Question

Show with the help of a diagram, how a perfectly competitive firm earns a normal profit in short-run equilibrium.

Explain the short-run equilibrium of a perfectly competitive firm earning a supernormal profit with the help of a diagram.

Answer 1

Under perfect competition, a firm’s average revenue curve is equal to the marginal revenue curve due to uniform prices for homogeneous goods. In, short-run, a competitive firm can earn supernormal profits, normal profits can also suffer losses. The adjacent diagram shows a perfectly competitive firm earning normal profits. Since the firm is a price taker, it has to decide the amount of output it should produce at the given price so as to maximise profits following the equilibrium conditions.
SMC = MR and AR = AC

In the given diagram, OQ is equilibrium output, where SMC is equal to MR Since SAC is tangent to P = AR = MR line, the firm covers only its SAC, which includes normal profits.

Answer 2

In the short term, a perfectly competitive firm can make a profit that is above average. This is when a company's total revenue exceeds its total costs. Firms are price takers in a completely competitive market, with the market price determined by the intersection of market supply and demand. When the market price exceeds the Average Total Cost (ATC) at the profit-maximising output level, a supernormal profit occurs. This scenario might be transient and is frequently the consequence of fortunate conditions such as increased product demand, technological advantages, or lower production costs than competitors. However, in the long run, the entry of new enterprises, drawn by the presence of above-average profits, increases the supply of the commodity, lowering the market price. The market price will eventually adjust to equal the average total cost and supernormal earnings will diminish, leaving just normal profits, which cover all costs.

The diagram shows the firm's Marginal Cost (MC) curve intersecting the Average Total Cost (ATC) curve at a position lower than the Market Price (Pl), which is also equivalent to the firm's Marginal Revenue (MR). The difference between price and ATC at a quantity with MC = MR represents supernormal profit.