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M06.L05 — Long-Run Equilibrium in Perfect Competition: Entry, Exit, and Normal Profit

Module: Module 06 — Market Equilibrium and Perfect Competition Lesson: L05 of 05 Duration: ~30 minutes Level: Introductory Provenance: OpenStax Principles of Microeconomics 3e | MIT OCW 14.01 Principles of Microeconomics

Learning Objective

Explain how entry and exit drive long-run equilibrium in perfect competition.

The Adjustment Process

Perfect competition reaches long-run equilibrium through:

  1. Economic Profit → Entry
  2. New firms enter
  3. Market supply increases

  4. Price falls until profit = 0

  5. Economic Loss → Exit

  6. Firms exit
  7. Market supply decreases
  8. Price rises until loss = 0

Australian example: Solar panel installation market - Early 2010s: High profits → surge of new installers - By 2020: Prices stabilized → normal profits

Long-Run Conditions

At equilibrium: - P = MC = min ATC - Firms earn normal profit (zero economic profit) - Productive efficiency (min ATC) - Allocative efficiency (P = MC)

Key distinction: - Economic profit = 0 - Accounting profit > 0 (includes opportunity costs)

Worked Example

Australian Taxi Industry Post-Uber

  1. Pre-Uber:
  2. Limited licenses → high P

  3. Economic profits

  4. Ride-sharing entry:

  5. Supply increases
  6. Prices fall

  7. Traditional taxis exit

  8. Long-run:

  9. Normal returns for remaining operators
  10. Lower prices for consumers

Common Misconception

"Zero economic profit means firms aren't making money"

Actually, normal profit means firms earn exactly their opportunity cost - enough to keep them in the industry. Owners still get fair compensation for their work and capital.

Key Takeaways

  • Entry/exit eliminate economic profits/losses
  • Long-run equilibrium achieves dual efficiency
  • Normal profit sustains business activity
  • Real-world markets constantly adjust

Extension: Monopolistic Competition — a Realistic Middle Ground

Perfect competition assumes identical products. Most real markets have product differentiation — restaurants, cafes, clothing brands, petrol stations. These are examples of monopolistic competition:

Feature Perfect competition Monopolistic competition
Number of firms Many Many
Products Identical Differentiated
Entry/exit Free Free
Price Taker (P = MR) Maker (downward-sloping demand)
Long-run profit Zero Zero

Short run: Each firm faces a downward-sloping demand curve (like a mini-monopolist) and may earn positive profit.

Long run: Free entry attracts new firms → each firm's demand shrinks and becomes more elastic → entry continues until P = ATC (zero economic profit). Unlike perfect competition, P > MC still holds, so there is some residual inefficiency.

Welfare trade-off — business stealing vs product variety: - Business stealing effect: A new entrant takes customers from existing firms — a negative externality the entrant ignores, suggesting too many firms may enter. - Product variety effect: More firms mean more choice for consumers — a positive externality the entrant ignores, suggesting too few firms may enter. - Net result: ambiguous. Monopolistic competition may have too many or too few firms; the model is honest about this uncertainty.

Australian examples: Independent cafes in Melbourne, petrol stations on a suburban strip, gyms, hairdressers.

Practice

  1. Why don't firms exit when earning normal profit?
  2. In monopolistic competition, what happens to a firm's demand curve as new rivals enter? Why does this eliminate economic profit in the long run?
  3. What happens to industry supply if input prices rise?
  4. Explain the "business stealing vs product variety" trade-off in monopolistic competition. Why is the welfare effect ambiguous?

Further Resources

Provenance: OpenStax Principles of Microeconomics 3e | MIT OCW 14.01 Principles of Microeconomics