Optimistic Outlook: Firm's Return on Capital in a Competitive Industry
What will happen to a firm's return on capital in a perfectly competitive industry in the long run?
A. It will remain at 12%
B. It will increase to 15%
C. It will decrease to 9.5%
D. It will fluctuate depending on market conditions
The firm's return on capital in a perfectly competitive industry will eventually fall to 9.5% in the long run. Why is this true?
In the long run, the firm's return on capital will be 9.5%. The reason behind this is the process of the entry of new firms in a perfectly competitive industry, which eventually causes the return on capital to fall.
When a firm is earning a 12% return on capital in a perfectly competitive industry and the market return outside the industry is 9.5%, it means that the firm is earning an above-average return. This attractive return will incentivize new firms to enter the market and compete for profits.
As more firms enter the industry, the supply of goods and services increases, leading to a more elastic demand curve for each individual firm. This increased supply will eventually drive down market prices, resulting in lower profit margins for each firm.
Some firms may choose to exit the industry due to declining profit margins, while others may continue operating at a lower level of profitability. Over time, the continued entry of new firms will lead to a decrease in the firm's return on capital, aligning it with the market return outside the industry of 9.5%.