10. c. Zero Profit Theorem
In the long-run, all firms in a competitive firm will earn zero economic profits. This is not a bad
thing; in fact, firms in a competitive firm tend toward this outcome because this does not mean the firms
are receiving zero returns, rather an average return. The Zero-Profit Theorem states that entry into a
competitive industry will continue until all opportunity for positive economic profit is reduced to zero. A
competitive firm maximizes profits by producing at a price and output where marginal cost (MC) is equal
to marginal revenue (MR), or in other words, where MC is equal to price. When this price is more than
average costs (AC), the firm earns a positive economic profit. In figure 10.c.1, this is the blue shaded area.
When price is $90, the firm maximizes profits by producing at an output of 140 units, resulting in profits
equal to the shaded area, above the AC. If price falls to $60 then the output produced will also fall to 80
units and there will be no positive economic profits and the firm will earn an average return.
The firms in a perfectly competitive industry are price takers, which means that they take the price
the market gives them. The price and output of the industry is determined by the equilibrium point of the
industry supply and demand curve. In figure 10.c.2 (a), the S and D equilibrium is at output 8 and price $9.
This price becomes the price of the individual firm and also its horizontal demand curve shown in figure
10.c.2 (b). At this price, the individual firm will maximize its profits by producing an output where MC and
the demand curve intersect. Since at this level of output costs are less than the price, the individual firm
makes a profit equal to the shaded area demonstrated in figure 10.c.1.
Without barriers to entry in a perfectly competitive market, the profit will attract new firms into
the industry. This will increase the supply and result in a downward shift of the industry supply curve. In
figure 10.c.2 (a), the supply curve shifts to the right, resulting in a new equilibrium point of S’ and D, and a
lower price of $6. When the price is lowered to $6, the individual firm will maximize profits by producing
where MC is equal to price, which in figure 10.c.2 (b) is at an output of 80 units. At this level of output, the
representative firm is making zero economic profits.
If more and more firms enter the industry, the industry supply curve will shift more to the right,
resulting in even lower prices and ultimately less profit for the individual firm. This will cause some firms
to leave, which would decrease the supply and shift it to the left, resulting in higher prices. This cycle will
continue until all profits are reduced to zero and no firm makes any positive economic profits.
Figure 10.c.1:
Dollars
Per Unit
The firm initially maximizes
profit (140,90)
MC
AC
90
New firms enter
resulting in price
reduction
60
Zero Economic
Profit P=AC
(80,60)
0
The firm's positive economic profit
80
140
Output
Figure 10.c.2:
Dollars
Per Unit
Dollars
Per Unit
S
MC
AC
S'
9
90
6
60
D=AR=M R
D'=AR'=M R'
D
8
14
(a)
Output
80
(b)
140
Output