Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.

PART 5  Firm Behavior and the Organization of Industry

Chapter 14 of 36

Firms In Competitive Markets

Section 20 of 24

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Figure 7 here

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Per Figure 7 panel (a)

In the long run firms enter or exit the market until economic profit is driven to zero.

If price (P) > average total costs (ATC) there are profits, this encourages new firms to enter the market.

If P < ATC there are losses, this encourages some existing firms to exit the market.

…

The process of firms entry into and exit from the market ends when P settles at ATC.

Each competitive firm maximizes profits (or minimizes losses) by choosing a quantity at which P = marginal cost (MC)

Market free entry and exit eventually forces P =  ATC.

Therefore at market equilibrium, P = MC = ATC  and there is no further market entry and exit. 

MC = ATC only when the firm is operating at minimum ATC.

…

Panel (a) shows a firm’s long-run equilibrium lowest cost efficient scale.

P = MC, so the firm is profit-maximizing.

P = ATC, so economic profits are zero.

New firms have no incentive to enter the market and existing firms have no incentive to leave the market.

In a competitive market, with free entry and exit

· there is only one P consistent with zero profit/loss

· it is where P is at the minimum of ATC

…

Panel (b) shows the long-run competitive market supply curve must be horizontal at the given price.

Any price above minimum ATC

· would generate economic profits

· leading to entry of new firms

This would result in an increase in the total quantity supplied and profit driven back down to zero.

…

Any price below minimum ATC

· would generate economic losses

· leading to exit of existing firms

This would result in a decrease in the total quantity supplied and losses driven back up to zero.

Eventually, the number of firms in a competitive market

· adjusts so P equals the minimum of ATC

· resulting in enough firms and supply to satisfy all the demand at this price

… …

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