Question

Consider a firm at a price- taker market. If the firm is making profits in the short run, describe what will happen to the market price in the long run

Answer 1

In the long run,

When firms make a positive economic profit in the short run, new firms are attracted by this profit in the long run and start entering the market. When new firms enter the market, the aggregate supply of the good increases. So, the equilibrium price decreases leading to a decrease in the profit of each firm. This process of entry of new firms and a decrease in the price of the product will continue until each firm earns zero economic profit.

It means, in the long run, the market price is equal to minimum Average Total Cost (ATC).

On the other hand, when firms incur a loss in the short run, some firms will exit the market in the long run. When some firms leave the market, the aggregate supply of the good decreases. So, the equilibrium price increases leading to an increase in profit of each firm. This process of exit of firms and an increase in the price of the product will continue until each firm earns zero economic profit.