Assume that in a purely competitive industry: (1) the entry and exodus of firms are the only long-run adjustments; (2) firms in the industry have identical cost curves; and (3) the industry is a constant-cost industry. Explain how long-run equilibrium

Question

is eventually achieved in the industry when there are initially economic profits and losses.

What will be an ideal response?

Answer 1

When long-run equilibrium is achieved, the product price will be exactly equal to, and production will occur at, the minimum average total cost for each firm. Firms seek profits and want to avoid losses. Firms may freely enter and exit the industry. If economic profits are being earned in the industry, then marginal revenue (= price) is above the minimum of average total cost for the representative firm. New firms will enter the industry, which increases the market supply, causing the marginal revenue line or product price to fall to the equilibrium price where zero economic profits are earned (MR = P = minimum ATC). If losses are incurred in the short run by the representative firm, then marginal revenue (= P) is below the minimum ATC. Firms will leave the industry, which decreases the market supply, causing the marginal revenue to rise until losses disappear and normal profits are earned. The outcome from the model is one of zero economic profits. Yet, this situation allows for a normal profit to be made by each firm in the long run.