Long-Run Market Equilibrium and Firm Entry and Exit
Firm Entry and Exit Effects
The key mechanism in perfectly competitive long-run markets is straightforward: profits attract firms, and losses push them out. This process continues until economic profits hit zero.
When economic profits exist in the short run, new firms enter the market to capture some of those profits. As they enter (think new coffee shops opening in a trendy neighborhood), market supply increases. That increased supply drives the market price down, which shrinks profits for every firm in the industry. Entry keeps happening until economic profits reach zero and the market settles into long-run equilibrium.
The reverse works the same way. When firms face economic losses, some exit (unprofitable restaurants closing, for example). Their departure reduces market supply, which pushes the price back up. Remaining firms see their losses shrink. Exit continues until losses are eliminated and the market is back in equilibrium.
The end result: in the long run, perfectly competitive firms earn zero economic profit. That doesn't mean they earn nothing. They still cover all their costs, including a normal return on investment. Zero economic profit just means there's no extra incentive for new firms to enter or existing firms to leave.
Market Adjustment Processes
How the market adjusts depends on what happens to input prices as firms enter or exit. This gives us three types of industries.
Constant-Cost Industries
In a constant-cost industry, the entry or exit of firms doesn't change input prices. The industry is small enough relative to its input markets that adding or losing firms has no noticeable effect on what inputs cost.
- The long-run supply curve is horizontal (perfectly elastic).
- The long-run equilibrium price stays the same regardless of changes in demand; only quantity adjusts.
Example: T-shirt manufacturing. If demand for t-shirts rises, new firms enter. Market supply increases and quantity rises, but the price of cotton and thread doesn't budge because t-shirt makers use such a small share of the total cotton market. Price returns to its original level.
Increasing-Cost Industries
In an increasing-cost industry, new firms entering the market bid up input prices. This raises costs for everyone.
- The long-run supply curve slopes upward.
- Higher demand leads to both higher quantity and a higher long-run price.
Example: Housing construction. When demand for new homes rises, builders enter the market and compete for lumber, concrete, and skilled labor. Those input prices climb, raising the cost of building each home. The new long-run equilibrium has more houses built, but at a higher price than before.
When demand falls, the process reverses: firms exit, input prices drop, and the long-run price settles at a lower level.
Decreasing-Cost Industries
In a decreasing-cost industry, more firms entering actually lowers input prices, typically through economies of scale in the input markets.
- The long-run supply curve slopes downward.
- Higher demand leads to higher quantity but a lower long-run price.
Example: Semiconductor manufacturing. As more chip producers enter the market, suppliers of silicon wafers and specialized equipment can produce at larger scale, driving per-unit input costs down. The new long-run equilibrium has more output at a lower price.
When demand falls and firms exit, those scale advantages disappear. Input costs per unit rise, and the long-run price actually increases.
Long-Run Supply Curve Comparisons
| Industry Type | Long-Run Supply Curve | What Happens to Input Prices with Entry | Long-Run Price Effect |
|---|---|---|---|
| Constant-cost | Horizontal (perfectly elastic) | No change | Price stays the same |
| Increasing-cost | Upward sloping | Input prices rise | Price increases |
| Decreasing-cost | Downward sloping | Input prices fall (economies of scale) | Price decreases |
| The slope of the long-run supply curve tells you everything about how an industry responds to demand shifts over time. For your exam, be ready to trace through the full adjustment story: demand shifts → firms enter or exit → input prices change (or don't) → new long-run equilibrium. |
Market Structure and Entry Decisions
Perfect competition assumes free entry and exit, meaning no significant barriers prevent firms from joining or leaving the industry. This is what drives profits to zero in the long run.
Other market structures don't share this feature. In monopoly and oligopoly, barriers to entry like patents, high start-up costs, or government regulations block new firms from entering. That's exactly why firms in those structures can sustain economic profits over time. Monopolistic competition has low barriers, so it behaves more like perfect competition in the long run, with profits also trending toward zero.
When analyzing entry decisions, firms also weigh opportunity cost: the value of the next-best alternative use of their resources. A firm won't enter a market earning zero economic profit if it could earn positive economic profit elsewhere.