Profits and Entry

We notice that, in the picture just shown, the firm is making an "economic profit." All costs, explicit and implicit, are included in the firm's Average Cost curve. In particular, Average Cost includes the opportunity cost of capital investment -- so another way of putting it is that investors in this industry are making more than their best alternative investment in any other industry.

These profit opportunities will attract new firms into the industry. With "free entry," the (short run) supply curve of the industry shifts to the right, causing the price to drop until the economic profits are eliminated.

This process of entry and price change is known as the "long run equilibrium process" and it continues until "long run equilibrium" is attained. Here is a picture of the firm and industry in "long run equilibrium:"

Figure 2

The new price, quantity, firm demand and short run supply are indicated by primes -- p', q'. Q', d', S'. We see that, at a slightly lower price, the individual firm is lower on the MC curve and produces a little less, but since there are more firms in the industry, the industry as a whole produces more.