Question

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

Short answer

In the long run, losses in a perfectly competitive industry tend to vanish due to the process of entry and exit of firms. When firms earn excess profits, new firms are attracted to the industry, increasing supply and driving down prices until profits are only enough to cover long-run average costs. Conversely, when firms face losses, some exit the market, reducing supply and increasing prices until losses are eliminated. This leads to a long-run equilibrium where firms break even, as the price of the product equals their long-run average cost.

Step-by-step solution

Characteristics of Perfectly Competitive Industry

A perfectly competitive industry has the following characteristics: - Large number of buyers and sellers. - Homogeneous products. - Perfectly elastic demand curve for individual firms. - Free entry and exit of firms. - Perfect information. These characteristics create an environment in which firms can't generate sustained profits or losses, as we will see in the following steps.

Short-run Equilibrium

In the short run, firms produce goods within a given set of resources. They can't change the size of their production facilities. As a result, they can experience temporary profits or losses based on changes in demand, costs, or competition. For example, if a firm has lower-than-average costs, it may be able to generate short-term profits.

Long-run Equilibrium

In the long run, firms are free to enter or exit the market, and they are also able to change the size of their production facilities. When a firm earns higher-than-normal profits in a perfectly competitive market, the following process occurs: 1. Other firms are attracted to the industry because of the higher profits. 2. As new firms enter, the supply of the product increases. 3. The increase in supply leads to a decrease in the price of the product. 4. This process continues until profits are only enough to cover the firm's long-run average costs (which include returns on investment). 5. Finally, the industry reaches its long-run equilibrium, and there are no more excess profits for firms to earn, causing firms to break even. Similarly, if firms in a perfectly competitive industry are facing losses, the following process occurs: 1. Some firms exit the market. 2. This reduces the supply of the product. 3. As a result, the price of the product increases. 4. The process continues until losses are eliminated, and firms are breaking even.

Break-even Point

In the long-run equilibrium, firms in a perfectly competitive market tend to break even because their total revenues equal their total costs (including both the variable and fixed costs). At this point, the price of the product equals the long-run average cost of the firm. In summary, losses for firms in a perfectly competitive industry tend to vanish in the long run due to the process of entry and exit of firms. As new firms enter the market and drive down prices or as firms exit the market and allow prices to rise, the industry ultimately reaches an equilibrium where firms are breaking even. This is because competition and market forces cause prices to adjust until each firm's total revenues equal their total costs, with no excess profits or losses in the long run.