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Profit is the difference between revenue and cost. In short run a firm operates with a fixed amount of capital and must choose the levels of its variable inputs (labour and materials). Profit is maximized when the marginal revenue of the firm is equal to the marginal cost of production and this holds true for every firm. Since the demand curve facing the firm in a competitive market is horizontal so marginal revenue and price are equal. So the condition for profit maximization rule is that marginal revenue equals marginal cost at a point at which the marginal cost curve is rising rather than falling.
A firm need not always earn a profit in the short run due to the increased fixed cost of production. This raises average total cost and marginal cost curves.
Thus a firm might operate at a loss in short run because it expects to earn a profit in future as the price of its product increases or costs of production fall.
A firm will find it profitable to shut down when the price of its product is less than the minimum average variable cost. In long run, the firmearns zero economic profits. Economic profit takes account of opportunity costs. One such opportunity cost is the return that the owners of the firm could make if their capital were invested elsewhere. A firm earning zero economic profits need not go out of business, because zero profit means the firm is earning a reasonable return on its investment.
A positive profit means an unsually high return on investment. This high return causes investors to direct resources away from other industries into this one there will be entry into the market. Eventually the increased production assosciated with new entry causes the market supply curve to shift to the right so that the market output increases and the the market price falls. Therefore there will be zero economic profits. When a firm earns zero profit, it has no incentive to enter. A long run competitive eqilibrium occurs when three conditions hold.
First, all firms in the industry are maximizing profit. Second , no firm has an incentive either to enter or exit the industry, because all firms in the industry are earning zero economic profit. Third the price of the product is such that the quantity supplied by the industry is equal to quantity demanded by the consumers. The concept of long run equilibrium tells us the direction that firm’s behaviour is likely to take. The idea of an eventual zero profit , long run equilibrium should not discourage a manager whose reward depends on short run profit that the firm earns.
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