(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 327

302 PART 2 • Producers, Consumers, and Competitive Markets
for example, that the firm uses labor and capital inputs; its capital equipment
has been purchased. Accounting profit will equal revenues R minus labor cost
wL, which is positive. Economic profit p, however, equals revenues R minus
labor cost wL minus the capital cost, rK:
p = R - wL - rK
As we explained in Chapter 7, the correct measure of capital cost is the user
cost of capital, which is the annual return that the firm could earn by investing
its money elsewhere instead of purchasing capital, plus the annual depreciation
on the capital.

• zero economic profit
A firm is earning a normal
return on its investment—i.e.,
it is doing as well as it could by
investing its money elsewhere.

ZERO ECONOMIC PROFIT When a firm goes into a business, it does so in
the expectation that it will earn a return on its investment. A zero economic
profit means that the firm is earning a normal—i.e., competitive—return on that
investment. This normal return, which is part of the user cost of capital, is the
firm’s opportunity cost of using its money to buy capital rather than investing it
elsewhere. Thus, a firm earning zero economic profit is doing as well by investing its
money in capital as it could by investing elsewhere—it is earning a competitive return
on its money. Such a firm, therefore, is performing adequately and should stay
in business. (A firm earning a negative economic profit, however, should consider
going out of business if it does not expect to improve its financial picture.)
As we will see, in competitive markets economic profit becomes zero in the
long run. Zero economic profit signifies not that firms are performing poorly,
but rather that the industry is competitive.
ENTRY AND EXIT Figure 8.13 shows how a $40 price induces a firm to increase

output and realize a positive profit. Because profit is calculated after subtracting
the opportunity cost of capital, a positive profit means an unusually high return
on a financial investment, which can be earned by entering a profitable industry.
This high return causes investors to direct resources away from other industries
and into this one—there will be entry into the market. Eventually the increased
production associated with new entry causes the market supply curve to shift to
the right. As a result, market output increases and the market price of the product falls.7 Figure 8.14 illustrates this. In part (b) of the figure, the supply curve
has shifted from S1 to S2, causing the price to fall from P1 ($40) to P2 ($30). In part
(a), which applies to a single firm, the long-run average cost curve is tangent to
the horizontal price line at output q2.
A similar story would apply to exit. Suppose that each firm’s minimum longrun average cost remains $30 but the market price falls to $20. Recall our discussion earlier in the chapter; absent expectations of a price change, the firm will
leave the industry when it cannot cover all of its costs, i.e., when price is less than
average variable cost. But the story does not end here. The exit of some firms from
the market will decrease production, which will cause the market supply curve to
shift to the left. Market output will decrease and the price of the product will rise
until an equilibrium is reached at a break-even price of $30. To summarize:
In a market with entry and exit, a firm enters when it can earn a positive longrun profit and exits when it faces the prospect of a long-run loss.
7

We discuss why the long-run supply curve might be upward sloping in the next section.