While a firm can lose money in the short run, no firm
can keep doing it forever. So what does the
competitive equilibrium look like in the long run?
Take a look at this figure.
It illustrates that in the long run, a perfectly
competitive industry will be in equilibrium where
price equals average total cost. At this point, firms
will earn what economists call alternatively either
normal profits or 0 economic profits.
In order to understand this condition, let's first
talk about what we mean when we say 0, or normal,
economic profits. To do so, let's go back to our
distinction in the last lecture between accounting
profits and economic profits. Recall that accounting
profits are calculated simply by subtracting total
revenues and total costs. Recall further that what is
left over after taxes is available to be distributed
as dividends or kept by the firm as retained earnings.
Now suppose you go into business for yourself, and in
order to do so you have to forego a 40,000 dollar a
year after-tax salary. That's the opportunity cost of
your own resources of going into business. Now if you
wind up at the end of the year with accounting profits
of 40,000 dollars, you have earned 0 economic profits
because your accounting profits just cover your
opportunity costs. It likewise follows that if you
wind up with less than 40,000 dollars, your economic
profits are negative, and more than 40,000 dollars,
your economic profits are positive.
Now let's generalize this 0 economic profits concept
to businesses and investors. Let's suppose that you
have 100,000 dollars that you just inherited from a
rich aunt in Paducah who always thought you were a
lovely child because you ate your broccoli. What do
you do with the dough? Of course, you could blow it
all on a Mercedes and a trip around the world. But
suppose instead you decided to invest it. What kind of
rate of return on your funds can you expect? Well, the
conventional wisdom in economics is that if you invest
your money in the stock market, over time the
inflation adjusted real rate of return on your
investment will be roughly 3 percentage points above
the return you could have earned investing in risk-
free government bonds. So, after adjusting for risk,
any investment yielding you that return would be
considered a normal profit, or 0 economic profits. And
note here that your profit from an accounting
standpoint isn't 0 at all. You've simply been fairly
compensated for your equity capital, no more and no
less. By the way, we'll talk more about some of these
investment considerations in our lecture on capital.
With that said, let's go back to our long-run
equilibrium condition to illustrate market performance
under perfect competition. My claim is that in the
long run, a perfectly competitive industry will
produce where price equals average total cost at its
minimum and earn 0 economic profits. The question, of
course, is how does the industry remarkably wind up at
this particular point? The answer lies in one of our
original assumptions, free entry and exit into the
market. Let's work this out together, and let's start
with the total market for widgets and the individual
firm in short-run equilibrium in this market.
Note that the equilibrium market price is 50 dollars,
equilibrium quantity in the industry is a 100,000
units, and economic profits are 0.
Now, what do you think will happen to both of these
figures after a report comes out in the American
medical journal showing that widgets can reduce the
incidence of Alzheimer’s disease among senior
citizens? Well, for starters, the demand curve will
shift outward, reflecting an increase in demand.
This will, in turn, increase the firm's price and
marginal revenue and lead to an increase of profits
above the 0 level.
But that's not all. What happens next? Because of the
lure of high profits, additional firms will enter the
industry. What will this do to the industry supply
curve, price, and profits?
The correct answer is b, did you get it right? Entry
by new firms shifts the supply curve out and returns
the industry to long-run equilibrium.
This drives the price back down to 50 dollars, and
economic profits back to 0. So far so good, but why
does the process always stop at 0 economic profits?
Well, think of the process in reverse. Suppose that,
instead of extolling the virtues of widgets as a cure
for Alzheimer’s, the American medical journal had
warned that widgets significantly increased the risk
of breast cancer. What would have happened to demand
and supply, and price and profits? Take a minute to
draw the adjustment process. Demand shifts in, price
goes down, and so do profits.
In the short run, firms can incur losses, but over the
long run they exit the industry. This shifts the
supply curve in, driving up price, and driving
economic profits back to 0.
Thus, in the long run, perfectly competitive firms
earn a normal profit, no more and no less. The
importance of this conclusion about long-run
equilibrium lies in its implications for the
efficiency of the perfectly competitive market. We can
think of efficiency in at least two dimensions of
market performance, allocative efficiency and
productive efficiency.
