Final answer:
An industry is expected to expand when firms within it are earning economic profits, as these profits act as an incentive for existing businesses to grow and for new firms to enter the market. This increases competition and supply in the industry, ultimately driving economic profits down to zero in the long run.
Step-by-step explanation:
In a competitive market, profits serve as a powerful incentive for businesses to expand their operations. An industry is expected to expand if firms in the industry are earning economic profits, which are profits over and above the normal returns expected by investors. Economic profits occur when a firm’s total revenues exceed both the explicit costs and the opportunity costs of production, including the normal return on investment. In contrast, accounting profits only consider the explicit costs and do not take into account the opportunity costs. Therefore, they are not as important a signal for expansion as economic profits.
When firms in an industry earn economic profits, it acts as a signal for other potential firms that there is money to be made in that industry. This phenomenon will attract entry of new firms into the market, looking to capitalize on these profit opportunities. As new firms enter, they will increase the industry’s production output, which tends to drive down prices. Over time, if entry continues, the economic profits will be eroded as the supply increases and the market reaches a new equilibrium. This process continues until profits are driven down to a point where they just cover the opportunity costs, resulting in zero economic profits in the long run.
If, conversely, firms are only earning normal profits (e.g., covering their costs of production including opportunity costs) or are suffering losses, there will be no incentive for new firms to enter the market. In fact, losses in an industry would eventually lead to the exit of firms, thereby reducing the industry’s output and potentially driving prices up till firms remaining could make normal profits or economic profits.
Therefore, we can conclude that an industry will experience expansion typically when firms within it are earning economic profits, leading to entry of more firms in the market until economic profits are nullified in the long run.