What will happen in the perfectly competitive market if firms are earning losses?

Zero economic profits. The entry and exit of firms, which is possible in the long‐run, will eventually cause each firm's economic profits to fall to zero. Hence, in the long‐run each firm earns normal profits. If some firms are earning positive economic profits in the short‐run, in the long‐run new firms will enter the market and the increased competition will reduce all firms' economic profits to zero. Firms that are earning negative economic profits (losses) in the short‐run will have to either make some changes in their fixed factors of production in the long‐run or choose to leave the market in the long‐run. A perfectly competitive market achieves long‐run equilibrium when all firms are earning zero economic profits and when the number of firms in the market is not changing.

Minimization of long‐run average total cost. In the long‐run, a perfectly competitive firm can adjust the amount it uses of all factor inputs, including those that are fixed in the short‐run. For example, in the long‐run, the firm can adjust the size of its factory. In making these adjustments, the firm will seek to minimize its long‐run average total cost. If, in the short‐run, the firm is operating below its minimum efficient scale and experiencing economies of scale, in the long‐run it can adjust its use of factor inputs so as to increase its output to the minimum efficient scale level.

Alternatively, if the firm is experiencing diseconomies of scale because its short‐run level of output exceeds its minimum efficient scale, in the long‐run the firm can adjust its use of factor inputs so as to reduce its output to the minimum efficient scale level. Thus, in the long‐run the firm will be operating at the minimum point of its long‐run average total cost curve.

Graphical illustration of long‐run profit maximization. The long‐run equilibrium for an individual firm in a perfectly competitive market is illustrated in Figure .

The profit maximizing level of output, where marginal cost equals marginal revenue, results in an equilibrium quantity of Q units of output. Because the firm's average total costs per unit equal the firm's marginal revenue per unit, the firm is earning zero economic profits. Furthermore, the firm is shown to be producing at the minimum point of its long‐run average total cost curve, at the minimum efficient scale level of output.

Long‐run market supply curve. The short‐run market supply curve is just the horizontal summation of all the individual firm's supply curves. The long‐run market supply curve is found by examining the responsiveness of short‐run market supply to a change in market demand. Consider the market demand and supply curves depicted in Figures (a) and (b). Here, the market demand curves are labeled D 1, and D 2, while the short‐run market supply curves are labeled S 1 and S 2.

Figure (a) depicts demand and supply curves for a market or industry in which firms face constant costs of production as output increases. At the intersection of D 1 and S 1, the market is in long‐run equilibrium at a market price of P 1. An increase in demand from D 1 to D 2 results in a new, higher market price of P 2. In the short‐run, existing firms in this market will earn positive economic profits. In the long‐run, however, new firms will enter, causing short‐run market supply to shift from S 1 to S 2 and driving the market price back down to P 1. The long‐run market supply curve is therefore given by the horizontal line at the market price, P 1

Figure (b) depicts demand and supply curves for a market or industry in which firms face increasing costs of production as output increases. Starting from a market price of P 1, an increase in demand from D 1 to D 2 increases the market price to P 2. In the short‐run, firms are earning positive economic profits. In the long‐run, new firms will enter the market, the short‐run supply curve will shift from S 1 to S 2, and the new market price will be P 3. The new, long‐run market price of P 3 is greater than the old market price of P 1 because in an increasing‐cost industry, the firm's average total costs rise as it produces more output. Thus, the long‐run market supply curve in an increasing‐cost industry will be positively sloped.