Module VI·Article IV·~2 min read
Entry, Exit, and Long-Run Equilibrium
Profit and Firm Behavior
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Entry, exit, and long-run equilibrium
The short-run decision for a firm is the choice of production volume. The long-run decision is whether to enter or exit an industry. These decisions determine the structure of the industry and long-run equilibrium.
Signals for Entry and Exit
Positive economic profit:
- Signal for entry of new firms
- Resources are directed into a profitable industry
- Supply increases
Negative economic profit:
- Signal for exit
- Resources are redirected to more efficient uses
- Supply decreases
Zero economic profit:
- No incentives to enter or exit
Long-Run Equilibrium
Mechanism of convergence
When supernormal profits occur:
- New firms enter
- Market supply increases
- Market price falls
- Profit of existing firms decreases
- Process continues until economic profit = 0
In case of losses:
- Firms exit
- Market supply decreases
- Market price rises
- Losses of those remaining decrease
- Process continues until economic profit = 0
Barriers to Entry
Barriers to entry are factors that impede free entry and allow supernormal profits to be maintained.
Economies of scale:
- High MES (minimum efficient scale) requires large investments
- A newcomer must immediately reach scale or bear high costs
Capital requirements:
- Large initial investments
- Limited access to financing
Access to resources:
- Control of key resources (patents, deposits)
- Supplier networks, contracts
Brand loyalty:
- Reputation, consumer trust
- Marketing costs for newcomers
Regulatory barriers:
- Licenses, permits
- Standards, requirements
Network effects:
- Value of the product increases with the number of users
- It is difficult for a newcomer to compete with an established network
Barriers to Exit
Factors that make exit difficult even in case of losses:
Sunk costs:
- Irrecoverable investments (specific equipment)
- Psychologically difficult to "recognize losses"
Obligations:
- Long-term contracts with workers, suppliers
- Penalties for early termination
Regulatory:
- Social obligations
- Environmental requirements when closing
Strategic:
- Presence in the industry for other purposes
- "Flagship" product
Types of Industries by Barriers
Low entry and exit barriers:
- Competitive markets
- Low stable profits
- Example: restaurants, retail trade
High entry barriers, low exit barriers:
- Sustained high profits
- Example: pharmaceuticals, software
Low entry barriers, high exit barriers:
- Excess capacity, price wars
- Unstable low profits
- Example: airlines, hotel business
High entry and exit barriers:
- High but volatile profits
- Example: heavy industry
For the Investor
Profit sustainability:
- Supernormal profits without barriers are temporary
- Entry barriers are key to sustainable competitive advantage
- "Moat" analysis (defensive moat)
Threat of entry:
- High profits attract — assess threat of new competitors
- Disruption from new technologies can circumvent traditional barriers
Exit dynamics:
- Industries with high exit barriers — protracted price wars
- Consolidation is often necessary to restore profitability
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