How Entry Responds to Economic Profit

Why Positive Economic Profit Attracts Entry

In a competitive market, an individual firm takes the market price as given. If firms earn positive economic profit, however, other firms have an incentive to enter when they can access the market and use comparable technology. The important change is not that existing firms suddenly face a different cost curve. Rather, there are more firms supplying the market, so the industry supplies more at any given price.

With demand unchanged, this additional supply puts downward pressure on the market price. Incumbent firms then respond to that lower price: an incumbent with an upward-sloping marginal-cost curve generally chooses a lower output, and its economic profit falls. The size and speed of these effects depend on how easily firms can enter and on whether demand, costs, or technology also change.

Definition: A firm earns positive economic profit when its revenue exceeds its full economic cost, including the opportunity cost of the resources it uses. In notation, economic profit is $\pi=TR-TC$, where $TR$ is total revenue and $TC$ is total economic cost. Entry is attractive when a potential entrant expects positive economic profit after accounting for those costs and the relevant risks.

The entry response described here assumes that firms sell a homogeneous product, take the market price as given, and face no prohibitive legal, technological, or strategic barriers to entry. It also assumes, for tracing the basic effect, that demand and incumbent firms’ costs do not change while entry occurs. These assumptions do not imply that entry is instantaneous or that every potential entrant will have the same costs.

From Entry to a Market-Supply Shift

Suppose each of $n$ identical firms supplies $s(P)$ units at market price $P$, over the price range where the firms are operating. Market supply is the sum of individual firms’ supplies: $Q_s(P)=n s(P)$. If additional firms enter, the number of suppliers rises. At a given price, each existing firm may still supply the same amount, but the total supplied by the industry is greater.

n_{\text{new}}>n_{\text{old}} \quad\Longrightarrow\quad Q_{s,\text{new}}(P)>Q_{s,\text{old}}(P)

This is a rightward shift of market supply, not a movement along the original market-supply curve. A movement along a supply curve is caused by a change in the good’s price. Entry changes the number of firms supplying the good, so market supply changes at each price.

To see why price tends to fall, hold demand fixed. At the old equilibrium price, entry makes quantity supplied greater than quantity demanded. If market demand slopes downward and market supply slopes upward, the market clears at a lower price: the lower price reduces quantity supplied by each firm and increases quantity demanded. Total quantity traded can therefore rise even while each incumbent produces less. Entry adds firms to the market, so the industry’s total output need not move in the same direction as an individual firm’s output.

Positive economic profit is observed.
Potential entrants compare expected revenue with all relevant economic costs, including the opportunity cost of their resources.

Firms enter if access is feasible.
New suppliers add to market supply at each price, assuming the entrants can produce the same good and have comparable costs.

Market price adjusts downward.
At the former price, the extra supply creates excess supply. With demand unchanged, price falls toward a new market-clearing level.

Incumbents adjust their decisions.
A lower price leads an incumbent with upward-sloping marginal cost to choose a lower output. The lower price also reduces its maximum attainable profit.

Worked Examples

Worked Example: Entry Lowers Price and Incumbent Profit

A competitive market has demand $Q_d=100-P$. Each firm has short-run supply $q=P-10$ for prices above $10. Initially, four identical firms operate. Their total cost is $C(q)=10q+0.5q^2+20$, with quantities measured in units and money in dollars. Positive economic profit attracts four additional firms. Assume demand and all firms’ cost conditions remain unchanged. Find the market price and quantity before and after entry, and calculate one incumbent’s profit at both prices.

Method. Add the firms’ supplies to obtain market supply, equate it to market demand, and then calculate an incumbent’s revenue and total cost. This method avoids treating a change in the number of firms as a change in an incumbent’s own supply curve.

Before entry. With four firms, market supply is $Q_s=4(P-10)=4P-40$. Equating supply and demand gives $100-P=4P-40$, so $140=5P$ and $P=28$. Market quantity is $Q=100-28=72$. Each firm supplies $q=28-10=18$.

The incumbent’s revenue is $TR=28(18)=504$. Its total cost is $C(18)=10(18)+0.5(18^2)+20=180+162+20=362$. Its economic profit is $\pi=504-362=142$ dollars.

After entry. Eight firms now supply the market, so $Q_s=8(P-10)=8P-80$. Equilibrium requires $100-P=8P-80$, giving $180=9P$ and $P=20$. Market quantity is $Q=100-20=80$, and each firm supplies $q=20-10=10$.

At the new price, the incumbent’s revenue is $TR=20(10)=200$. Its total cost is $C(10)=10(10)+0.5(10^2)+20=100+50+20=170$. Its economic profit is $\pi=200-170=30$ dollars. The check is consistent: market quantity equals eight firms’ output, $8(10)=80$, and the incumbent’s profit remains positive but is lower than $142.

Common mistake avoided: multiplying the old market supply by the new number of firms while keeping the old price as the new equilibrium. The new price must be found by solving market demand against the new market supply.

Worked Example: Tracing an Incumbent’s Response to a Price Fall

In another competitive market, demand is $Q_d=106-3P$. Each firm has supply $q=P-12$ for $P>12$ and total cost $C(q)=12q+0.5q^2+10$. Initially, two firms operate; entry increases the number of firms to four. Find the equilibrium price and market quantity at each stage, then calculate an incumbent’s output and economic profit at each price.

Method. Solve market clearing separately for each firm count, then apply the same incumbent cost function at each resulting price. This avoids the trap of assuming that an incumbent keeps producing its initial quantity after the market price changes.

Initially, with two firms, market supply is $Q_s=2(P-12)=2P-24$. Set $106-3P=2P-24$, so $130=5P$ and $P=26$. The market quantity is $106-3(26)=28$. Each firm supplies $q=26-12=14$, and the check $2(14)=28$ matches market quantity.

The incumbent’s revenue is $26(14)=364$. Its total cost is $C(14)=12(14)+0.5(14^2)+10=168+98+10=276$. Its economic profit is $364-276=88$ dollars.

After entry, with four firms, market supply is $Q_s=4(P-12)=4P-48$. Set $106-3P=4P-48$, giving $154=7P$ and $P=22$. Market quantity is $106-3(22)=40$. Each firm supplies $q=22-12=10$, and $4(10)=40$ confirms the market quantity.

The incumbent’s revenue is now $22(10)=220$. Its total cost is $C(10)=12(10)+0.5(10^2)+10=120+50+10=180$. Its economic profit is $220-180=40$ dollars. Entry has lowered price from $26 to $22 and the incumbent’s output from 14 to 10 units; total market quantity has increased from 28 to 40.

Common mistake avoided: concluding that industry output must fall because each incumbent produces less. There are more firms, so total market output can rise while an individual incumbent’s output falls.

Worked Example: Accounting Profit Is Not the Entry Signal

A workshop sells 50 units for $30 each. Its explicit operating costs are $1,200. The owner also provides resources with an annual opportunity cost of $350; assume this amount is not included in the explicit costs. Calculate accounting profit and economic profit, and assess whether the accounting result by itself implies that comparable firms will enter.

Method. Calculate revenue, subtract explicit costs for accounting profit, then include the owner’s opportunity cost when calculating economic profit. This avoids mistaking a positive accounting figure for an economic return above the value of the resources used.

Total revenue is $TR=50(30)=1{,}500$ dollars. Accounting profit is $1{,}500-1{,}200=300$ dollars. Total economic cost is $1{,}200+350=1{,}550$ dollars, so economic profit is $1{,}500-1{,}550=-50$ dollars. The calculation checks: economic profit is $350 below accounting profit, exactly the omitted opportunity cost.

The positive accounting profit does not establish that entry is attractive. On these figures, the workshop earns negative economic profit after valuing the owner’s resources. A potential entrant comparing its expected return with the opportunity cost of its own resources would not treat the $300 accounting profit as a $300 economic gain.

Common mistake avoided: using revenue minus explicit costs as though it were economic profit. Entry incentives depend on economic profit, not accounting profit alone.

Why Incumbent Profit Tends to Fall

An incumbent’s profit-maximizing output depends on the market price and its costs. In the standard competitive-firm model, a firm that is operating chooses output where price equals marginal cost on the relevant upward-sloping part of its marginal-cost curve. When entry reduces the market price, an incumbent with upward-sloping marginal cost therefore chooses a lower output. The firm’s supply decision is a response to the new price; it is not a voluntary response to the number of firms as such.

There is also a general reason that a fall in price cannot increase the incumbent’s maximum profit when its costs and feasible choices are unchanged. Let $P_1$ be the original price and $P_2<P_1$ the lower price. For any fixed feasible output $q$, revenue at $P_2$ is lower because $P_2q<P_1q$ for $q>0$, while cost is unchanged. The firm can reconsider its output at the lower price, but it cannot achieve a higher maximum profit than it could at the higher price: every output available at $P_2$ was also available at $P_1$, where it generated at least as much revenue.

\max_q\{P_2q-C(q)\} \leq \max_q\{P_1q-C(q)\} \qquad\text{when }P_2<P_1

This comparison concerns the incumbent’s best attainable profit under unchanged costs and feasible choices. It does not promise that profit remains positive after entry: in some circumstances, additional entry can reduce profit to zero or below. Nor does it establish the final number of firms or the eventual market price. Those outcomes require further assumptions about entry, adjustment, and the market’s long-run conditions.

When the Entry Mechanism Needs Qualification

The basic direction is useful, but it depends on the setting. If demand rises while entry is occurring, that increase can offset some or all of the downward price pressure. If entrants use different technology, have different costs, or face capacity constraints, they may not add the same amount of supply at every price. Barriers to entry can prevent firms from responding even when incumbents appear to earn positive economic profit. Finally, expected profit can differ from profit calculated using current conditions: entrants decide based on what they expect to earn, not just on what incumbents earned in the past.

For a clean analysis, keep three quantities distinct: the number of firms in the market, the output of an individual firm, and total market output. Entry increases the number of firms. The lower price generally reduces each incumbent’s output. Yet total output can increase because the additional firms collectively supply more than the incumbents reduce. A careful answer states which of these quantities it is describing.

Key takeaway: With demand and costs unchanged, positive economic profit can attract entry when the market is freely accessible. Entry shifts market supply to the right and tends to lower price. Incumbents then typically reduce output, and their maximum economic profit falls, although the outcome depends on the market’s conditions and adjustment process.

Check Your Understanding

For each problem, identify the market effect of entry separately from the effect on an individual incumbent.

A market has demand $Q_d=100-2P$. Each of two firms supplies $q=P-10$, for $P>10$. Entry increases the number of firms to four. Find the equilibrium price and total quantity before and after entry. (Answer: Initially $P=30$ and $Q=40$; after entry $P=70/3\approx23.333$ and $Q=160/3\approx53.333$.)
An incumbent’s total cost is $C(q)=12q+0.5q^2+10$. Its price falls from $26 to $22 after entry, and it chooses output where $P=12+q$. Find its output and economic profit at each price. (Answer: At $26, $q=14$, cost is $276, and profit is $88; at $22, $q=10$, cost is $180, and profit is $40.)
A firm has revenue of $1,500, explicit costs of $1,200, and an opportunity cost of its owner’s resources of $350. Find its accounting and economic profit, and state whether the positive accounting profit alone establishes an incentive for entry. (Answer: Accounting profit is $300; economic profit is $-$50$; the accounting profit alone does not establish an incentive for entry.)
With demand fixed, four identical firms each supply 12 units at the original market price. Two more firms enter, and each firm’s supply at that same price is still 12 units. How much does market supply increase at the original price, and what price pressure follows if the original price was an equilibrium price? (Answer: Market supply rises from 48 to 72 units, an increase of 24 units; with unchanged downward-sloping demand, the excess supply puts downward pressure on price.)

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