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Explain why a firm in a perfect competition can make economic profit only in the short run.

Perfect competition refers to a theoretical market structure that contains the following characteristics: a large number of small firms; no control over price; all firms sell a homogeneous product; no barriers to entry; perfect information. Economic profit occurs when total revenue is greater than the total economic costs, which comprises of implicit and explicit costs. The short run is period of time during which at least one factor of production is fixed (unchanging) and all other factors are variable (changing).
Figure 1
Figure 2
Figure 1 and figure 2 (diagrams are hyperlinked to the text) display the identical watermelon stand operating in a perfect competition earning an economic profit and normal profit respectively. In the short run, the firm is earning an economic profit (figure 1) because the marginal revenue is greater than the average cost of producing a good. Moreover, competitor quantity is lower that of the long run. In the long run, firms earn a normal profit (figure 2) because of the assumption of perfect competition being low barriers to entry and perfect information, new firms enter the market as they recognise that firms are earning an economic profit. As a result of firms entering the market, the market supply increases, causing a reduction in the accepted price. The market price falls until it is tangential to the average total cost. If the price is lower, the firm will eventually terminate operation. An exemplar in which the concept of normal profit being earned in the long run is the agricultural market. Small watermelon stands for instance earn economic profit in the short run because of fewer competitors. However, in the long run, vegetable stands for instance can rearrange factors of production to produce watermelons and enter the profitable market. Subsequently, the amount of watermelon supply increases, causing a reduction in price tangential to the average production cost of each watermelon stand. Thus, a normal profit is earned in the long run. If the watermelon stand makes a loss, operations terminate because the average cost of producing each watermelon is greater than its price.



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