A worked diagrammatic analysis comparing short-run and long-run equilibrium in a perfectly competitive market. Read the description carefully, fill in the missing words, then check your answers against the model commentary at the end of each section.
Short-run equilibrium with supernormal profit
Figure 1: A firm earning supernormal profit in the short-run in a perfectly competitive market.
Firms in a perfectly competitive market are earning profits at price P1. At this price individual firms will be faced with a price elastic demand curve AR1=MR1. Given that firms are profit maximisers (MR1=MC), they will each be producing output at price P1, thus making supernormal profit (AR1>AC).
Show missing words
Missing words: supernormal, perfectly, Q1.
The adjustment to long-run equilibrium
The prospect of earning profit will encourage the of new firms into the market driven by the profit motive. Firms can do this easily and without cost because there are no to entry in the long run. This will cause a rightward in the market supply curve from S1 to . Ceteris paribus, this forces down the ruling market price from P1 to P2. As a result, the market price that individual firms can obtain because their perfectly price elastic demand curves fall from AR1=MR1 to .
Show missing words
Missing words: entry, barriers, shift, S2, decreases, AR2=MR2.
Figure 2: Long-run equilibrium in a perfectly competitive market.
Long-run equilibrium with normal profit only
As can be seen in the diagram, the new market equilibrium price P2 equals the average cost of production for firms. These firms are still profit-maximising (MR=MC) but are now only earning profit (AR=AC). In effect, the supernormal profit has been away by the entry of new firms into the industry. Ceteris paribus, there will be no further for movement of firms in and out of the industry, thus a long-run has been established where price = average cost AC2 at output where MR2=MC2.
Show missing words
Missing words: normal, competed, incentive, equilibrium, P2, Q2.
Productive and allocative efficiency at long-run equilibrium
The diagram also shows that at the long-run equilibrium price of P2 and output Q2, perfectly competitive firms are both efficient (AC=MC) and efficient (P2=MC). In effect, firms are producing the profit-maximising output possible at the price which consumers are and to pay.
Show missing words
Missing words: productively, allocatively, maximum, cheapest, willing, able.
Why this matters at A-level
Perfect competition is the benchmark market structure A-level Economics uses to evaluate every other market structure (monopolistic competition, oligopoly, monopoly). The diagrams above are the same diagrams an examiner expects to see in answers about productive efficiency, allocative efficiency, and the long-run effects of free entry on profit.
- Productive efficiency: occurs where AC is at its minimum and MC = AC.
- Allocative efficiency: occurs where price equals marginal cost (P = MC).
- Normal profit: total revenue equals total cost (P = AC), measured at the firm's chosen output.
Top-band answers explicitly point out all three at long-run equilibrium and link them to the underlying assumptions of perfect competition (many small firms, homogeneous products, free entry and exit, perfect knowledge).
Common diagrammatic mistakes
- Drawing MR as a downward-sloping line. (That is monopolistic competition or monopoly, not perfect competition.)
- Not drawing MC through the minimum of AC.
- Putting q* where MC = AC instead of where MC = MR.
- Drawing the abnormal profit rectangle but not labelling it.
- Using one diagram for the whole answer rather than the firm-and-market pair.
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