Perfect Competition: Long-Run Equilibrium

1. The Foundation: Economic Profit vs. Accounting Profit

To understand long-run equilibrium, we must first be crystal clear about what economists mean by "profit." A common point of confusion is why a firm would continue to operate if it earns "zero economic profit." The distinction between economic and accounting profit resolves this.

• Accounting Profit = Total Revenue - Explicit Costs (e.g., wages, rent, materials). This is the profit you see on a company's financial statements.
• Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs). Implicit costs represent the opportunity costs of using the firm's own resources (e.g., the income the owner could have earned in their next-best alternative job).

Therefore, zero economic profit means a firm is earning enough revenue to cover all its explicit costs plus all its implicit costs. This is also called a normal profit. The firm is doing just as well as it could in its next-best alternative, so there is no incentive to leave the industry.

To solidify this critical distinction, please read the following brief sections.

With this foundation, let's examine the mechanics of how the market achieves this long-run equilibrium.

2. From Short-Run Profit to Long-Run Equilibrium

In the previous lesson, we saw how a firm can earn a short-run economic profit if the market price is above its Average Total Cost (ATC). This situation, however, acts as a powerful signal to the market.

Because there are no barriers to entry in a perfectly competitive market, these profits attract new entrepreneurs. Here is the chain of events:

1. Profits Attract Entry: New firms enter the market to capture some of the available economic profit.
2. Market Supply Increases: As more firms begin producing, the overall market supply increases, shifting the market supply curve to the right.
3. Price Falls: This increase in supply causes the market equilibrium price to fall. For each individual firm, this means their horizontal demand curve (and thus MR curve) shifts downward.
4. Profits Are Eliminated: This process continues until the price has fallen to the point where it is exactly equal to the minimum of the Average Total Cost curve. At this point, economic profits are zero, and there is no longer an incentive for new firms to enter.

The following video provides an excellent, step-by-step graphical walkthrough of this adjustment process.

3. From Short-Run Loss to Long-Run Equilibrium

The adjustment mechanism works symmetrically when firms are initially incurring losses (i.e., when the market price is below ATC).

1. Losses Cause Exit: Firms that cannot cover their total costs in the long run will exit the market to seek better returns elsewhere. The ability to do so is guaranteed by the no barriers to exit characteristic.
2. Market Supply Decreases: As firms leave, the total market supply decreases, shifting the market supply curve to the left.
3. Price Rises: This decrease in supply causes the market equilibrium price to rise. For the remaining firms, the horizontal demand (MR) curve shifts upward.
4. Losses Are Eliminated: This continues until the market price has risen back to the minimum of the ATC curve. At this point, the remaining firms are breaking even (earning zero economic profit), and the incentive to exit disappears.

Let's return to the same video to see this process illustrated.

4. Characteristics of Long-Run Equilibrium

Through the dual processes of entry and exit, the market eventually settles into a stable long-run equilibrium. This state has several defining characteristics that are critical for the CFA exam.

In long-run equilibrium, the typical firm produces a quantity (q) where the following condition holds:

$P=\text{Marginal Cost (MC)}=\text{minimum Average Total Cost (ATC)}$

This single condition implies two types of market efficiency:

1. Productive Efficiency (P = min ATC): Firms produce at the lowest possible cost per unit. Competition forces them to be as efficient as possible to survive. Any firm with higher costs would incur losses and eventually exit.
2. Allocative Efficiency (P = MC): The resources of society are allocated to produce the "right" mix of goods. The price (P) represents the value consumers place on the last unit of the good, and the Marginal Cost (MC) represents the cost to society of the resources used to produce that last unit. When P = MC, the value to consumers equals the cost to society, meaning resources are allocated efficiently.

The following resources will help you consolidate your understanding of these equilibrium conditions and their efficiency implications.

5. Long-Run Industry Supply

So far, we've assumed that as firms enter or exit, the costs for individual firms don't change. This results in a horizontal long-run industry supply curve and is known as a constant-cost industry.

However, in some cases, industry expansion can affect production costs:

• Increasing-Cost Industry: As the industry expands, it bids up the prices of key inputs (e.g., more home construction increases demand for and wages of carpenters). This raises the ATC for all firms. The long-run industry supply curve is upward-sloping.
• Decreasing-Cost Industry: As the industry expands, it allows for economies of scale in input-supplying industries (e.g., growth in the PC industry led to cheaper microchips). This lowers the ATC for all firms. The long-run industry supply curve is downward-sloping.

While constant-cost is the most common case presented, being aware of these variations adds depth to your understanding, which is valuable for the CFA exam. The video by Jacob Clifford from earlier (resource LINK, starting at 04:55) provides a good visual introduction to this idea.

Conclusion

This lesson explained the dynamic process that leads a perfectly competitive market to its long-run equilibrium. Short-run profits or losses are inherently unstable; they create incentives that, through free entry and exit, push the market toward a stable outcome.

Key Takeaways:

• In the long run, economic profit in a perfectly competitive market is driven to zero due to the entry and exit of firms.
• Zero economic profit is not a bad outcome; it means firms are earning a normal profit, covering all their explicit and implicit (opportunity) costs.
• The long-run equilibrium occurs where firms produce at the quantity that satisfies the condition P = MC = minimum ATC.
• This equilibrium is both productively efficient (goods are produced at the lowest possible cost) and allocatively efficient (the right amount of the good is produced from society's perspective).

Preview of the Next Lesson:

We have now completed our analysis of the idealized market structure of perfect competition. In the next module, we will relax one of its key assumptions—the idea of a homogeneous product. We will begin our study of monopolistic competition, exploring its characteristics and how product differentiation gives firms a degree of market power, leading to different short-run and long-run outcomes.