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IAI Actuarial Core Principles · Business Economics · Production, costs, revenue and profit in price and output decisions

In the long run, a perfectly competitive industry earns abnormal profits. What is the expected sequence of adjustment?

New firms enter the industry, shifting industry supply to the right and pushing market price down. Entry continues until price equals minimum average cost, leaving firms with only normal profit. This follows from free entry and exit in perfect competition.

  1. AFirms exit, supply falls, price rises until profit is normal
  2. BNew firms enter, industry supply rises, price falls until abnormal profit is eliminatedCorrect
  3. CExisting firms restrict output to protect the price
  4. DDemand falls permanently so profits vanish
  5. Firms raise price because they are price-makers

Explanation

With free entry and exit, abnormal profit attracts new firms. Industry supply shifts right and market price falls. Entry continues until price equals minimum average cost and only normal profit remains. Exit would occur only under losses.

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