Long-run equilibrium of the individual firm

After you have worked through this section of the learning unit, you should be able to:

  • describe the long-run equilibrium position

We have learnt that, in the short run, firms will be restricted in some way by the presence of fixed costs. However, in the long run, all factors of production and costs become variables, and firms are able to enter and exit the market. If firms in the market are making economic profits, this will attract new entrants into the market, whereas if firms are making economic losses, this will lead to firms exiting the market.

What condition of perfect competition allows firms to enter and exit?

  • Many buyers and sellers
  • Homogeneous goods
  • Complete freedom of entry and exit
Click to Show Answer

This is due to complete freedom of entry and exit.

When existing firms are making an economic profit, it will attract new firms wishing to enter the market. As more firms enter the market, the market supply increases and the equilibrium price decreases. This process will continue until firms are only making a normal profit.

This can be illustrated by the following diagrams:

The market is represented in diagram A, while the individual firm is represented in diagram B.

At a market price of P1, the firm is making an economic profit as the average revenue is greater than the average cost. This is indicated by point A. The economic profit attracts firms to enter the market, and the market supply curve thus shifts to the right, and the market equilibrium price decreases to P2. As the market equilibrium price decreases, the firm's economic profit declines, as indicated by point B. This process of an increase in the number of new entrants, an increase in the market supply and a decrease in market equilibrium price continues until point C is reached, where only normal profits are earned. Thus, in the perfectly competitive market, long-run equilibrium will only be achieved once all firms are earning normal profits.

Activity

Indicate whether the following statement relating to a competitive market is true or false:

If all the firms in a perfectly competitive industry earn economic profits, new firms will be attracted to the market. The supply of the goods will increase, thus lowering the price. Eventually, all the firms will be earning normal profit only.

Correct. The statement is indeed true. Economic profits attract new entrants and the market supply increases, which decreases the price; and as the price decreases, economic profits decline.

Incorrect. The statement is true. Economic profits attract new entrants and the market supply increases, which decreases the price; and as the price decreases, economic profits decline.

If individual firms make an economic loss, it will result in existing firms exiting. The market supply thus decreases and the market supply curve shifts leftwards and the market price increases. This change in the market price causes the marginal revenue curve of the individual firm to shift upwards causing the economic loss of the firm to decline. This process continues until only a normal profit is made by the firm.

The above is illustrated in the following diagram:

Click to Show Answer