Why Zero Profit Equilibria Can Subsist

In the long run equilibrium, firms in competitive markets make zero profit. This may seem odd, considering all the effort and time that has to be put into running a company. So why should these firms stay in business?

The answer to this question lies in the definition of the term profit. What most people think of when they hear profit is a number on the balance sheet of a firm. We call this the accounting profit. However, for many economic issues, considering accounting profits may not be sufficient. In those cases, we need to look at a different type of profit as well; the so-called economic profit.

Accounting profit

As mentioned above, accounting profit is the surplus we can find on a balance sheet. It can be calculated as the difference between total revenue and costs. However, the important aspect here is that accounting profit only includes explicit costs. That is, it only accounts for costs that result in an outflow of money (or an increase in dept) for the firm.

For example, think of an ice cream seller who wants to open a new business. Let's assume he faces costs of $100'000 for equipment and ingredients. At the end of the year, he has sold ice cream for a total of $150'000. Thus he makes an accounting profit of $50'000 ($150'000 - $100'000).

This approach is rather business-oriented. It includes everything that is relevant to set up a balance sheet. However, since we are looking at the issue from an economic perspective, we need to include some additional aspects. Therefore, we shall look at economic profits.

Economic profit

Economic profit is defined as total revenue minus total costs. That means in addition to the explicit costs it also includes implicit costs, such as opportunity costs. In other words, economic profit also accounts for the time, money and effort an owner puts into his company.

Regarding the zero profit condition, this suggests that in the long run equilibrium, owners need to be compensated for their opportunity costs. Hence the company must actually generate a positive accounting profit in the amount of the opportunity costs incurred. Therefore it will generate at least the amount of profit that is needed to maintain the factors of production (labor, capital, etc.). This profit is referred to as the normal profit.

To illustrate that idea, let's go back to our ice cream seller. If he had decided not to set up his business, he could have for instance deposited the $100'000 (i.e. the explicit costs) in a bank account to earn $5'000 in interest. In addition to that he could have worked for another ice cream producer to earn $45'000 a year. As a result, his opportunity costs add up to $50'000. If we include those costs in the calculation of the accounting profit above we get the economic profit for this case, which will amount to zero ($150'000 - $100'000 - $50'000).

This shows that even if economic profits are zero, producers still earn positive accounting profits. They have no reason to go out of business, because they receive compensation for their opportunity costs, so there is no alternative that would generate higher profits for them.

In a nutshell

In the long run equilibrium, firms in competitive markets make zero profits. This may seem odd at a first glance. However it makes sense because the statement refers to economic profit. It is important to note that unlike accounting profit (i.e. revenue minus explicit costs), economic profit (i.e. revenue minus explicit and implicit costs) includes opportunity costs. As a result according to the zero profit condition, competitive firms in the long run equilibrium are compensated for their opportunity costs. That means there is no superior alternative for them so they have no incentive to go out of business. On the contrary, they may still generate substantial accounting profits.

Perfect Competition vs. Imperfect Competition

Firm behavior in competitive markets is probably one of the most fundamental subjects in economics. That is mainly due to the fact that most markets we encounter in reality are competitive, at least to a certain degree.

Competition is characterized by a multitude of firms offering the same (or a similar) good or service or a close substitute. In general it can be said that the more similar the goods or services are, the more competitive the markets will be. However, the competitiveness of a market is still highly dependent on firm behavior. For example, companies engaging in collusive behavior may result in a significant impediment to competition. For now, we will assume that firms do not engage in such activities.

As mentioned above, competitive markets may experience different degrees of competition. To explain the principle of competitiveness, it is useful to distinguish between two different market structures: perfect competition and imperfect competition.

Perfect competition

As the name suggests, perfect competition is considered the purest form of competition. For a market to be perfectly competitive, the following criteria need to be met:

• The goods that are sold need to be homogeneous. In other words, they need to be exactly the same and can thus be substituted at no cost.
• There must be no preferences between different sellers. For the customers it should not matter from which seller they buy their products.
• No actor should have the ability to affect the market price. That means, both buyers and sellers do not have any market power and can thus be considered price takers.

Looking at these criteria, it becomes apparent, that they will hardly ever be met in reality. Even so, an example that comes fairly close to perfect competition is the market for rice. There are thousands of buyers and sellers and the products are mostly identical. But it will never be perfectly competitive, as there will always be minor differences in products, preferences between sellers and so on.

However, at this point it is important to note that the idea behind perfect competition as a theoretical construct is to help explain various market mechanisms and economic behavior. So even though we may not find perfectly competitive markets in reality, the concept is still extremely relevant.

Imperfect competition

In contrast to perfect competition, imperfect competition is a fairly common market structure in practice. It is defined by the following characteristics:

• The goods that are sold are differentiated. That means, even though they mostly satisfy the same needs, there are minor differences that allow customers to distinguish the products from one another. 
• Due to the differentiated goods, customers develop preferences for some sellers. Thus, they are willing to spend more money on goods from specific sellers.
• As a result, the sellers may exert a certain degree of market power and charge a price premium. Hence, they can directly influence the market price to a limited degree and are no longer pure price takers.

An example of imperfect competition is the market for cereals. Just think about the cereal aisle at your local supermarket, you will find dozens of different cereals (Cap'n Crunch, Lucky Charms, Froot Loops, Apple Jacks, etc.). Out of those brand you probably have a favorite, like most people. However, if you think about it, those cereals are actually not that different. Ultimately, they all serve the exact same need; providing you with a tasty breakfast.

In a nutshell

Competitive markets are characterized by a multitude of firms offering the same (or a similar) good or service or close substitutes. They can either be perfectly competitive or imperfectly competitive. In perfectly competitive markets the goods are homogeneous, consumers have no preferences, and neither buyers nor sellers can influence the market price. Imperfectly competitive markets on the other hand are distinguished by differentiated products, consumer preferences, and as a result a certain degree of market power for sellers.