The Long Run for a Competitive Industry

Our analysis of zero-profit conditions showed that firms might stay in business for a time even though they are unprofitable. This situation is possible particularly for firms with high fixed capital costs. With this analysis we can understand why in business downturns many of America’s largest companies, such as General Motors, stayed in business even though they were losing billions of dollars Such losses raise a troubling question: Is i~ possible that capitalism is heading toward “euthanasia of the capitalists, a situation where increased competition produces chronic losses? For this question, we need to analyze the long-run shutdown condition .

We showed that firms shut down when they can no longer cover their variable costs. But in the long run, all costs are variable. A firm that is losing money can payoff its bonds, its managers, and let its leases expire. In the long run, all commitments are once again options. Hence, in the long run firms will produce only when price is at or above the zero profit condition where price equals average cost.

There is, then, a critical zero-profit”point below which long-run price cannot remain if firms are to stay in business. In other words, long-run price must cover out-of-pocket costs such as labor, materials, equipment, taxes, and other expenses, along with  opportunity costs such as competitive return on the owner’s invested capital. That means long-run price’ must be equal·to or above total long-run average cost. . What happens if the long-run price falls below this critical zero-profit level? Firms, not making a profit, will start leaving the industry. Since fewer firms are producing, the short-run market supply curve will shift to the left, and the price surprise (draw the graph for yourself). Eventually, the price will rise enough so that the industry is no longer unprofitable.

But the process works in the other direction, as well. Suppose that the, long-run price is above total long-run average cost; so firms are making positive economic profits. Now suppose entry into the industry is absolutely free in the long run, so any number of identical firms can come into the industry and produce at exactly the same costs as those firms all ready in the industry. In this situation, new firms will, be attracted by prospective profits, the short-run supply curve shifts to, the right, and price falls. Eventually it falls to the zero-profit level, so it is no longer profitable for other firms to enter the industry.

 The conclusion is that in the long run, the price in a competitive industry will tend toward the cal point where identical firms just cover their full competitive costs. Below this critical long-run price, firms would leave the industry until price; returns to long-run average cost. Above this long-run price, new firms would enter the industry, thereby forcing market price back, down to the long-run equilibrium price where all competitive costs are just covered.

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