If firms incur losses, some of them will close down being unable to tolerate losses. As a result, total supply in the market declines and consequently, supply curve shifts towards the left. This causes the equilibrium to move upward and price appreciates. This continues till price becomes equal to average cost.
Thus, in the long-run, firms arrive at a no-profit-no-loss situation. That is, they neither earn super-normal-profit nor do they incur any loss at the output level where both the profit maximising conditions are satisfied. This process is explained with the help of a diagram (see figure 10.6).
Let us start with a case of a profit-making firm. Left panel of figure 10.6 shows total demand and total supply curves of a product which are represented by DD and S1S1 respectively. Intersection of these two curves determine P1 price.
The right panel of figure 10.6 shows what quantity an individual firm operating under perfect competition will produce for maximizing profit, given the product price. MC and AC represent this individual firm’s marginal and average costs respectively.
Since price line and MR curve are same for a firm under perfect competition, profit maximizing conditions are satisfied at point ‘b’. From this point, we obtain profit maximizing quantity of output as OQ1 at OQ1 output level, per unit cost is equal to Q1c.
So, total cost incurred by this firm is equal to the area hcQ1O, whereas total revenue generated by the firm is abQ1O. Clearly, profit earned by the firm is equal to the area ‘abch’. This super-normal profit will allure potential entrants to enter into this industry.
Increase in number of firms causes a rightward shift of the total supply curve. This continues till the market supply curve shifts to S3S3. Intersection of S3S3 with the demand curve DD determines price OP3. At this price, profit maximising output level of this firm becomes OQ3.
At OQ3 output level, per unit price (OP3) and per unit cost (Q3e) become equal. This implies that at OQ3 output level, total revenue generated and total cost incurred by the firm are equal and this ensures attainment of no-profit-no- loss situation of a firm in the long-run.
Now, we take up the case where initially firms incur losses. Assume that the initial supply curve of the market is represented by S2S2. Intersection of DD and S2S2 determines OP2 price. Given OP2 price, the firm under consideration will produce OQ2 Quantity of output.
At OQ2 output level, per unit cost (Q2m) exceeds per unit price (OP2). Thus, total loss incurred by the firm is ‘jmkf. Being unable to tolerate losses, some firms will go out of this industry without any hurdle, because of non-existence of exit barriers.
Reduction in number of firms leads to leftward shift in market supply curve. This process containues till the market supply curve shifts to S3S3 which ensures attainment of no-profit-no-loss situation of the firm in the long-run.