Long Run Entry and Exit Decisions

Have you ever noticed that prices of some goods tend to go up and up over time, while the prices of other goods seem to come down over time? What is different about those two cases in perfectly competitive markets? What affects the decisions of entry and exit in the long run? Read on to find out!

Long-run entry and exit decisions meaning

In perfect competition, firms can make positive economic profits in short-run equilibrium, but they can only make a normal profit in the long run.

That's because, in the long run, firms will enter this market and drive down profits. Figure 1. visually depicts the firm's cost curves as well as the short-run market equilibrium where the market price is exactly equal to the breakeven price, which is the minimum value of ATC. When $P_M=minimumATC$ the firms in this market are neither making positive economic profits nor taking a loss. They are breaking even, or, earning a normal profit.

Fig. 1 - Long-run normal profit in perfect competition

How does this happen? First, when perfectly competitive firms are making a positive economic profit in short-run equilibrium, additional sellers join this market. Perfect competition is characterized by free entry and exit, so these changes can happen costlessly. This process is depicted in Figure 2.

Start with the short-run equilibrium at market price P_SR. Looking at the whole market, panel (b) shows that this price is at the intersection of market demand D and market supply S_SR, so this is indeed a short-run equilibrium. The firm is maximizing profit by producing Q_i units of the good.

The shaded green box represents the firm's positive economic profit. The height of the box is the difference between the market price P_SR and the value of ATC at quantity Q_i, which is the profit-maximizing quantity given the market price P_SR. Thus, the bottom of the box is slightly above P_LR.

Fig. 2 - Long-run entry and exit in perfect competition

Because the short-run equilibrium involves positive economic profits, new firms are incentivized to enter this market, shifting the market supply curve in panel (b) to the right from S_SR to S'. This shift lowers the equilibrium market price to P'. Notice what has happened to this firm's position. Suddenly, the market price is now P', and even at the profit-maximizing output of Q_i', the firm is losing money!

The amount of economic loss to the firm is represented by the red shaded box in panel (a). The height of this box is now the difference between the value of ATC at quantity Q_i' and the market price, now P', for which Qi' is the profit-maximizing quantity. Thus, the top of this box is slightly above P_LR. This is the same as calculating profit.

If the market price is above ATC, this box lies entirely above ATC and below the market price, and the firm is earning a profit. If instead, the market price is below ATC, this box lies entirely below ATC and above the market price, and the firm is losing money. The graphical area of the box represents the amount of profit or loss.

Now, with the additional sellers in this market and a market price of P', the firm maximizes profit by producing fewer units of the good, specifically Q_i' units. At this quantity and price, the firm is taking an economic loss. Since the market price is above AVC, it is profit-maximizing to keep the business alive in the current period, because some costs are fixed and sunk. We can think of the current period as the short run.

However, if the market price stays at this level for more than just the current period, the firm eventually shuts down production entirely and leaves the market. A firm cannot continue to operate without recouping its losses.

Thus, the lower market price incentivizes some firms to exit the market. When this happens, the supply curve shifts back to the left, from S' to S_LR in Figure 2 panel (a). This puts upward pressure on the market price and firm profits. Note that the responsive shift back to the left is smaller than the original shift to the right.

This process continues with firms entering and exiting until economic profits are exactly zero. This happens when the market price is precisely the breakeven price which is equal to the minimum ATC. The "long run" is whatever period of time it takes for these dynamics to settle down. It is also assumed that all costs are variable in the long run.

The new price now is P_LR. This is the breakeven price. Since the price is equal to the minimum ATC, firms are making just enough profit to cover all of their expenses, and they are not making any additional profit that could entice new firms to enter.

When the short-run equilibrium price equals the breakeven price, we are in long-run equilibrium. The market price conveys the information that consumers and firms need, and no one has an incentive to change their current behaviour.

Long-run supply curve in perfect competition

The long-run equilibrium under perfect competition is when market supply intersects with market demand precisely at the market price that equals the minimum average total cost. Equivalently, the long-run equilibrium outcome is any short-run equilibrium that is also on the long-run supply curve.

What is the long-run supply curve? A supply curve is a relationship between the market price and the quantity supplied in the market. However, the long-run supply curve only includes points in which the entry and exit process has finished running its course. Whereas in short-run equilibrium, firms may be losing money, over time those firms will drop out of the market, so they do not get included in the long-run supply curve.

A key determinant of long-run supply is the industry's cost structure. Under perfect competition, Figure 3 illustrates the effect of an exogenous shock to demand in the following types of industries:

• Panel (a) - An increasing cost industry
• Panel (b) - A decreasing cost industry
• Panel (c) - A constant cost industry

Imagine there is an exogenous shock to demand, the demand curve shifts to the right. Existing firms increase their quantity supplied, and this is a movement along the original supply curve. In addition, new firms enter the market due to the now higher price and higher profit, and this shifts the supply curve to the right. Which one of these impacts is bigger determines what type of industry we are in.

Notice that the industry cost structure - whether increasing, decreasing, or constant - also describes the industry's long-run supply curve. Just as the supply curve for an individual firm is the firm's marginal cost curve above minimum AVC, a similar relationship holds true for the industry. The market's long-run supply curve is the industry's long-run cost curve.

Fig. 3 - Long-run supply curve in perfect competition in different cost industries

In all three types of industries, an exogenous increase in demand results in a higher equilibrium quantity. However, the direction of change in the equilibrium price, if any, is unknown. The price could be higher, lower, or the same, depending on the cost structure of the industry.

Long-run efficiency in perfect competition

In perfect competition, both short-run and long-run equilibrium is efficient, but in different ways. The short-run equilibrium is allocatively efficient ( $P=MC$); however, it is not productively efficient ( $P\ne minimumATC$). Since firms can make positive profits in short-run equilibrium, we cannot be sure that the good is being produced by the most efficient producers - those with the lowest cost curves. Productive efficiency can only be achieved over a longer timeframe.

While some costs are fixed in the short run, in the long run even those fixed costs become variable. Over time, sellers are able to decide what level of fixed cost, or investment, provides the lowest overall minimum ATC. This is the most efficient scale on which to operate. Once a perfectly competitive market reaches long-run equilibrium, the market price is the break-even price and firms earn only a normal profit.

If anyone was able to produce the goods more cheaply, they would have entered this market in order to make positive profits. Free entry in perfect competition ensures that. Therefore, the sellers who are breaking even must be the producers with the lowest cost curve. On the other hand, any firm with a higher cost curve has already exited this market.

Thus, in the long run under perfect competition, when the market price stabilizes at the breakeven price $(P=minimumATC)$, we know that the good is being produced only by the most efficient manufacturers. We also know that, even in the short-run equilibrium, the price system ensures the good is being consumed only by the consumers who value it most $(P=MC)$. In this way, the long-run equilibrium is both allocatively and productively efficient.