Questions: Long-Run Equilibrium with Free Entry and Exit

Question 1

A firm in a perfectly competitive industry earns zero economic profit in long-run equilibrium. Which statement is most accurate?

• A. The firm covers explicit costs only — it does not earn a return on the owner's capital or time
• B. The firm earns a normal return on all inputs and has no incentive to exit the industry
• C. The firm is on the verge of bankruptcy and will exit if conditions do not improve
• D. The firm's accounting profit is also zero, since economic and accounting profit measure the same thing

Answer: (B)

Zero economic profit means the firm earns exactly what its inputs could earn in their best alternative use — including a normal return on capital and full compensation for the owner's time. It is the break-even condition for resource allocation, not a crisis. A restaurant at zero economic profit is paying rent, wages, suppliers, and a market-rate return to the owner's investment. It has no incentive to exit. Options A, C, and D all confuse economic profit with accounting profit; accounting profit at zero economic profit is typically positive.

Question 2

In a constant-cost industry, what happens to the long-run equilibrium price after a permanent increase in market demand?

• A. Price rises permanently to reflect the higher demand
• B. Price rises in the short run but returns to its original level as new firms enter and supply expands
• C. Price falls because new entrants create economies of scale that lower minimum ATC
• D. Price is unaffected immediately because demand does not determine price in the long run

Answer: (B)

The demand increase raises short-run price and profits, attracting new entrants who shift supply rightward, driving price back down. Entry continues until the zero-profit condition is restored. In a constant-cost industry, the zero-profit condition pins the long-run equilibrium price at minimum ATC — the same level as before. More output is now produced by more firms each at minimum ATC, not at a higher price. This is why the long-run supply curve for a constant-cost industry is horizontal.

Question 3

If firms in a competitive industry are earning zero economic profit, the industry will shrink as firms seek better opportunities elsewhere.

• T. True
• F. False

Answer: False

Zero economic profit means firms are earning exactly their opportunity cost — what they could earn elsewhere. There is no incentive to exit. Firms exit only when they earn *negative* economic profit (below opportunity cost). This is the key distinction between economic and accounting profit: a firm reporting positive accounting profit can still be earning zero or negative economic profit if its capital and owner's time are worth more in alternative uses. At zero economic profit, the industry is in stable equilibrium.

Question 4

In long-run competitive equilibrium, P = MC = minimum ATC, meaning resources are allocated at the lowest feasible per-unit cost.

• T. True
• F. False

Answer: True

This triple equality is the defining feature of long-run competitive equilibrium. P = MC comes from profit-maximizing behavior. P = ATC comes from the zero-profit condition imposed by free entry and exit. Both hold simultaneously only at the minimum of the ATC curve, where MC intersects ATC from below. This means competitive markets in the long run force production at minimum efficient scale — no cheaper way to produce the good exists at this scale.

Question 5

Why does free entry and exit in a competitive market drive long-run economic profit to zero, and what does 'zero economic profit' mean for the firms earning it?

Model answer: Free entry means positive economic profit attracts new competitors who increase supply and drive down price until profit disappears. Free exit means negative economic profit causes firms to leave, reducing supply and raising price until losses stop. The equilibrium is zero economic profit. For firms at this point, 'zero economic profit' means they earn exactly a normal return on all resources including capital and owner's time — they have no incentive to exit because alternatives offer no better return.

The mechanism is self-correcting: profit signals that resources should flow in; losses signal they should flow out. Zero economic profit is the equilibrium point where resources are neither attracted nor repelled. It is emphatically not a failure state — it is the market's statement that this industry allocates resources about as efficiently as any alternative use would, and that no windfall is available to attract further entry.