8.3 Entry and Exit Decisions in the Long Run

Long-Run Market Dynamics

Entry and Exit Drive Profits to Zero

The defining feature of perfect competition in the long run is free entry and exit. There are no barriers stopping new firms from joining the market or existing firms from leaving. This single fact is what drives economic profits to zero over time.

Here's how the adjustment works:

• When firms earn economic profits in the short run, new firms enter the market. More firms means greater market supply, which pushes the market price down. Profits shrink as the price falls.
• When firms suffer economic losses in the short run, some firms exit. Fewer firms means less market supply, which pushes the market price up. Losses shrink as the price rises.

This process keeps going until economic profit equals zero. At that point, every remaining firm earns normal profit, which covers all explicit costs (wages, rent, materials) and all implicit costs (like the opportunity cost of the owner's time and capital). Zero economic profit doesn't mean firms are barely surviving. It means they're earning exactly what they could in their next-best alternative, so there's no incentive for anyone to enter or leave.

Long-Run Adjustment Process

Not every industry adjusts to the same final price after entry or exit. The outcome depends on what happens to input prices as the industry grows or shrinks. This gives us three industry types, each with a differently shaped long-run supply curve.

• Constant-cost industry
  • The long-run supply curve is perfectly elastic (horizontal).
  • Entry and exit of firms don't affect input prices. The industry is small enough relative to its input markets that adding or losing firms doesn't bid up the cost of labor, materials, or other resources.
  • After adjustment, the long-run equilibrium price returns to exactly where it started, even though industry output may be larger or smaller.
• Increasing-cost industry
  • The long-run supply curve is upward-sloping.
  • As more firms enter and industry output expands, firms compete for limited resources like skilled labor or raw materials. That competition drives input prices up, which raises each firm's cost curves.
  • After adjustment, the new long-run equilibrium price is higher than before. This is the most common industry type.
• Decreasing-cost industry
  • The long-run supply curve is downward-sloping.
  • As more firms enter, input prices actually fall. This can happen through economies of scale in input markets (suppliers offer bulk discounts to a larger industry) or through positive externalities like shared knowledge and infrastructure improvements.
  • After adjustment, the new long-run equilibrium price is lower than before. This type is less common but does occur, especially in growing tech sectors.

Market Supply Shifts and Long-Run Equilibrium

Changes in input prices, technology, taxes, or subsidies can shift the market supply curve, setting off a new round of long-run adjustment.

Rightward shift (supply increases):

1. The market price falls below the original long-run equilibrium.
2. If the new price drops below some firms' minimum average total cost ($ATC_{min}$), those firms incur losses and begin to exit.
3. Exit reduces supply, gradually raising the price back up.
4. Exit continues until economic profit returns to zero at a new long-run equilibrium with a different quantity (and possibly a different price, depending on the industry type).

Leftward shift (supply decreases):

1. The market price rises above the original long-run equilibrium.
2. The higher price means existing firms earn economic profits, since price now exceeds $ATC_{min}$.
3. Profits attract new entrants, which increases supply and pushes the price back down.
4. Entry continues until economic profit returns to zero at a new long-run equilibrium.

The size of the change in the final equilibrium price and quantity depends on two things:

1. Elasticity of demand — If demand is inelastic, a supply shift produces a larger price change and a smaller quantity change. If demand is elastic, the opposite holds.
2. Industry cost structure — In a constant-cost industry, the long-run price barely changes. In an increasing-cost industry, price adjusts more significantly. In a decreasing-cost industry, price may move in the opposite direction from what you'd initially expect.