Figure 9-10 The Effect of Exit Caused by Losses
Profits in a competitive industry are a signal for the entry of new firms; the industry will
expand, pushing price down until economic profits fall to zero.An Exit-Inducing Price
We have seen that the firm’s supply curve is the section of its marginal
cost curve above the average variable cost curve. If the market price falls
below the minimum of average variable cost, the firm will produce no
output. If the low price is expected to persist, the firm will likely exit the
industry altogether.
If firms are making losses but the market price is above the shut-down
point, there will still be exit from the industry, but it will be gradual.
Although in this situation the firms are covering their variable costs, they
are not earning enough to cover their fixed costs. The return of the
owners’ capital is therefore less than the opportunity cost of their capital,
which is a signal for the gradual exit of firms. Old plants and equipment
will not be replaced as they wear out. As a result, the industry’s supply
curve eventually shifts leftward, and the market price rises. Firms will
continue to exit, and the market price will continue to rise, until the
remaining firms can cover all their costs. Once again the market reaches a
zero-profit equilibrium. The exit of firms then ceases. This gradual
process of exit is shown in Figure 9-10.