In the short run a perfect competition market structure a firm may begin making supernormal profits when its average variable costs are firmly below the market price. Consider the scenario below in which a perfect competition exists. Since each individual firm is in a perfect competitive industry each firm earns P* matching its output, while P* represents the additional revenue (MR) being earned by the firm subject to selling additional outputs (Doyle 2005, p.207).
This situation will result in other firms entering the market prompting the firm to react to the market changes. "Firms will not compete by offering different quality goods as goods are presumed to be homogenous" (Doyle 2005, p.208). The firm may decide to increase its advantage in the long run by expanding is output tremendously. In the Long run response there will be an increase in industry-wide supply of the competitive product (Grant & Vidler 2003, p. 82).
Due to the lowering price index the equilibrium changes. The prices in the firm consequently fall in response to the corresponding price of the industry (Doyle 2005, p.208). Moreover, the reduction in price might continue until such a time when the AR becomes tangential to the long-run average cost curve (LRAC) shown above (Doyle 2005, p.208). However, if a firm cannot keep with the price changes during the long run due to an influx in the number of players in the competitive market occasioned by large short run profits the firm will fall out of business.
As such the firm may be forced out of business because the firm's average price fall relatively below the industry price index while all the production factors have adjusted to these changes. This ultimately results in an allocative efficiency achieved when the P=MC (Grant & Vidler 2003, p.83)
Moreover, the perfect competition may respond to the supernormal profits experienced during the short run by decreasing the price of in such a manner that the marginal and average costs remain stable.
Alternatively, the perfect competition structure can respond by keeping the price constant irrespective of the demand levels with an aim of preserving profits accrued during the short run. This is primarily determined by the occurring economies of scale which can either encourage or discourage price hikes.
In essence, this implies that external and internal economies of scale play role in the actual determination of the price levels during the long run. Hence, an increase or decrease in demand will dramatically affect the respective price variations during the long run.
Monopolistic Competition Market Structures
A monopolistic market structure allows dominance of one player in the market by virtue of its size. As such the demand curve for such a firm will be similar to overall industry's demand (Grant & Vidler 2003, p.88).
In the short scenario, the monopolist in the market needs to ensure that variable costs are recovered. "His price should not go below his average variable costs, otherwise he will stop producing" (Saraswathi & Reddy 2007, p.135). A change in demand may lead to the potential occurrence of supernormal profits.
Point E represents the equilibrium point where MC=MR, while in the event the price if equilibrium becomes OP or AM, the equilibrium price AM now becomes greater than the average cost BM leading to supernormal profits represented by ABCP (Khanna & Jain 2009, p.230).
In the long run because of limited players in the market, the monopoly does not allow any firm to extrapolate the supernormal profits experienced during the short run cycle. During this period the firm has an option of increasing its production capacity going by the industry potential. "The firm can change the size of its plant and machinery and new firms can enter the industry" (Khanna & Jain 2009, p.231). Because of the enormous capacity wielded by the firm no firm can easily outdo the leading monopoly in the market meaning no one earns supernormal profits. "In the long run, firms earn normal profits only" (Khanna & Jain 2009, p.231).
Even if the firms adjusted all its production factors to boost its production capacity to the maximum, supernormal profits cannot be experienced in the long run. This is due to a number of reasons. First, should the firms be in a position to earn supernormal profits, this would attract other player in the industry by virtue of the fact that entry into the market is virtually free, hence the total supply will increase and this will be distributed among the increased number of firms thus depriving them the opportunity to earn supernormal profits (Khanna & Jain 2009, p.418). Secondly, since there is monopoly creating demand will entail lowering the prices including old firms to justify their existence in the market, thus this will only lead to the creation of normal profits (Khanna & Jain 2009, p.418). Thirdly, the advantage presented by a free entry into the market and low cost of installation implies that entry of new players into the industry will only result in an increase in the cost of factors leading to an increase in the average cost and low price of the products thus disapproving the element of supernormal profits (Khanna and Jain 2009, p.418).
In this representation, LAC represents the Long run Average Cost, LMC is the Long run Marginal Cost, OM represents the equilibrium output (=AM), hence at this point the average curve becomes tangential to the LAC at point A, which implies that in the occurrence of an equilibrium situation AR=LAC hence the firms can only earn normal profits (Khanna & Jain 2009, p.418). This equilibrium is primarily achieved due to the market situation which actively supports the virtue of free entry.
In the event the firm intends to preserve the supernormal profits accrued in the short run, the firm can decide to react to the situation by increasing production factors such that other players find it significantly difficult to enter due to increased cost factors on account of capacity. "Thus, under this case increasing the plant size maximizes the profit of the monopolist, besides increasing the total costs as the plant size is larger than the optimal size, and plan is over utilized" (Saraswathi & Reddy 2007, p.137). This scenario can effectively be depicted as follows:
On the other hand, the firm can choose to preserve supernormal profits experienced during the short run by optimizing the plant facilities during the long run to spur competition and market share.
Other Significant Differences
In essence, the demand curve of a perfect competition is horizontal while the demand curve in monopolistic competition slopes downwards and as a result the resultant demand revenue seen in monopolistic competition will be lower than perfect competition (Murkhejee 2002, p.438). This implies that in the event profit maximization in the long run for monopolistic competition the output can only be stretched until marginal revenue equals marginal cost while for perfect competition this will always go past the marginal cost.
Moreover, in monopolistic competition the occurrence of competitive factors in perfect competition implies that a firm has to set the lowest price in order to remain competitive in the market. This is especially seen during occurrence of the horizontal demand curve shown above. However, in the case of monopolistic competition occasioned with a downward sloping curve, it will reach a point of equilibrium at which the lowest point of the average total cost curve occurs (Murkhejee 2002, p.438-439). As a result, the equilibrium point fails to reduce the firm's Average Cost in the long run for monopolistic competition while for perfect competition that there is greater probability of this happening.