3 Long-Run Entry, Exit, and Equilibrium

Profit and the long-run equilibrium

In a perfectly competitive industry, individual firms take the market price as given. Over the long run, they can adjust all inputs and capacity, and firms can enter or leave the industry. These adjustments link firms’ incentives to market supply and price.

Economic profit is total revenue minus all costs, including the opportunity cost of resources supplied by the firm’s owners. This differs from accounting profit, which generally subtracts only explicit expenses. Zero economic profit does not mean owners receive no return: it means they cover explicit costs and earn the normal return available in the next-best use of their resources.

The zero-profit condition

A competitive firm chooses output where price equals marginal cost, provided producing is worthwhile. With free entry and exit, long-run equilibrium removes firms’ incentives to enter or leave. Under the standard model’s assumptions, a firm then produces where:

Here, $P$ is price, $MR$ is marginal revenue, $MC$ is marginal cost, and $LRAC$ is long-run average cost. Price equals minimum long-run average cost, so the firm earns zero economic profit. This is the zero-profit condition, also called normal profit.

How entry and exit change supply

When firms earn positive economic profit, new firms have an incentive to enter. Entry increases industry supply, putting downward pressure on market price and reducing the profits of firms already operating. Entry continues while economic profit remains positive.

When firms incur economic losses, some firms leave in the long run. Exit reduces industry supply, putting upward pressure on price and reducing the losses of firms that remain. Exit continues until firms no longer have an incentive to leave.

A firm may continue producing in the short run while covering its variable costs, even if it is losing money overall. In the longer run, exiting allows it to avoid costs that are no longer fixed once it leaves.

Adjustment after demand rises

Suppose a rise in demand raises the market price above firms’ average cost. Existing firms expand output, and positive economic profit attracts entrants. As industry supply grows, price falls. In a constant-cost industry, adjustment eventually returns price to its original long-run level, while industry output is higher.

The long-run industry supply curve

The long-run industry supply curve describes how equilibrium price changes with total industry output after firms have had time to enter or exit and adjust production. Its slope depends on how industry-wide production costs respond as output expands.

• Constant-cost industry: Input prices and firms’ production costs stay approximately unchanged as the industry expands. Entry can increase total supply without changing the long-run equilibrium price, so long-run supply is horizontal.

• Increasing-cost industry: Expansion raises the prices of scarce inputs or otherwise increases firms’ costs. A higher market price is needed to sustain greater output, so long-run supply slopes upward.

• Decreasing-cost industry: Expansion lowers costs, for example through industry-wide learning or improved input availability. Greater output can be sustained at a lower price, so long-run supply slopes downward.

These are model outcomes, not rules that every real industry must follow. The industry’s long-run supply curve is distinct from an individual firm’s supply curve.