How the market moves from the short run to the long run

Overview

How entry competes supernormal profit away, how exit removes losses, and where the market settles once both have run their course.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Explain the mechanism by which supernormal profit disappears in a perfectly competitive industry.

   Model answer

   Supernormal profit means resources earn more in this industry than elsewhere. Because information is perfect, outside firms observe it, and because there are no barriers, they enter. Their output adds to industry supply, shifting the industry supply curve to the right, which lowers the market price. Each existing firm's horizontal average revenue line falls with the market price, so it slides back down its marginal cost curve to a smaller output and its profit rectangle shrinks. Entry continues while any supernormal profit remains, and stops only when price has fallen to minimum average total cost.

2. 2

   Explain the mechanism by which losses disappear in a perfectly competitive industry.

   Model answer

   Losses mean resources earn less here than elsewhere. Because exit is free in the long run, firms leave the industry once they can escape their fixed costs. Their departure removes their output, shifting the industry supply curve to the left, which raises the market price. Each surviving firm's horizontal average revenue line rises with it, so it moves up its marginal cost curve to a larger output and its loss rectangle shrinks. Exit continues while losses remain, and stops when price has risen to minimum average total cost, at which point the survivors earn normal profit.

3. 3

   An industry of 100 identical firms, each with fixed costs of £60 and total variable costs of 40, 64, 78, 96, 130 and 186 at outputs of one to six units, faces demand Qd = 1000 − 10P and a short-run price of £50. Work out how many firms the industry ends up with in the long run.

   Model answer

   At £50 each firm produces five units and earns (50 − 38) × 5 = £60 of supernormal profit, since average total cost is £38 at five units. That profit attracts entry, which shifts industry supply to the right and pushes the price down. Entry stops only when the price reaches minimum average total cost of £38. At £38 each firm still produces five units, and demand is 1000 − 380 = 620 units. The number of firms is 620 ÷ 5 = 124, so 24 firms enter. Industry output rises from 500 to 620 units and the price falls from £50 back to £38.

4. 4

   An industry of 120 identical firms is in long-run equilibrium at £38, each producing 5 units, with demand Qd = 980 − 10P. Each firm has fixed costs of £60 and total variable costs of 40, 64, 78, 96, 130 and 186 at outputs of one to six units. Demand now falls by 200 units at every price. Trace the short-run and long-run outcome.

   Model answer

   Demand becomes Qd = 780 − 10P. In the short run the 120 firms remain. At a price of £30 each firm's best output is four units, since the fourth unit costs £18 and the fifth costs £34, giving industry supply of 480 units, and demand at £30 is 780 − 300 = 480, so £30 is the new short-run price. Average total cost at four units is £39, so each firm loses (39 − 30) × 4 = £36, and the industry loses £4,320. In the long run firms exit, supply shifts left and the price recovers to minimum average total cost of £38. Demand at £38 is 780 − 380 = 400 units, and at five units per firm that supports 400 ÷ 5 = 80 firms, so 40 firms leave.

5. 5

   Describe the pair of diagrams showing the movement of a perfectly competitive market from short-run supernormal profit to long-run equilibrium.

   Model answer

   In the industry panel, with industry quantity on the horizontal axis and price in pounds on the vertical, draw demand and an initial short-run supply curve crossing at the high price. Then draw a second supply curve to the right of the first, representing the entrants' output, crossing demand at the lower long-run price: industry quantity rises and price falls. In the firm panel, with the firm's output on the horizontal axis and price, cost and revenue in pounds on the vertical, the horizontal average revenue and marginal revenue line falls from the high price to the lower one, and the firm slides down its marginal cost curve to a smaller output. Initially the price line was above average total cost, enclosing a profit rectangle; finally it is tangent to the minimum point of average total cost, so the rectangle has vanished and only normal profit remains.

6. 6

   Why does entry lower the price faced by an existing firm even though that firm has done nothing differently?

   Model answer

   The firm's price is not its own decision: it is imported from the industry diagram. Entrants add their output to the industry, shifting industry supply to the right, and at the old price there is now more being offered than buyers will take. The price must fall to clear the market. Because the existing firm is a price taker with an identical product, it has no choice but to accept the new lower price, so its horizontal average revenue line drops even though its own costs and its own product are unchanged.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.