How is price determined in the perfectly competitive market structure? Explain the process by which supernormal profits in the short run are transformed to normal profits in the long run

Economics Nov 28, 2020

How is price determined in the perfectly competitive market structure? Explain the process by which supernormal profits in the short run are transformed to normal profits in the long run.

Expert Solution

In perfect competition, firms are too small to influence market price. So price is determined by equality of market demand and market supply curves. Each firm accepts this market determined price as its own price.

Short run supernormal profit attracts new entry, since entry is free. Entry of more firms increases market supply, shifting market supply curve rightward and decreasing market price. As price falls and individual firm's demand falls, profit of firms starts to decrease, until long run equilibrum is restored where each firm is earning normal profit only.

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