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Eliminating Economic Profit: The Role of Entry

25 April, 2016 - 09:12

The process through which entry will eliminate economic profits in the long run is illustrated in Figure 9.12, which is based on the situation presented in Figure 9.6. The price of radishes is $0.40 per pound.Mr. Gortari’s average total cost at an output of 6,700 pounds of radishes per month is $0.26 per pound.Profit per unit is $0.14 ($0.40 − $0.26 ). Mr. Gortari thus earns a profit of $938 per month (= $0.14 × 6, 700 ).

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Figure 9.12 Eliminating Economic Profits in the Long Run

If firms in an industry are making an economic profit, entry will occur in the long run. In Panel (b), a single firm’s profit is shown by the shaded area. Entry continues until firms in the industry are operating at the lowest point on their respective average total cost curves, and economic profits fall to zero.

Profits in the radish industry attract entry in the long run. Panel (a) of Figure 9.12 shows that as firms enter, the supply curve shifts to the right and the price of radishes falls. New firms enter as long as there are economic profits to be made—as long as price exceeds ATC in Panel (b). As price falls, marginal revenue falls to MR2 and the firm reduces the quantity it supplies, moving along the marginal cost (MC) curve to the lowest point on the ATC curve, at $0.22 per pound and an output of 5,000 pounds per month. Although the output of individual firms falls in response to falling prices, there are now more firms, so industry output rises to 13 million pounds per month in Panel (a).