Question

“In a market with free entry and exit, profit is driven to zero in the long run”. Qualify the validity of this statement and discuss why a firm that makes a zero economic profit would stay in that market. Please explain

Answer 1

entry and the exit in the market is depends on the incentives in the market enjoying by the existing firm and the entrepreneurs. when the existing firms are earning a profit then new firm will enter into the market while if existing firm are earning the loss then firm will exit the market. the entry will expand the number of firms,and so, it will increase the quantity supplied and also drive down the price and the profit. inversely when firm will exit the market the remaining firms supply will increase and overall supply will decrease and drive up the price and profit. at the end , this process of entry and exit, firm that remains in the market will earn zero economic profit.

why the firm that makes zero economic profit would stay in the market?

because firm is earning accounting profit.

profit equals to TR minus TC. and TC includes the opportunity cost as well as explicit cost. remember that economist counts both of cost while accountant only counts the explicit cost. so in short firm earns zero economic profit but earns positive accounting profit.

for example:

if A has job of 10000$, and he has money worth 100000$. now he wants to open a mall with that money. he can deposit that money into the bank and can earn 10% interest but he opens the mall. he pays salary of $1000 to the his employee.

now here the explicit cost is 1000 and implicit cost will be 10000 of job and 10000 as interest that is toal 20000.

now suppose that mall can gives 21000 revenue then economic profit will be

21000-(1000+20000)= 0.

but accounting profit will be=21000-1000=20000.