Points About Long Run Equilibrium

We have seen that profits will lead to the entry of new firms into a P-competitive industry. This also works in the opposite direction: if firms in the industry were taking losses, supply in the industry will decrease. Firms in the industry might continue to produce in the short run, despite the losses. Remember -- from the last chapter -- that a profit-maximizing firm will continue to produce, in the short run, so long as it can cover its variable costs. However, in the long run, firms will drop out of the industry, if they continue to lose money. Thus, the supply curve of the unprofitable industry will shift to the left. But that in turn means prices will rise, and the long run equilibrium comes where the price is equal to average cost, as shown in Figure 2.

This discussion could apply to any economic activity to which there is "free entry." Economic profits -- profits over and above the opportunity cost of capital -- will attract new entrants. Returns less than the opportunity cost of capital will cause firms to get out of the industry. This will continue until the return to capital in that activity is the same as the opportunity cost of invested capital, that is, until profits are zero.

We might call this principle "the Entry Principle." It says that

In the long run, with free entry, returns to invested capital in an industry are just enough to offset the opportunity cost. When there are economic profits or losses, entry into the industry or exit of firms from it will shift the industry supply until economic profits are zero.