Long run equilibrium
Because supernormal profits can be made in the short run, new firms enter the market.
When new firms enter the market, market supply increases from MS1 to MS2 which drives the price down from P1 to P2. There is a new equilibrium of price P2 and quantity Q2. For the individual firm in the market (diagram on the right), the firm now charges price P2 leading to MR and AR moving down to P2 as well. Point Y is the profit maximisation point (MR2=MC), therefore the firm will sell at quantity Q2 and total revenue gained is the rectangular area P2YQ2O. Because AC=MC, the rectangular for the firm’s total costs is P2YQ2O as well. This means that supernormal profits are not being made, only normal profits are being made. Costs per unit are equal to revenue per unit and so the firm is unable to make supernormal profits in the long run. Price = Long run ACs as well.
Furthermore, the firm is producing fewer units of output. Because there are no supernormal profits being made by firms within the market, there is no incentive for firms to enter or exit the market and the market is said to be at rest.
In the LR in a perfectly competitive market, there is….
· Productive efficiency because the firm is producing at AC’s lowest point (Q2). The firm is producing at its cost minimising point. Resources are used efficiently.
· Allocative efficiency because firms are allocating the same amount of extra cost (MC) to customers as customers are allocating extra revenue to firms (P). Therefore P=MC, so it is allocatively efficient.
A perfectly competitive market is the only type of market structure where it is possible to be both allocatively and productively efficient.
This model of a perfectly competitive market is a theoretical extreme and is used to judge how closely real world industries approximate to this even if they are not truly competitive. This model, although unrealistic, holds the strong argument that resources are allocated efficiently and firms make beneficial exchanges which enable it to be efficient. The model provides a benchmark in which imperfectly competitive markets can be compared and contrasted.