Chapter 8: Problem 36

Why will losses for firms in a perfectly competitive industry tend to vanish in the long run?

Short Answer

Expert verified

In the long run, losses for firms in a perfectly competitive industry tend to vanish due to market adjustments, entry, and exit of firms. As loss-making firms exit the market, industry supply decreases, increasing market price and allowing firms to cover their average total costs, making normal profits. This attracts new firms to enter, which intensifies competition and lowers market price back towards the minimum average total cost. Eventually, the market reaches equilibrium where firms make normal profits, eliminating losses and achieving efficiency and allocative optimization.

Step by step solution

1. Understanding a Perfectly Competitive Market

A perfectly competitive market is characterized by a large number of small firms producing identical products with no barriers to entry or exit. Each firm is a price taker, meaning they have no control over the market price and must accept the prevailing market price for their products. Firms in such an industry aim to maximize profits, and they adjust their production based on the market price.

2. Concept of Long Run

In the context of economics, the long run refers to a period of time where all factors of production are variable, meaning that the firm can change its production levels to meet changing market conditions. This allows firms to make adjustments to minimize losses and achieve an equilibrium state.

3. Market Adjustments due to Losses

In a perfectly competitive market, if firms are making losses in the short run, this signals that the market price is lower than the firm's average total cost. Given that there are no barriers to entry or exit, loss-making firms will exit the market in the long run, reducing the industry supply. As the industry supply decreases, the market price will increase to a level where firms can cover their average total costs and make normal profits.

4. Achieving Long Run Equilibrium

As the market price increases and firms make normal profits, this will attract new firms to enter the market. Competition will intensify, causing the market price to fall back towards the minimum average total cost. In the long run, a perfectly competitive market reaches equilibrium where firms are making normal profits (zero economic profits), meaning they are covering their opportunity costs but not earning any surplus profits.

5. Vanishing Losses

In a perfectly competitive industry, losses tend to vanish in the long run due to market adjustments made by firms. The process of entry and exit ensures that the market reaches an equilibrium where firms make normal profits, and losses are eliminated. This mechanism allows the industry to achieve efficiency and allocative optimization in the long run.