect competition, why do firms earn zero economic profit in the long run?

• A. Government regulation forces profits to zero.
• B. Free entry and exit drive profits to zero; price equals marginal cost and equals average total cost.
• C. Firms collude to set price equal to average total cost.
• D. Demand becomes perfectly elastic causing profits to zero.

Answer: (D)

In perfect competition, zero economic profit in the long run comes from free entry and exit driving profits to a normal level. If firms are earning above-normal profits, new firms can enter the market, increasing overall supply and pushing the price down until those profits disappear. If firms are incurring losses, some leave the market, reducing supply and pushing the price up until profits disappear. At that long-run equilibrium, price equals average total cost, and because firms take the price as given in a competitive market, their marginal revenue equals marginal cost. This means price also equals marginal cost, so the firm earns zero economic profit even though it produces efficiently. The notion that demand becomes perfectly elastic is a characteristic of a competitive firm’s demand curve, but the driving force behind zero profits in the long run is the entry and exit process adjusting price to the point where economic profit is zero.

In perfect competition, zero economic profit in the long run comes from free entry and exit driving profits to a normal level. If firms are earning above-normal profits, new firms can enter the market, increasing overall supply and pushing the price down until those profits disappear. If firms are incurring losses, some leave the market, reducing supply and pushing the price up until profits disappear. At that long-run equilibrium, price equals average total cost, and because firms take the price as given in a competitive market, their marginal revenue equals marginal cost. This means price also equals marginal cost, so the firm earns zero economic profit even though it produces efficiently. The notion that demand becomes perfectly elastic is a characteristic of a competitive firm’s demand curve, but the driving force behind zero profits in the long run is the entry and exit process adjusting price to the point where economic profit is zero.