Economics “Ask the Instructor” Clip 47 Transcript



Economics “Ask the Instructor” Clip 47 Transcript

What do we mean when we say that competitive firms do not earn “economic” profit in the long run?

Normal profit is the amount that must be paid to induce an investor to invest. This varies depending on how risky the industry is perceived to be. Any profit above this level is referred to as an economic profit. By definition, economic profit is greater than what is required to induce investment in an industry. Economic profit can be thought of as what’s left after paying all costs, including the cost of attracting and holding financial capital.

The long run is a time period sufficiently long to allow existing firms to change the scale of their operations, for new firms to enter the industry, or for existing firms to leave the industry. For example, in the long run, used-car dealers can expand their lot size, sales staff, and number of cars available for sale. In the long run, new firms can enter the industry. For example, someone who operates a car repair shop can get a license to sell used cars, erect the necessary signage, and enter the industry.

An important attribute of a competitive industry is absence of barriers to entry. There are no patents, no large investment required, no exclusive franchise rights, or anything else that would prohibit entry. That is, entry is virtually free. This feature –easy entry –is what keeps profits at a normal level in the long run.

Of course, certain events can allow firms to earn economic profits for a time. If demand increased, those firms already in the industry would enjoy economic profits. However, easy entry assures that economic profits cannot persist in the long run. This explains why businesses already in an industry attempt to get government to limit entry.

Profits are a signal for resource allocation. Firms and industries with above-normal profits attract investment funds. Society benefits from profits because resources move to highest-valued uses. But in the long run, there is an irony: the entry of resources to profitable firms results in a lower price. As price is driven down, the above-normal profits—the economic profits—tend to be eliminated.

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