Q.Explain how equilibrium price is determined under perfect competition, and describe what happens to price and profit in the long run if firms are initially earning supernormal profit.

Because no single firm sets price under perfect competition, the price has to be explained at the level of the whole industry, and free entry then decides whether that price can last.

Under perfect competition, no individual firm can set the price, so the price has to be explained at the level of the industry as a whole rather than at the level of any one firm. The industry's total demand curve (obtained by adding up the quantities all buyers wish to buy at each price) and its total supply curve (obtained by adding up the quantities all firms together wish to sell at each price) are drawn together, and the point at which they intersect — where the total quantity demanded exactly equals the total quantity supplied — gives the market equilibrium price and quantity. Every individual firm then simply accepts this price as given and decides its own output by producing up to the point where its own marginal cost equals this price, since MC = MR = P is the profit-maximising condition for a price-taking firm.

This short-run equilibrium price, however, need not last, because it depends on how the initial price compares with firms' average cost of production. If the initial equilibrium price is high enough that firms are earning supernormal (above-normal) profit — revenue exceeding total cost, including a normal return on the entrepreneur's own investment — this profit is a visible signal that attracts new firms, since entry into a perfectly competitive industry is completely free and unobstructed by any barrier. As new firms enter and begin producing, total industry supply rises, shifting the supply curve to the right; with demand unchanged, this pushes the equilibrium price down. New firms keep entering, and price keeps falling, for as long as existing profit remains above normal, and the process only comes to rest once price has fallen to exactly the minimum level of average cost, at which every firm earns just a normal profit — enough to keep it in the industry, but not enough to attract any further entrant. …

A common mistake is assuming supernormal profit simply continues indefinitely under perfect competition — free entry always erodes it back to a normal profit in the …