8.3 Entry and Exit Decisions in the Long Run

In perfectly competitive markets, firms can freely enter or exit based on profits or losses. This dynamic process drives economic profits to zero in the long run, as new firms enter profitable markets and struggling firms exit unprofitable ones.

Market adjustments vary across industry types. In constant-cost industries, prices remain stable as firms enter or exit. Increasing-cost industries see rising prices with entry, while decreasing-cost industries experience falling prices due to economies of scale.

Long-Run Market Equilibrium and Firm Entry and Exit

Firm entry and exit effects

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• In perfectly competitive markets, firms can freely enter or exit the industry based on economic profits or losses
• When economic profits exist in the short run, new firms enter the market to capture some of those profits
  • Entry of new firms (e.g., new coffee shops) increases market supply, driving down the market price and reducing economic profits for all firms
  • Entry continues until economic profits are driven to zero and the market reaches long-run equilibrium
• When firms face economic losses in the short run, some exit the market (e.g., unprofitable restaurants closing)
  • Exit of firms decreases market supply, driving up the market price and reducing economic losses for remaining firms
  • Exit continues until economic losses are eliminated and the market reaches long-run equilibrium
• In the long run, perfectly competitive markets have zero economic profits due to the entry and exit of firms (e.g., equilibrium in the fast-food industry)
  • This process is driven by profit maximization, as firms seek to maximize their returns

Market adjustment processes

Constant-cost industries

• Long-run supply curve is perfectly elastic (horizontal)
• Changes in market demand do not affect the long-run market price
• Entry or exit of firms occurs without changing the price of inputs (e.g., t-shirt manufacturing)
• Increase in demand: New firms enter, market supply increases, price remains constant, and quantity increases
• Decrease in demand: Some firms exit, market supply decreases, price remains constant, and quantity decreases

Increasing-cost industries

• Long-run supply curve is upward sloping
• Entry or exit of firms affects the prices of inputs (e.g., housing construction)
• Increase in demand: New firms enter, input prices increase (e.g., lumber prices rise), market supply increases, price rises, and quantity increases
• Decrease in demand: Some firms exit, input prices decrease (e.g., steel prices fall), market supply decreases, price falls, and quantity decreases

Decreasing-cost industries

• Long-run supply curve is downward sloping
• Entry or exit of firms leads to changes in input prices and economies of scale (e.g., semiconductor manufacturing)
• Increase in demand: New firms enter, input prices decrease due to economies of scale (e.g., bulk discounts on raw materials), market supply increases, price falls, and quantity increases
• Decrease in demand: Some firms exit, input prices increase due to diseconomies of scale (e.g., higher per-unit costs), market supply decreases, price rises, and quantity decreases

Long-run supply curve comparisons

• Constant-cost industries: Long-run supply curve is perfectly elastic (horizontal)
  • Entry or exit of firms does not affect input prices or long-run market price (e.g., generic pharmaceutical drugs)
• Increasing-cost industries: Long-run supply curve is upward sloping
  • Entry of firms increases input prices (e.g., skilled labor), leading to higher long-run market prices
  • Exit of firms decreases input prices (e.g., commercial real estate), leading to lower long-run market prices
• Decreasing-cost industries: Long-run supply curve is downward sloping
  • Entry of firms leads to economies of scale and lower input prices (e.g., volume discounts), resulting in lower long-run market prices
  • Exit of firms leads to diseconomies of scale and higher input prices (e.g., higher shipping costs), resulting in higher long-run market prices

Market Structure and Entry Decisions

• Different market structures (e.g., perfect competition, monopolistic competition, oligopoly, monopoly) affect entry and exit decisions
• Barriers to entry influence the ease with which new firms can enter a market
  • Examples include high start-up costs, patents, and government regulations
• The opportunity cost of entering or exiting a market plays a role in firms' decisions
• Market equilibrium is achieved when supply and demand forces balance, influencing entry and exit decisions