Final answer:
In a perfectly competitive market, short-run economic profits result from prices exceeding average costs. However, these profits attract new firms, increase supply, lower prices, and lead to zero economic profits in long-run equilibrium where firms have no incentive to enter or leave the market.
Step-by-step explanation:
For a firm in a perfectly competitive market, the situation of economic profits can be illustrated when the market price is higher than the average cost(AC) of production. In the short run, an increase in demand leads to higher prices and firms start to make economic profits as they increase output where price (P) equals marginal revenue (MR) equals marginal cost (MC).
However, in the long run, these economic profits attract new firms into the market, increasing the supply and thus driving the price down. As the market adjusts, the firms will eventually earn zero economic profits where P = MR = MC and P = AC, and no firm has the incentive to either enter or leave the market, resulting in a long-run equilibrium.
If a firm is currently achieving economic profits, we can expect an influx of competition from new firms, leading to a reduction in prices and profits over time. This movement towards long-run equilibrium is fundamental to the dynamics of a perfectly competitive market, where firms make their output decisions by calculating profits, identifying profits and losses with the average cost curve, and understanding the shutdown point.