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Minimizing losses to make the best of a bad situation
156 Part III: Market Structures and the Decision-Making Environment
Motivating entry and exit: Where did all your profit go?
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Remember that economic profit is based on all production costs; therefore, zero economic profit represents a normal rate of return for your business. If economic profit is greater than zero, your business is earning something greater than a normal return. This profit attracts other firms to enter the market. Similarly, if initial economic losses (negative economic profit) exist, firms leave the market. In the long run, economic profit ultimately equals zero.
Zero economic profit means that price equals average total cost.
Determining the long-run equilibrium
Profit maximization depends on producing a given quantity of output at the lowest possible cost, and the long-run equilibrium in perfect competition requires zero economic profit. Therefore, firms ultimately produce the output level associated with minimum long-run average total cost. In Chapter 8 I tell you that marginal cost must pass through the minimum point of average total cost. Therefore, in the long-run equilibrium, price equals three costs: minimum long-run average total cost, LRATC; the minimum point on one short-run average-total-cost curve, SRATC; and marginal cost, MC.
Figure 9-5 illustrates the long-run equilibrium in perfect competition. The left diagram in Figure 9-5 illustrates the equilibrium price, PE, being determined by the intersection of demand and supply in the market. The perfectly competitive firm is a price taker, so this price is the firm’s marginal revenue curve, P = MR = d, in the right diagram. This price also corresponds to minimum long-run average total cost to ensure zero economic profit in the long run. Thus, new firms have no incentive to enter the market, and existing firms have no incentive to leave the market. Price or marginal revenue equals marginal cost at q0, ensuring that profit is maximized.
Assume the short-run average-total-cost function associated with minimum long-run average total cost is
