In perfectly competitive markets, firms can freely enter or exit based on profits. This dynamic process drives economic profits to zero in the long run, as new entrants increase supply and lower prices, while exits decrease supply and raise prices.

The long-run adjustment process varies depending on industry type. In constant-cost industries, prices remain stable as output changes. Increasing-cost industries see rising prices with expansion, while decreasing-cost industries experience falling prices as output grows.

Long-Run Market Dynamics

Entry and Exit Drive Profits to Zero

• Long run perfectly competitive market has no barriers to entry or exit
  • Firms freely enter market when observing economic profits
  • Firms freely exit market when incurring economic losses
• Economic profits in short run attract new entrants
  • New entrants increase market supply, drive down market price, reduce profits
• Economic losses in short run cause some firms to exit market
  • Firms exiting decrease market supply, drive up market price, reduce losses
• Entry and exit process continues until economic profits driven to zero
  • At this point, firms earn normal profit covering all explicit and implicit costs (wages, rent, opportunity costs)
  • No incentive for new firms to enter or existing firms to exit market

Long-Run Adjustment Process

• Constant-cost industry
  • Long-run supply curve perfectly elastic (horizontal)
  • Entry and exit of firms do not affect input prices or production costs (labor, materials)
  • In long run, price remains constant as industry output expands or contracts
• Increasing-cost industry
  • Long-run supply curve upward-sloping
  • As industry output expands, input prices increase, raising production costs
    • More firms entering market compete for limited resources (skilled labor, raw materials), driving up input prices
  • In long run, price increases as industry output expands
• Decreasing-cost industry
  • Long-run supply curve downward-sloping
  • As industry output expands, input prices decrease, lowering production costs
    • More firms entering market benefit from economies of scale (bulk purchasing) or positive externalities (knowledge spillovers)
  • In long run, price decreases as industry output expands

Market Supply Shifts Impact Equilibrium

• Shifts in market supply caused by changes in input prices, technology, taxes, or subsidies
• Rightward shift in market supply (increase)
  • Leads to lower long-run equilibrium price and higher equilibrium quantity
  • Encourages entry of new firms, as market price initially exceeds minimum of average total cost curve
  • Entry continues until economic profits driven to zero and new long-run equilibrium reached
• Leftward shift in market supply (decrease)
  • Leads to higher long-run equilibrium price and lower equilibrium quantity
  • Encourages exit of firms, as market price initially falls below minimum of average total cost curve
  • Exit continues until economic profits driven to zero and new long-run equilibrium reached
• Magnitude of change in long-run equilibrium price and quantity depends on:
  1. Elasticity of demand (elastic vs inelastic)
  2. Type of industry (constant-cost, increasing-cost, decreasing-cost)