Question

1. Long Run Competitive Equilibrium and a firm’s Supply Decisions:

1. Will firms in a competitive industry continue to earn a positive economic profit in the long run?   Explain why or why not using the assumption of free entry and exit in a competitive market.

2. Why may it be optimal for a firm to incur losses in the short run but not in the long run? Under what conditions will a firm choose to shut down?

Answer 1

A. In the long run, firms will earn no economic profit or losses because if the firms earn economic profits in the short run then due to free entry and exit, many firms will enter the market. This will drive the prices below and thus, profits will wipe off. Similarly, in case of losses firms will exit and prices will rise in the long run, hence no economic profit or loss for competitive firms.

B. If the firm earn economis losses in the short-run, it may continue to earn as it may cover the losses in the long run. However, a firm incurring losses in the long-run will not operate as it has no incentives to continue. A firm will shut down in the short run when prices will be below average variable cost and below average total cost in the long-run. This is because to contiune a firm should at least be able to cover its operating cost.