Question

Why will losses for firms in a perfectly competitive industry tend to vanish in the long run?

Short answer

Losses for firms in a perfectly competitive industry tend to vanish in the long run because of market adjustments. When firms face losses, they exit the market, leading to a decrease in supply and an increase in market price. This allows the remaining firms to increase their revenues, reaching a long-run equilibrium where they cover their average total costs and neither make losses nor attract new firms to enter the market.

Step-by-step solution

Perfect Competition Characteristics

A perfectly competitive industry has the following key characteristics: 1. Many small firms with identical products 2. Free entry and exit of firms in the market 3. Perfect information about prices and products 4. No barriers to entry 5. Firms are price takers

Short-Run Losses

In the short run, firms in perfectly competitive industries may experience losses due to changing market conditions, such as increased costs or demand shocks, that cause prices to fall below average total costs. During this time, firms may have to operate in the loss zone.

Long-Run Adjustments

In the long run, however, firms in a perfectly competitive industry respond to losses through market adjustments: 1. Firms exiting the market: Firms experiencing losses will eventually leave the market to avoid further losses. This exit reduces the supply of the product in the market. 2. Decrease in supply: With the decrease in supply, the market price for the product will rise, assuming the demand remains constant. 3. Increase in revenue: As price rises, the revenue for the remaining firms in the market increases, leading to break-even or positive profit conditions.

Long-Run Equilibrium

The long-run equilibrium in a perfectly competitive industry occurs when firms in the market are earning just enough to cover their average total costs. In this situation, no firm has any incentive to exit the market (since they are not making losses) or to enter the market (since there are no excess profits to be earned).

Conclusion

Losses for firms in a perfectly competitive industry tend to vanish in the long run due to market adjustments. When firms experience losses, they will leave the market, causing a decrease in supply and the market price to rise. This adjustment results in increased revenues for the remaining firms, allowing them to reach a long-run equilibrium where firms are not making losses.