- Explain how entry and exit lead to zero profits in the long run
The line between the short run and the long run cannot be defined precisely with a stopwatch, or even with a calendar. It varies by industry and by specific business within an industry. The distinction between the short run and the long run is therefore more technical: in the short run, firms cannot change the usage of fixed inputs, while in the long run, the firm can adjust all factors of production.
In a competitive market, profits are a red cape that incites businesses to charge. If a business is making a profit in the short run, it has an incentive to expand existing factories or to build new ones. New firms may start production, as well. When new firms come into an industry in response to high profits, it is called entry.
Losses are the black thundercloud that causes businesses to flee. If a business is making losses in the short run, it will either keep limping along or just shut down, depending on whether its revenues are covering its variable costs. But in the long run, firms that are facing losses will downsize, reducing their capital stock, in hopes that smaller factories and less equipment will allow them to eliminate losses. Some firms will cease production altogether. When firms leave the industry in response to a sustained pattern of losses, it is called exit.
Why do firms cease to exist?
Can we say anything about what causes a firm to exit an industry? Profits are the measurement that determines whether a business stays operating or not. Individuals start businesses with the purpose of making profits. They invest their money, time, effort, and many other resources to produce and sell something that they hope will give them something in return. Unfortunately, not all businesses are successful, and many new startups eventually realize that their “business adventure” must end.
In the model of perfectly competitive firms, those that consistently cannot make money will “exit,” which is a nice, bloodless word for a more painful process. When a business fails, after all, workers lose their jobs, investors lose their money, and owners and managers can lose their dreams. Many businesses fail.The U.S. Small Business Administration indicates that in 2011, 534,907 new firms “entered,” and 575,691 firms failed.
Sometimes a business fails because of poor management or workers who are not very productive, or because of tough domestic or foreign competition. Businesses also fail from a variety of causes that might best be summarized as bad luck. For example, conditions of demand and supply in the market shift in an unexpected way, so that the prices that can be charged for outputs fall or the prices that need to be paid for inputs rise. With millions of businesses in the U.S. economy, even a small fraction of them failing will affect many people—and business failures can be very hard on the workers and managers directly involved. But from the standpoint of the overall economic system, business exits are sometimes a necessary evil if a market-oriented system is going to offer a flexible mechanism for satisfying customers, keeping costs low, and inventing new products.
How Entry and Exit Lead to Zero Profits in the Long Run
No perfectly competitive firm acting alone can affect the market price. However, the combination of many firms entering or exiting the market will affect overall supply in the market. In turn, a shift in supply for the market as a whole will affect the market price. Entry and exit to and from the market are the driving forces behind a process that, in the long run, pushes the price down to minimum average total costs so that all firms are earning a zero profit.
To understand how short-run profits for a perfectly competitive firm will evaporate in the long run, imagine the following situation. The market is in long-run equilibrium, where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC. No firm has the incentive to enter or leave the market. Let’s say that the product’s demand increases, and with that, the market price goes up. The existing firms in the industry are now facing a higher price than before, so they will increase production to the new output level where P = MR = MC.
This will temporarily make the market price rise above the average cost curve, and therefore, the existing firms in the market will now be earning economic profits. However, these economic profits attract other firms to enter the market. Entry of many new firms causes the market supply curve to shift to the right. As the supply curve shifts to the right, the market price starts decreasing, and with that, economic profits fall for new and existing firms. As long as there are still profits in the market, entry will continue to shift supply to the right. This will stop whenever the market price is driven down to the zero-profit level, where no firm is earning economic profits.
Watch It: The meaning of Zero Economic Profits
In this clip, Tyler and Alex explain why the “zero profit” can be misleading because zero profits simply mean that a firm is covering all of its cost, including enough to pay their ordinary opportunity costs and all of their labor and capital costs (meaning that they are making enough money to be satisfied). In other words, “zero profits” is what other people may call “normal profits.”
Short-run losses will fade away by reversing this process. Say that the market is in long-run equilibrium. This time, instead, demand decreases, and with that, the market price starts falling. The existing firms in the industry are now facing a lower price than before, and as it will be below the average cost curve, they will now be making economic losses. Some firms will continue producing where the new P = MR = MC, as long as they are able to cover their average variable costs. Some firms will have to shut down immediately as they will not be able to cover their average variable costs, and will then only incur their fixed costs, minimizing their losses. Exit of many firms causes the market supply curve to shift to the left. As the supply curve shifts to the left, the market price starts rising, and economic losses start to be lower. This process ends whenever the market price rises to the zero-profit level, where the existing firms are no longer losing money and are at zero profits again. Thus, while a perfectly competitive firm can earn profits in the short run, in the long run the process of entry will push down prices until they reach the zero-profit level. Conversely, while a perfectly competitive firm may earn losses in the short run, firms will not continually lose money. In the long run, firms making losses are able to escape from their fixed costs, and their exit from the market will push the price back up to the zero-profit level. In the long run, this process of entry and exit will drive the price in perfectly competitive markets to the zero-profit point at the bottom of the AC curve, where marginal cost crosses average cost.
Let’s take an example of this adjustment process. Suppose the National institutes of Health publishes a study indicating that consumption of corn leads to longer lives. The demand for corn products would increase causing an increase in the market price of corn. Farmers who are already growing corn would earn positive economic profits in the short run. In the long run, farmers would increase their acreage devoted to growing corn, perhaps by reducing their acreage of wheat. The increased market supply of corn would drive the market price of corn down to the average cost of producing corn. The lower corn price would reduce the profitability of growing corn. This process would continue until corn farmers were earning zero economic profits.
Long-Run Adjustment for a Constant Cost Industry
Perfect competition is often the result of a constant cost industry, where there is no advantage for a firm to be large. An increase in a firm’s capital stock, simply shifts the firm’s cost curves parallel to the right. The result is a long run industry supply curve which is very elastic. The following video will explain this with two graphs: one representing a typical firm and the other representing the market (or industry as a whole).
Watch It: Constant Cost Industry
Watch this video to see how a typical firm, as well as the industry which the firm is a part of, adjust to changes in demand for the product.
- constant cost industry:
- an industry whose technology is such that there is no advantage to size; a large firm faces the same average costs as a small firm does.
- the long-run process of firms entering an industry in response to industry profits
- the long-run process of firms reducing production and shutting down in response to industry losses
- long-run equilibrium:
- where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC
- zero economic profits:
- a firm is covering all of its cost, including the opportunity costs of its capital; i.e. normal accounting profits