Negative profits lead to the eventual exit of some firms as their capital
becomes obsolete or becomes too costly to operate; this exit increases
the equilibrium price and increases profits for those firms remaining in
the market. The initial market equilibrium is in part (i), with
equilibrium price. At this market price, a typical firm is producing
units and is making negative profits but, because price exceeds AVC, the
firm remains in business. Since firms are earning less than the
opportunity cost on their capital, they do not replace their capital as it
becomes obsolete. Eventually, some firms close down. As firms exit the
industry, the industry supply curve shifts to the left and the market price
increases to. For the remaining firms, this price increase leads them to
increase their output from to , the level of output at which they are
just covering their total costs. Notice that the remaining firms are
producing more than before, but because of the exit of firms total industry
output has fallen from to.
Losses in a competitive industry are a signal for the exit of firms; the industry will contract,
driving the market price up until the remaining firms are just covering their total costs.The Speed of Exit
E 0
p∗ 0p∗ 1
q 0 ∗ q 1 ∗Q∗ 0 Q∗ 1