Suppose a competitive firm is currently making abnormal profit at e0. Also, suppose that the firm does not increase its plant size and the abnormal profit induces new firms to enter. As a result, market supply increases and price comes down (left panel, Figure 7.8). The firm in question has to sell lesser quantity ql al a lower jpricu Px instead of the original higher quantity q0 sold by it at a higher price P(y Thus, entry of new firms has eliminated the abnormal profits of the firm in question.
(ii) The competitive firm with abnormal profit increases its plant size before the entry of the new firms:
Suppose the firm itself decides to increase its plant size before any new entry may take place. In such a case, the short run average cost curve of the firm descends downwards due to the scale economies that accrue to it. The firm produces more at a lower cost. The market supply increases and the market price comes down in consequence. The firm sells all that is produced at a lower market price. Its abnormal profit also disappears (Figure 7.9).
(iii) Short run losses of competitive firms force exit on some firms:
The case is exactly opposite to case (i). The smaller or the vulnerable firms fail to bear the loss and decide to quit. Exit of such firms reduces market supply. In consequence, market price rises. The remaining firms gain as their losses are made good at e1. They now begin to earn normal profits. Figure 7.10 demonstrates the process.
(iv) The loss making firm reduces the plant size before the exit of other firms:
Clearly, this is opposite of the case discussed in (ii) above. Assume that a competitive firm is a making loss in the short run. It decides to reduce its plant size, if possible. If it succeeds, its contribution to the market supply would decline and in consequence, the market price would rise. The firm being a price taker would sell the current output at a higher market price. It would adjust its output in such a way that its loss gets eliminated. The firm would be in stable equilibrium with normal profits, as shown in Figure 7.11.
The long run equilibrium of a competitive firm involves only normal profits. Figure 7.12 shows the ultimate equilibrium of the competitive firms whether it results in consequence of free entry/exit of firms, or in consequence of their own action of expansion/contraction of the plant size. At this stage, the reader may concern with what the long run equilibrium looks like rather than how it is reached.