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MODULE 24 (60) Long-Run Outcomes in Perfect Competition

MODULE 24 (60) Long-Run Outcomes in Perfect Competition. Why industry behavior differs in the short run and the long run What determines the industry supply curve in both the short run and the long run. Introduction. So far we have learned a perfectly competitive firm’s short-run situation:

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MODULE 24 (60) Long-Run Outcomes in Perfect Competition

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  1. MODULE 24(60)Long-Run Outcomes in Perfect Competition

  2. Why industry behavior differs in the short run and the long run • What determines the industry supply curve in both the short run and the long run

  3. Introduction • So far we have learned a perfectly competitive firm’s short-run situation: • Whether to produce or not, and if so, whether the firm earns a positive profit, breaks even with a normal profit, or takes a loss. • In this module, we look at the long-run situation in a perfectly competitive market.

  4. Firm Supply Curve to Industry Supply Curve • Why will an increase in the demand for organic tomatoes lead to a large price increase at first but a much smaller increase in the long run? • The answer lies in the behavior of the industry supply curve—the relationship between the price and the total output of an industry as a whole. • How do we derive an industry supply curve? • The industry supply curve is the horizontal sum of the individual supply curves of all firms • In the short run the number of firms in an industry is fixed—there is no entry or exit. 

  5. The Short-Run Individual Supply Curve The short-run individual supply curve shows how an individual producer’s optimal output quantity depends on the market price, taking fixed cost as given. Price, cost of bushel Short-run individual supply curve MC A firm will cease production in the short run if the market price falls below the shut-down price, which is equal to minimum average variable cost. $18 A T C E 16 A VC 14 C 12 B 10 Shut-down price A Minimum average variable cost 0 1 2 3 3.5 4 5 6 7 Quantity of tomatoes (bushels)

  6. The Long-Run Equilibrium • A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur.

  7. The Short-Run Market Equilibrium The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers. Price, cost of bushel Short-run industry supply curve, S $26 22 There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given. E MKT Market price 18 D 14 Shut-down price 10 0 200 300 400 500 600 700 Quantity of tomatoes (bushels)

  8. Profitability and the Market Price (b) Individual Firm (a) Market Price, cost of bushel Price, cost of bushel MC S S S 2 1 3 $18 E $18 MKT E A 16 D 16 A T C MKT D B 14.40 Z Y 14 Break-even price C 14 C MKT D 0 3 4 4.5 5 6 0 500 750 1,000 Quantity of tomatoes (bushels) Quantity of tomatoes (bushels) A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur.

  9. The Effect of an Increase in Demandin the Short Run and the Long Run (c) Existing Firm Response to New Entrants (a) Existing Firm Response to Increase in Demand (b) Short-Run and Long-Run Market Response to Increase in Demand Higher industry output from new entrants drive price and profit back down. Price, cost Price, cost Price An increase in demand raises price and profit. LRS S S MC 1 2 MC $18 Y A T C A T C Y Y MKT 14 X Z D Z X 2 MKT MKT D 1 QX Qy Qz Qy 0 0 Q Q Q 0 Quantity Quantity Quantity X Y Z The LRS shows how the quantity supplied responds to the price once producers have had time to enter or exit the industry. Increase in output from new entrants.

  10. Perfectly Elastic Long Run Supply Cruve • It is possible LRIS will be perfectly elastic in the long run: given time to enter or exit, firms will supply any quantity that consumers demand at a price of $14.  • Possible if all firms have identical cost curve if there are perfectly elastic supply of inputs (i.e., agriculture or bakeries). • LRIS curve can be upward sloping. • The usual reason is inelastic supply of inputs. i.e., beach resort industry. • LRIS curve can be downward sloping. • A condition that occurs when the cost structure for firms becomes lower as the industry expands.

  11. Comparing the Short-Run andLong-Run Industry Supply Curves Price Short-run industry supply curve, S A higher price attracts new entrants in the long run, resulting in a rise in industry output and lower price. Long-run industry supply curve, LRS A fall in price induces existing producer to exit in the long run, generating a fall in industry output and a rise in price. The long-run industry supply curve is always flatter – more elastic than the short-run industry supply curve. Quantity

  12. The Cost of Production and Efficiency in the Long-Run Equilibrium • In a perfectly competitive industry in equilibrium, the value of marginal cost is the same for all firms. • In a perfectly competitive industry with free entry and exit, each firm will have zero economic profits in long-run equilibrium. • The long-run market equilibrium of a perfectly competitive industry is efficient: no mutually beneficial transactions go unexploited.

  13. The industry supply curve depends on the time period. • The short-run industry supply curve is the industrysupply curve given that the number of firms is fixed. • Theshort-run market equilibrium is given by the intersectionof the short-run industry supply curve and thedemand curve. • The long-run industry supply curve is the industry supplycurve given sufficient time for entry into and exit fromthe industry. • In the long-run market equilibrium—given by the intersection of the long-run industry supplycurve and the demand curve—no producer has an incentiveto enter or exit.

  14. The long-run industry supply curve isoften horizontal. It may slope upward if there is limitedsupply of an input. It is always more elasticthan the short-run industry supply curve. • In the long-run market equilibrium of a competitiveindustry, profit maximization leads each firm to produceat the same marginal cost, which is equal to marketprice. • Free entry and exit means that each firm earnszero economic profit—producing the output correspondingto its minimum average total cost. So the total costof production of an industry’s output is minimized. • Theoutcome is efficient because every consumer with a willingness to pay greater than or equal to marginal cost getsthe good.

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