8.3 Entry and Exit Decisions in the Long Run
2 min read•june 25, 2024
In perfectly competitive markets, firms can freely enter or based on profits. This dynamic process drives economic profits to zero in the , as new entrants increase supply and lower prices, while exits decrease supply and raise prices.
The long-run adjustment process varies depending on industry type. In constant-cost industries, prices remain stable as output changes. Increasing-cost industries see rising prices with expansion, while decreasing-cost industries experience falling prices as output grows.
Long-Run Market Dynamics
Entry and Exit Drive Profits to Zero
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- Long run perfectly competitive market has no or exit
- Firms freely enter market when observing economic profits
- Firms freely exit market when incurring economic losses
- Economic profits in short run attract new entrants
- New entrants increase market supply, drive down market price, reduce profits
- Economic losses in short run cause some firms to exit market
- Firms exiting decrease market supply, drive up market price, reduce losses
- and exit process continues until economic profits driven to zero
- At this point, firms earn covering all explicit and implicit costs (wages, rent, opportunity costs)
- No incentive for new firms to enter or existing firms to exit market
Long-Run Adjustment Process
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- Long-run perfectly elastic (horizontal)
- Entry and exit of firms do not affect input prices or production costs (labor, materials)
- In long run, price remains constant as industry output expands or contracts
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- Long-run supply curve upward-sloping
- As industry output expands, input prices increase, raising production costs
- More firms entering market compete for limited resources (skilled labor, raw materials), driving up input prices
- In long run, price increases as industry output expands
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- Long-run supply curve downward-sloping
- As industry output expands, input prices decrease, lowering production costs
- More firms entering market benefit from (bulk purchasing) or positive externalities (knowledge spillovers)
- In long run, price decreases as industry output expands
Market Supply Shifts Impact Equilibrium
- Shifts in market supply caused by changes in input prices, technology, taxes, or subsidies
- Rightward shift in market supply (increase)
- Leads to lower price and higher quantity
- Encourages entry of new firms, as market price initially exceeds minimum of curve
- Entry continues until economic profits driven to zero and new long-run equilibrium reached
- Leftward shift in market supply (decrease)
- Leads to higher long-run equilibrium price and lower equilibrium quantity
- Encourages exit of firms, as market price initially falls below minimum of average total cost curve
- Exit continues until economic profits driven to zero and new long-run equilibrium reached
- Magnitude of change in long-run equilibrium price and quantity depends on:
- Elasticity of demand (elastic vs inelastic)
- Type of industry (constant-cost, increasing-cost, decreasing-cost)
Key Terms to Review (30)
Average Total Cost: Average total cost (ATC) is the total cost of production divided by the quantity of output produced. It represents the average cost per unit of output and is a crucial factor in a firm's decision-making process, especially in the context of perfect competition.
Barriers to Entry: Barriers to entry are obstacles or factors that make it difficult for new firms to enter a particular market or industry. These barriers can give existing firms a competitive advantage and allow them to maintain higher prices and profits in the long run.
Constant-Cost Industry: A constant-cost industry is a market structure where the cost of production for firms remains the same regardless of the quantity produced or the number of firms in the industry. This means that as the industry expands or contracts, the per-unit cost of production does not change, in contrast to industries with increasing or decreasing costs.
Decreasing-Cost Industry: A decreasing-cost industry is a market structure where the average cost of production decreases as the total output of the industry increases. This is often due to economies of scale, where larger firms can produce goods more efficiently and at a lower per-unit cost than smaller firms. The concept of a decreasing-cost industry is particularly relevant in the context of long-run entry and exit decisions, as it can influence the dynamics of competition and market structure over time.
Demand Curve: The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity demanded of that good or service. It depicts how the quantity demanded changes as the price changes, ceteris paribus (all other factors remaining constant).
Diseconomies of Scale: Diseconomies of scale refer to the increase in average cost per unit that can occur when a company or industry expands its scale of production beyond an optimal level. This phenomenon is the opposite of economies of scale, where average costs decrease as output increases.
Economic Profit: Economic profit is the difference between a firm's total revenue and its total economic costs, which include both explicit costs (such as wages, rent, and raw materials) and implicit costs (such as the opportunity cost of the owner's time and the cost of using the firm's own capital). Economic profit is a more comprehensive measure of a firm's profitability compared to accounting profit, which only considers explicit costs.
Economies of Scale: Economies of scale refer to the cost advantages that businesses can exploit by expanding their scale of production. As a company increases its output, its average costs per unit typically decrease due to more efficient utilization of resources, specialized equipment, and division of labor.
Entry: Entry refers to the process by which new firms or producers join an industry or market, often in response to the potential for profitable opportunities. It is a crucial concept in the analysis of long-run decisions and market dynamics.
Equilibrium: Equilibrium is a state of balance where the forces acting on a system are in perfect harmony, resulting in no net change or movement. In the context of economics, equilibrium refers to the point where the quantity supplied and the quantity demanded of a good or service are equal, leading to a stable market price and quantity.
Exit: Exit refers to the decision of a firm to cease operations and leave a particular market or industry. It is a crucial long-term decision that firms must consider in the context of their overall business strategy and profitability.
Increasing-Cost Industry: An increasing-cost industry is a market structure where the cost of production rises as the industry expands. This is in contrast to a constant-cost industry, where the cost of production remains the same regardless of the industry's size. The increasing costs in an increasing-cost industry are typically due to factors such as limited resources, higher input prices, or diminishing returns to scale.
Incumbent Firms: Incumbent firms refer to established companies that currently hold a dominant position in a particular market or industry. These firms have been operating in the market for some time and possess significant advantages over potential new entrants.
Invisible Hand: The invisible hand is a metaphor used in economics to describe the unintended social benefits of individual actions. It suggests that in a free market, the pursuit of self-interest by individuals leads to the maximization of societal welfare, even though this was not the intention of those individuals.
Long Run: The long run is a period of time in which all factors of production, including capital equipment and facilities, can be varied. It is a time frame in which a firm can make any changes it desires to its production process, allowing it to adjust its scale of operations to the most efficient level.
Long-Run Equilibrium: Long-run equilibrium refers to the state in a market where firms have fully adjusted to changing conditions, and there is no incentive for new firms to enter or existing firms to exit the industry. At this point, the market has reached a stable, long-term balance between supply and demand.
Marginal Cost: Marginal cost is the additional cost incurred by a firm when producing one more unit of a good or service. It represents the change in total cost that results from a small increase in output. Marginal cost is a crucial concept in understanding a firm's production decisions and profitability across various market structures.
Market Saturation: Market saturation refers to the point at which a product or service has captured the maximum share of the target market, leaving little or no opportunity for further sales growth. It indicates that the market has reached its full potential for that particular offering, and any additional sales would likely come at the expense of competitors.
Market Structure: Market structure refers to the organizational and competitive characteristics of a market, which determine how firms in that market interact and the outcomes they can achieve. It is a key concept in economics that helps understand how the degree of competition in a market affects the pricing, output, and other decisions made by firms.
Minimum Efficient Scale: Minimum efficient scale (MES) is the smallest scale of production at which a firm can achieve the lowest possible per-unit cost of production. It represents the point where economies of scale are exhausted, and any further increase in output does not result in a significant reduction in average costs.
Monopolistic Competition: Monopolistic competition is a market structure characterized by many firms selling differentiated products, where each firm has a degree of market power to set its own price, but faces competition from other firms selling similar, yet not identical, products. This market structure lies between the extremes of perfect competition and monopoly.
Normal Profit: Normal profit is the minimum level of profit a firm must earn to remain in business in the long run. It represents the opportunity cost of the firm's resources, or the returns the firm's owners could earn by employing their resources elsewhere in the economy.
Perfect Competition: Perfect competition is a market structure characterized by a large number of small firms selling homogeneous products, with no barriers to entry or exit, and where firms are price takers rather than price makers. This market structure is a benchmark for analyzing the efficiency of other market structures in microeconomics and macroeconomics.
Potential Entrants: Potential entrants refer to firms or businesses that are not currently operating in a particular market or industry but have the capability and intention to enter and compete if certain conditions are met. They represent a source of potential competition that can influence the behavior and decision-making of incumbent firms in the long run.
Price Elasticity of Demand: Price elasticity of demand measures the responsiveness of the quantity demanded of a good or service to changes in its price. It quantifies how much the quantity demanded changes when the price changes, providing insights into consumer behavior and the dynamics of supply and demand in a market.
Profit Maximization: Profit maximization is the primary goal of a firm, which involves producing the optimal level of output that generates the highest possible profit. This concept is central to understanding the decision-making processes of firms operating in different market structures, including perfect competition, monopoly, and monopolistic competition.
Shutdown Point: The shutdown point is the level of output at which a firm in a perfectly competitive market will choose to shut down production in the short run rather than continue operating. At this point, the firm's revenue is just enough to cover its variable costs, but not its fixed costs, making it unprofitable to continue production.
Sunk Costs: Sunk costs refer to costs that have already been incurred and cannot be recovered, regardless of future actions taken. These costs are considered irrelevant for decision-making purposes as they do not affect the future outcome of a situation.
Supply Curve: The supply curve is a graphical representation of the relationship between the price of a good or service and the quantity supplied of that good or service. It depicts the willingness and ability of producers to offer their products for sale at different price levels in a given market.
Zero Profit: Zero profit refers to a situation where a firm's total revenue exactly equals its total cost, resulting in no economic profit or loss. This concept is particularly relevant in the context of a firm's entry and exit decisions in the long run.