The long-run equilibrium in a perfectly competitive market is a stable state where all firms are earning zero economic profit (or normal profit). This equilibrium is reached due to the characteristic of free entry and exit of firms in the long run.
In this long-run equilibrium, two key efficiencies are achieved:
- Productive Efficiency: Firms produce at the minimum point of their Long-Run Average Cost (LRAC) curve.
- Allocative Efficiency: The price consumers pay is equal to the Marginal Cost (MC) of production.
Conditions for Long-Run Equilibrium
For a firm in a perfectly competitive market to be in long-run equilibrium, three conditions must hold simultaneously:
- Profit Maximization: The firm’s long-run Marginal Cost (LMC) must equal its Marginal Revenue (MR). Since a perfectly competitive firm is a price-taker, Price (P) = MR, so the condition is:
- Zero Economic Profit: The firm’s average revenue (Price) must equal its Long-Run Average Cost (LRAC). This ensures that firms are only earning a normal rate of return on capital, which is included in the cost:
- Optimum Scale of Production (Productive Efficiency): The firm must produce at the minimum point of its LRAC curve:
Combining these three conditions, the ultimate condition for long-run equilibrium for a firm is:
Process of Adjustment to Equilibrium
The key driver for reaching the long-run equilibrium is the free entry and exit of firms.
1. If Firms Earn Economic Profit (Supernormal Profit)
- Initial State: If the market price is high enough that firms are earning a positive economic profit (
).
- Entry: The supernormal profits act as a signal, attracting new firms to enter the industry.
- Adjustment: The entry of new firms increases the total market supply, causing the market supply curve to shift to the right.
- Result: The increased supply drives the market price down until economic profits are eliminated, meaning again.
2. If Firms Incur Economic Loss
- Initial State: If the market price is so low that firms are incurring an economic loss (
).
- Exit: Firms suffering losses will begin to exit the industry in the long run.
- Adjustment: The exit of firms decreases the total market supply, causing the market supply curve to shift to the left.
- Result: The decreased supply drives the market price up until economic losses are eliminated, meaning again.
This process of entry and exit continues until the market price stabilizes at a point where every firm in the industry earns only a normal profit (zero economic profit) by producing at the most efficient scale.
