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Long-run entry and exit decisions meaning
In perfect competition, firms can make positive economic profits in short-run equilibrium, but they can only make a normal profit in the long run.
Firms earn a normal profit when they make zero economic profit.
That's because, in the long run, firms will enter this market and drive down profits. Figure 1. visually depicts the firm's cost curves as well as the short-run market equilibrium where the market price is exactly equal to the breakeven price, which is the minimum value of ATC. When the firms in this market are neither making positive economic profits nor taking a loss. They are breaking even, or, earning a normal profit.
Fig. 1 - Long-run normal profit in perfect competition
How does this happen? First, when perfectly competitive firms are making a positive economic profit in short-run equilibrium, additional sellers join this market. Perfect competition is characterized by free entry and exit, so these changes can happen costlessly. This process is depicted in Figure 2.
Start with the short-run equilibrium at market price PSR. Looking at the whole market, panel (b) shows that this price is at the intersection of market demand D and market supply SSR, so this is indeed a short-run equilibrium. The firm is maximizing profit by producing Qi units of the good.
The shaded green box represents the firm's positive economic profit. The height of the box is the difference between the market price PSR and the value of ATC at quantity Qi, which is the profit-maximizing quantity given the market price PSR. Thus, the bottom of the box is slightly above PLR.
Fig. 2 - Long-run entry and exit in perfect competition
Because the short-run equilibrium involves positive economic profits, new firms are incentivized to enter this market, shifting the market supply curve in panel (b) to the right from SSR to S'. This shift lowers the equilibrium market price to P'. Notice what has happened to this firm's position. Suddenly, the market price is now P', and even at the profit-maximizing output of Qi', the firm is losing money!
The amount of economic loss to the firm is represented by the red shaded box in panel (a). The height of this box is now the difference between the value of ATC at quantity Qi' and the market price, now P', for which Qi' is the profit-maximizing quantity. Thus, the top of this box is slightly above PLR. This is the same as calculating profit.
If the market price is above ATC, this box lies entirely above ATC and below the market price, and the firm is earning a profit. If instead, the market price is below ATC, this box lies entirely below ATC and above the market price, and the firm is losing money. The graphical area of the box represents the amount of profit or loss.
If the firm is producing at the profit-maximizing Q, the firm's profit (or loss) can be calculated as the area of the box whose height is the difference between the market price and ATC and whose length is the quantity produced.
Now, with the additional sellers in this market and a market price of P', the firm maximizes profit by producing fewer units of the good, specifically Qi' units. At this quantity and price, the firm is taking an economic loss. Since the market price is above AVC, it is profit-maximizing to keep the business alive in the current period, because some costs are fixed and sunk. We can think of the current period as the short run.
However, if the market price stays at this level for more than just the current period, the firm eventually shuts down production entirely and leaves the market. A firm cannot continue to operate without recouping its losses.
Thus, the lower market price incentivizes some firms to exit the market. When this happens, the supply curve shifts back to the left, from S' to SLR in Figure 2 panel (a). This puts upward pressure on the market price and firm profits. Note that the responsive shift back to the left is smaller than the original shift to the right.
This process continues with firms entering and exiting until economic profits are exactly zero. This happens when the market price is precisely the breakeven price which is equal to the minimum ATC. The "long run" is whatever period of time it takes for these dynamics to settle down. It is also assumed that all costs are variable in the long run.
The new price now is PLR. This is the breakeven price. Since the price is equal to the minimum ATC, firms are making just enough profit to cover all of their expenses, and they are not making any additional profit that could entice new firms to enter.
When the short-run equilibrium price equals the breakeven price, we are in long-run equilibrium. The market price conveys the information that consumers and firms need, and no one has an incentive to change their current behaviour.
Long-run supply curve in perfect competition
The long-run equilibrium under perfect competition is when market supply intersects with market demand precisely at the market price that equals the minimum average total cost. Equivalently, the long-run equilibrium outcome is any short-run equilibrium that is also on the long-run supply curve.
What is the long-run supply curve? A supply curve is a relationship between the market price and the quantity supplied in the market. However, the long-run supply curve only includes points in which the entry and exit process has finished running its course. Whereas in short-run equilibrium, firms may be losing money, over time those firms will drop out of the market, so they do not get included in the long-run supply curve.
The long-run supply is flatter and more elastic because all costs are variable in the long run. Similarly, in the long run, market demand is also flatter and more elastic because more options are available to consumers in the long run.
A key determinant of long-run supply is the industry's cost structure. Under perfect competition, Figure 3 illustrates the effect of an exogenous shock to demand in the following types of industries:
- Panel (a) - An increasing cost industry
- Panel (b) - A decreasing cost industry
- Panel (c) - A constant cost industry
Imagine there is an exogenous shock to demand, the demand curve shifts to the right. Existing firms increase their quantity supplied, and this is a movement along the original supply curve. In addition, new firms enter the market due to the now higher price and higher profit, and this shifts the supply curve to the right. Which one of these impacts is bigger determines what type of industry we are in.
Notice that the industry cost structure - whether increasing, decreasing, or constant - also describes the industry's long-run supply curve. Just as the supply curve for an individual firm is the firm's marginal cost curve above minimum AVC, a similar relationship holds true for the industry. The market's long-run supply curve is the industry's long-run cost curve.
Fig. 3 - Long-run supply curve in perfect competition in different cost industries
In all three types of industries, an exogenous increase in demand results in a higher equilibrium quantity. However, the direction of change in the equilibrium price, if any, is unknown. The price could be higher, lower, or the same, depending on the cost structure of the industry.
Long-run efficiency in perfect competition
In perfect competition, both short-run and long-run equilibrium is efficient, but in different ways. The short-run equilibrium is allocatively efficient ( ); however, it is not productively efficient ( ). Since firms can make positive profits in short-run equilibrium, we cannot be sure that the good is being produced by the most efficient producers - those with the lowest cost curves. Productive efficiency can only be achieved over a longer timeframe.
While some costs are fixed in the short run, in the long run even those fixed costs become variable. Over time, sellers are able to decide what level of fixed cost, or investment, provides the lowest overall minimum ATC. This is the most efficient scale on which to operate. Once a perfectly competitive market reaches long-run equilibrium, the market price is the break-even price and firms earn only a normal profit.
If anyone was able to produce the goods more cheaply, they would have entered this market in order to make positive profits. Free entry in perfect competition ensures that. Therefore, the sellers who are breaking even must be the producers with the lowest cost curve. On the other hand, any firm with a higher cost curve has already exited this market.
Thus, in the long run under perfect competition, when the market price stabilizes at the breakeven price , we know that the good is being produced only by the most efficient manufacturers. We also know that, even in the short-run equilibrium, the price system ensures the good is being consumed only by the consumers who value it most . In this way, the long-run equilibrium is both allocatively and productively efficient.
Long Run Entry and Exit Decisions - Key takeaways
- Firms earn a normal profit in long-run equilibrium under perfect competition
- The number of firms is constant in the short run but varies in the long run due to entry and exit
- Positive economic profits drive new entries while economic losses drive some firms to exit
- The long-run equilibrium is any short-run equilibrium that has a market price equal to the minimum ATC
- The long-run supply curve is upward sloping in an increasing cost industry, downward sloping in a decreasing cost industry, and flat in a constant cost industry
- The long-run equilibrium market price could be higher or lower than the short-run equilibrium price
- The long-run equilibrium under perfect competition is both allocatively efficient and productively efficient
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Frequently Asked Questions about Long Run Entry and Exit Decisions
What are long run entry and exit decisions?
Long run entry and exit decisions stand in contrast to the short run, where the number of firms in perfect competition is constant. However, in the long run, depending on the market price, new firms may decide to enter this market and existing firms may decide to leave. If the market price is high, that will spur new entrants. If the market price is low, specifically below a firm's minimum average total cost, then in the long run this firm will have to drop out of the market.
What factors would determine entry and exit into a market?
The primary factor that influences entry and exit into a market is profit. Since perfect competition involves free entry and exit, if the existing firms are making positive economic profit, then new firms will enter. If the existing firms are taking economic losses, then the firms will the highest costs will leave the market.
When should a firm exit the market in the long run?
In the long run, if the market price is below the minimum ATC, then the firm is losing money and should exit the market. In the short run, it still makes sense to produce as long as the price is above the minimum AVC because the fixed costs are already sunk. But once those fixed costs "run out," and new fixed costs investments are called for, then the firm will shut down.
What is the long run exit rule?
P < minimum ATC
What triggers entry and exit in competitive market?
Nonzero economic profits and losses trigger entry and exit in a competitive market.
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