Source: Sample Midterm 1, Q4
Difficulty: Intermediate to Advanced | Prerequisites: Perfect competition, profit maximisation (MR = MC), average total cost, short-run vs long-run distinction.
This is where the course brings together the short-run behaviour of individual firms with the long-run dynamics of an entire competitive industry. The central mechanism is entry and exit: positive economic profits attract new firms, which shifts the market supply curve and drives profits back to zero. This was flagged as a hard exam question with high variance in scores, so spending extra time here pays off.
When firms in a competitive industry earn positive economic profits, new firms enter. Entry shifts the market supply curve rightward, driving the price down until economic profit is zero. In the long-run equilibrium, price equals the minimum of average total cost for the typical firm, the market quantity is higher, and each firm produces less than it did in the short run.
Economic profit
Total revenue minus total cost, where total cost includes the opportunity cost of all resources (including the owner's time and capital). In simple terms, it is the profit above and beyond what the owner could earn in their next-best alternative. Positive economic profit means the firm is doing better than its outside option.
Zero economic profit (normal profit)
The condition where the firm earns just enough to cover all costs, including opportunity costs. The firm has no reason to exit, and no outside firm has a reason to enter. This does not mean the firm is earning nothing; it is earning a normal return on its resources.
Entry (and exit)
New firms entering (or existing firms leaving) an industry. In a competitive industry with free entry, positive economic profits attract entry and negative profits prompt exit.
Long-run equilibrium
The state where no firm has an incentive to enter or exit, which requires zero economic profit. At this point, P = MC = MR = minimum ATC for the typical firm.
Average total cost (ATC)
Total cost divided by quantity. At the profit-maximising output, if ATC < P the firm earns positive economic profit; if ATC = P, profit is zero.
The typical firm is producing at q₁ (where MR = MC) and earning positive economic profit because P₁ > ATC at q₁.
The problem does not specify how the industry got here. It could have been a demand increase or a cost decrease. All that matters is that profits are positive.
Positive economic profits signal to potential entrants that this industry is more profitable than alternatives. New firms enter.
Entry increases the number of firms, so at any given price, more is supplied. The market supply curve shifts right (S₁ to S₂).
Important: entry shifts the market supply curve, not the individual firm's MC or ATC curves. Nothing changes about the typical firm's cost structure.
As supply shifts right, the market price falls.
Entry continues until economic profit is driven to zero. This happens at P₂, where P = MC = MR = minimum ATC for the typical firm.
At P₂, the typical firm produces q₂, which is less than q₁ (it has moved down its MC curve to a lower output level).
In the market diagram, the equilibrium quantity is higher (Q₂ > Q₁) because there are more firms, even though each firm produces less.
Market price: lower (P₂ < P₁)
Market quantity: higher (Q₂ > Q₁)
Typical firm output: lower (q₂ < q₁)
Typical firm profit: zero
Long-run equilibrium condition for a competitive firm:
P = MC = MR = \min(ATC)Two-part diagram: the left panel is the market (S and D with P and Q), the right panel is the typical firm (mc, atc, and horizontal mr/price lines).
Market panel: S₁ shifts to S₂ (rightward). Price falls from P₁ to P₂. Quantity rises from Q₁ to Q₂.
Firm panel: the firm's mc and atc curves do not move. The horizontal price/mr line drops from P₁ (= mr₁) to P₂ (= mr₂). At P₂, the mr₂ line is tangent to the bottom of the atc curve, confirming zero economic profit. The firm's output falls from q₁ to q₂.
When ride-sharing first became profitable, many new drivers entered the market. Over time, the flood of drivers pushed fares down, and individual drivers earned less. The market quantity of rides grew, but each driver's earnings moved toward a break-even point. This is the competitive entry dynamic in action.
Students sometimes shift the firm's ATC or MC curves in the long run. There is no reason for individual firm costs to change. Only the market supply curve shifts because there are more firms.
Some students think "zero economic profit" means the firm is failing. It means the firm is earning a normal return, covering all costs including opportunity costs. It is doing exactly as well as its next-best alternative.
Confusing the market supply shift with a change in individual firm technology. The market supply shifts because more firms are present, not because each firm becomes more efficient.
Feeling the need to explain what caused the initial positive profits. The question starts with positive profits as given. You do not need to invent a backstory, though it is not a major error if you do.
⚠️ This was flagged as a hard question with expected high variance in scores. Practise the two-part diagram until it is automatic.
⚠️ The key thing examiners look for: that you understand entry will occur and profits must reach zero in the long run.
⚠️ If you start by hypothesising how the industry reached positive profits (e.g. a demand increase from long-run equilibrium), that costs only a point or two, especially if you explain it is an assumption.
⚠️ Do not say the firm's ATC or MC shift. That is a clear conceptual error.
True or false: In the long run, firms in a competitive industry earn positive economic profit. (False, entry drives profit to zero.)
Fill in the blank: Entry shifts the market ______ curve to the right. (supply)
True or false: In long-run equilibrium, P = minimum ATC for the typical firm. (True.)
Fill in the blank: Each firm produces ______ in the long run than in the initial short-run situation. (less)
True or false: The typical firm's MC curve shifts when new firms enter the industry. (False, it stays put.)
Q: Starting from a situation where firms in a competitive industry are earning positive economic profits, explain and illustrate what happens in the long run to the market price, the market quantity, and the output of a typical firm.
A: Positive economic profits attract new firms into the industry. As firms enter, the market supply curve shifts rightward (S₁ to S₂), increasing market quantity (Q₁ to Q₂) and pushing price down (P₁ to P₂). Entry continues until economic profit is zero, which occurs when P = minimum ATC for the typical firm. At that lower price, the typical firm produces less (q₂ < q₁) because it has moved down its MC curve. In the long run: price is lower, market quantity is higher, firm-level output is lower, and economic profit is zero.
Q: Why doesn't the individual firm's cost curve shift when new firms enter the industry?
A: Entry changes the number of firms, not the technology or costs of any individual firm. The firm's MC and ATC curves depend on its own production function and input prices, which are unchanged by entry. What shifts is the market supply curve, because it aggregates the output of all firms, and with more firms, more is supplied at each price.
This connects to the monopoly topic by contrast: in monopoly there is no entry, so positive economic profits can persist in the long run. It also links to the distinction between short-run and long-run supply curves, and to the concept of constant-cost, increasing-cost, and decreasing-cost industries.
Competitive industry, perfect competition, economic profit, zero profit, normal profit, entry and exit, long-run equilibrium, short run vs long run, market supply curve, typical firm, ATC, average total cost, MC, marginal cost, two-part diagram, free entry, price taker, ECON 2, intro microeconomics, NYU Economics 2