Perfect Competition — Short Run to Long Run

What this diagram shows

This diagram illustrates the transition from short-run equilibrium (where perfectly competitive firms can make supernormal profits) to long-run equilibrium (where only normal profit is made). In the short run, a firm might produce where price exceeds average cost, earning supernormal profits shown by the shaded rectangle. However, because there are no barriers to entry in perfect competition, new firms are attracted by these profits, increasing market supply, reducing price, and eliminating supernormal profits until firms only make normal profit in the long run.

Key points

• Short run: Firms can make supernormal profits when price (AR) is above average cost (AC) at the profit-maximising output where MC = MR
• The supernormal profit area is shown as a rectangle between the price line and average cost curve
• Long run adjustment: New firms enter the market attracted by supernormal profits, as there are no barriers to entry
• Market supply increases, causing market price to fall and the individual firm's demand curve (AR = MR) to shift downward
• Long run equilibrium: Price falls until AR = AC, meaning firms only make normal profit and have no incentive to enter or leave the market

Exam board notes

All major exam boards treat this diagram identically, focusing on the adjustment mechanism from short-run supernormal profits to long-run normal profits through firm entry and exit.