Tuesday, February 10, 2015

Why do perfectly competitive firms always make normal profits in the long run? Illustrate and explain with an example of a firm under perfect competition.

A perfectly competitive firm exists in a market in which there are many different businesses in the industry, but there is little or no difference in the products themselves, they do not influence the market, and it is not difficult for any new business to compete. An example of this is farming: the difference between a banana grown on one farm is not drastically different from a banana grown on another farm, a single banana crop is far too small to affect the worldwide market for bananas, and it is not very difficult to start your own banana farm.
Under these circumstances, a perfectly competitive firm will always make profits on account of the most efficient distribution of resources, known as Pareto-efficient allocation. The production of a business's products does not affect the market, meaning that they do not change the structure or cost of the product or the customer response to the product. If a business raised its cost, the customers would simply purchase another company's products. What's more, there are no transaction costs, such as marketing the product itself.
In this example, the banana farm would always be profitable. Their bananas can always reach a customer, while the customer knows that the bananas from this farm as just as good as any other farm. New competitors can enter and leave the market, but will play no part on the market itself—if your neighbor decides to grow oranges instead of bananas, it will not affect your farm. Finally, you don't have to make commercials or advertisements for your bananas, meaning you can have steady profit in the long run.

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