Chapter 13: Long Run Entry & Exit Dynamics
Long Run Dynamics of Entry and Exit:
Economic theory predicts that in the long run equilibrium economic profits are zero, regardless of market structure. To make sense of this I’ll develop the following sections:
Economic profit versus accounting profit
Long run dynamics for a firm with market power
Long run dynamics for a firm without market power
Section 1: Economic profit vs accounting profit:
The key distinction between economic profits and accounting profits is that economic profits includes opportunity costs. Accounting costs measure only direct cash outlays, but economic costs also take opportunity costs into consideration.
For example, if you are able to start your own law firm and anticipate earning $70,000 the first year after paying for all your start-up costs like rent, branding, office supplies, computer, etc, this would represent your accounting profits. Economic profits need to consider your opportunity cost. Perhaps you gave up a job offer of $90,000 at an established law firm. This means your opportunity cost of starting your own law firm needs to consider the $90,000 opportunity cost. So while your accounting profits for the first year are $70,000 your true economic profits are -$20,000. Does it make sense to launch your own firms? Maybe yes, maybe no, as the answer really depends on the circumstances such as whether or not you’ll be able to grow the firm. But certainly you’ll be taking a loss during the first year, relative to your next best alternative.
Generally speaking economic costs are at least as big as accounting costs. If there’s zero opportunity costs, of course they’re the same. This means that economic profits are no larger than accounting profits. If there’s opportunity costs, economic profits are smaller. As a result, when we way there’s zero economic profit we actually mean there’s no profit above and beyond the next highest alternative use of resources. Moreover, we also mean the company is doing exactly as good as they would be doing anything else. This is why it makes sense that a firm would stay in business while making zero economic profits (they cannot do better either way).
Section 2: Long run dynamics with market power
A firm with market power faces a downward sloping demand curve. In the language we’ve developed we’ll say that firm’s demand curve is downward sloping. This means they can raise or lower their prices to respond to consumer demand and they can search out the profit maximizing price. By contrast a firm in a competitive market must simply take the price as given.
Firms have more market power when they have fewer rivals offering close substitutes. They have less market power when there are more rivals offering close substitutes. We account for changes in the competitive balance or number of rivals with the concept of entry and exit.
When new rivals enter the market they capture customers away from the existing incumbent firms. As a result the existing firms will see a decrease in demand and will notice their demand curve becoming more elastic. Graphically we model this with a leftward shift and flattening demand curve. Here’s that picture:
When current rivals exist the market they release customers that the remaining firms are able to capture and serve. As a result the remaining firms will see an increase in their demand and notice their demand curve becoming more inelastic. Graphically we model this with a rightward shift and steepening demand curve. Here’s that picture:
In the long run the firm will produce the quantity corresponding to where the market price equals its average total cost. As a result we have a set of circumstances where economic profits are zero, (Profits: (P-ATC) x Q = 0 because P=ATC). The logic is that if there were positive economic profits, this would attract entrants. As those new firms enter, the existing incumbent firms see their demand decreasing until economic profits go to zero. If there were negative economic profits, this would convince current firms to leave the market. With this sort of exit, demand would increase for incumbents until profits return to zero.
Section 3: Long run dynamics without market power
In a perfectly competitive market firms have no market power. They simply take the price as given and make their output decision in order to bring their marginal cost equal to the market price. If there’s positive economic profits this induces firms to enter. If there’s negative economic profits (losses) this convinces existing firms to exit. In the perfect competition world we model this with supply shifts. Remember, one of our determinants of supply was a change in the number of sellers.
If firms exit the market there’s a reduction in the number of producers and so we model this with a leftward shift of supply. This process ends once economic profits go to zero. Since there’s no longer anyone making economic losses, there’s no longer an incentive to leave the market.
If firms enter the market there’s an increase in the number of producers and so we model this with a rightward shift of supply. This process ends once economic profits go to zero. Since there’s no longer anyone making economic profits, there’s no longer an incentive to enter the market.
In the graph below we have the entire market depicted in the left panel and the situation faced by a single firm in the right panel. Since we’re assuming the market is perfectly competitive that individual firm takes the price as given. Whatever is the price, as determined by the mutual interaction of the rest of the market, also becomes that firm’s marginal revenue curve as well as its demand curve. That’s because each additional unit it sells will fetch exactly the market price, so that’s the additional contribution to total revenue, the marginal revenue. Also, for each quantity we can associate that given price, and that entire collection is a demand curve!
Supply curve 1, S1, crosses demand a price P1, and carries over to the right panel where it becomes MR1 and Demand1. The way this market is drawn, P1 crosses the single firm’s marginal cost curve at the minimum of ATC, which tells us the firm is making zero economic profits. To be clear, by definition of the relationship of marginal to average, the marginal cost curve will always cross average total cost (and average variable cost) from below at the respective minimum (as drawn).
If firms exited the market, we’d get a decrease market supply and move from S1 to S2. This would lead to an increase in the market price from P1 to P2, and the individual firm in the right panel would then be able to increase output because that new demand curve, D2, would cross its marginal cost curve at a higher point. This new point would be vertically higher than the corresponding point on the ATC curve indicating the firm would earn positive economic profits!
If firms entered the market, we’d get an increase in market supply and move from S1 to S3. This would lead to a decrease in market price from P1 to P3 and the individual firm in the right panel would have to reduce output as the new demand curve, D3, crosses a lower point on its MC curve. This point is vertically below the corresponding point on the ATC curve which tells us that the firm would be making an economic loss!
