Long-Run Equilibrium with Free Entry and Exit

Core Idea

In the long run with free entry and exit, firms earning positive profits attract new entrants, increasing market supply and driving down price until profit is zero (P = ATC). Losses cause firms to exit, reducing supply and raising price. Long-run equilibrium occurs where price equals the minimum of each firm's long-run average cost, and firms earn zero economic profit. This condition determines the long-run number of firms in the industry.

How It's Best Learned

Trace the adjustment process: start with positive (or negative) profits, observe entry (or exit), and follow how supply shifts until zero-profit equilibrium is reached. Examine how industry size responds to shifts in demand or technology.

Explainer

From your study of short-run competitive equilibrium, you know that the market price is set by supply and demand, and each price-taking firm produces where P = MC. But what happens over time? If price is high enough that firms are earning positive economic profit, the world outside the industry takes notice. New firms enter, each adding to market supply. The supply curve shifts rightward, driving price down. Entry continues until profit disappears. If price falls below average total cost — firms are losing money — some exit, supply contracts, and price rises until the losses stop. This adjustment process has a powerful and surprising conclusion: free entry and exit drives long-run economic profit to zero.

It is worth understanding precisely what "zero economic profit" means. Economic profit deducts the opportunity cost of all inputs, including the owner's time and invested capital — the best alternative uses of those resources. Zero economic profit means the firm earns exactly as much as its inputs could earn elsewhere. A restaurant earning zero economic profit is still paying wages, covering rent, and returning a normal rate of return to the owner's capital. What it is *not* doing is earning above-normal returns that would attract new competition. Zero economic profit is not a crisis; it is the equilibrium condition. Firms stay in the industry because they are doing at least as well as their alternatives — not because there is a windfall to capture.

Why does long-run equilibrium pin price at the *minimum* of average total cost? At any price above minimum ATC, firms are earning positive economic profit, so entry occurs and price falls. At any price below minimum ATC, firms are losing money, so exit occurs and price rises. Equilibrium requires P = ATC, and the only stable equilibrium point on the ATC curve is the bottom — the minimum efficient scale. Here P = MC = ATC simultaneously. This means competitive markets, in the long run, force all production to the lowest feasible per-unit cost. Resources are allocated efficiently within the industry: there is no cheaper way to produce the good at this scale.

The number of firms in the industry is determined endogenously by the equilibrium condition. Given demand D and each firm's minimum ATC (which sets both price P* and quantity per firm q*), the number of firms N = Q*/q*, where Q* is total industry quantity demanded at price P*. A permanent increase in demand raises short-run price and profits, inducing entry; the industry expands until the zero-profit condition holds again at the same P* with more firms. A technological improvement that lowers minimum ATC reduces the long-run equilibrium price, drives out higher-cost incumbents, and re-equilibrates at a lower price with a new (possibly larger or smaller) number of firms. The long-run supply curve for a constant-cost industry is therefore perfectly elastic (horizontal) at minimum ATC — price always returns to the same level, and the industry scales quantity through firm entry and exit.