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Market Structures, Costs and Revenue: Question 1

Syllabus 7.6.1, 7.6.4

Multiple choice A2 1 mark

A market for a standard grade of raw cotton is often treated as a real-world approximation to the theoretical model of perfect competition, since there are many small growers, an identical product, and freedom of entry and exit for new producers.

In the long-run equilibrium of a perfectly competitive market such as this, which outcome is correct?

Choose an answer to check it, then compare with the worked solution below.
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Worked solution

Step 1: Recall why perfect competition tends toward this long-run outcome

Perfect competition assumes many small firms selling an identical product, with perfect information and, crucially, freedom of entry and exit. If firms are earning supernormal profit in the short run, this profit acts as a signal that attracts new firms into the market. As new firms enter, total market supply rises, driving the market price down; each existing firm’s demand (average revenue) curve shifts down and becomes tangent to its average cost curve. Entry stops only once supernormal profit has been competed away entirely, leaving each firm earning just normal profit, the minimum return needed to keep it supplying this market rather than switching its resources elsewhere.

Because each firm also continues to produce where marginal cost equals marginal revenue (which, since demand is perfectly elastic for a price-taking firm, equals price), and because entry has pushed price down to the minimum point of the average cost curve, the long-run equilibrium is both allocatively efficient (price == marginal cost) and productively efficient (production occurs at the lowest point of the average cost curve).

Step 2: Evaluate each option

  • Option A: incorrect. Supernormal profit cannot persist indefinitely in perfect competition precisely because free entry allows new firms to compete it away.
  • Option B: correct. This is exactly the long-run equilibrium outcome described above: price == marginal cost == minimum long-run average cost, and only normal profit remains.
  • Option C: incorrect. Deliberately restricting output below the minimum efficient scale to sustain a price above average cost is a description of behaviour possible under monopoly or oligopoly, where a firm has some control over price; a perfectly competitive firm is a price taker with no such power.
  • Option D: incorrect. Blocking new entrants describes a barrier to entry, which is the defining feature of imperfect market structures, not perfect competition, whose central assumption is that entry and exit are free.

Final answer

Option B. In long-run equilibrium, price equals marginal cost and equals the minimum point of the long-run average cost curve, so competition from freely entering firms leaves each firm earning only normal profit.