Under what market conditions are firms most likely to enter an industry, and under what conditions are they most likely to exit?

• A. Firms are likely to enter when demand is falling and exit when supply is increasing.
• B. Firms are likely to enter when economic profits are positive and exit when economic profits are negative.
• C. Firms are likely to enter when fixed costs are high and exit when variable costs are low.
• D. Firms are likely to enter when prices are below average total cost and exit when prices are above average total cost.

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the concept of economic profits, which are calculated as total revenue minus total costs, including both explicit and implicit costs. Economic profits indicate whether a firm is making more than its opportunity costs.
2. Step 2: Recognize that firms are incentivized to enter an industry when they observe positive economic profits, meaning they can earn more than their next best alternative. This typically happens when the market price (P) is greater than the average total cost (ATC) of production.
3. Step 3: Conversely, firms are likely to exit an industry when economic profits are negative, meaning the market price (P) is less than the average total cost (ATC), and the firm is unable to cover all its costs in the long run.
4. Step 4: Note that changes in demand or supply alone do not directly determine entry or exit; rather, it is the resulting economic profits or losses that drive firms' decisions to enter or exit the market.
5. Step 5: Summarize that the key condition for entry is positive economic profits (P > ATC), and for exit is negative economic profits (P < ATC), which aligns with the principle of profit maximization and efficient resource allocation in competitive markets.