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Chapter 15

Chapter 15. Competitive Markets in the Long Run. Objective. Long Run Equilibrium Identical firms Heterogeneous firms Constant / Increasing/ Decreasing cost industries Welfare properties of competitive markets. Price. Price. LR or SR equilibrium?. ATC. S. MC. π 1. p e. p e. D.

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Chapter 15

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  1. Chapter 15 Competitive Markets in the Long Run

  2. Objective • Long Run Equilibrium • Identical firms • Heterogeneous firms • Constant / Increasing/ Decreasing cost industries • Welfare properties of competitive markets

  3. Price Price LR or SR equilibrium? ATC S MC π1 pe pe D 0 0 q1e Q Market FIRM 1

  4. Short-Run Equilibrium • Short run: A period of time not long enough for • Existing firms to adjust all factors of production • Firms will not be able to contract their capital stock if they are making losses • Firms will not be able to expand their capital stock if they are making profits • Outside firms to enter the market

  5. Price, Cost The adjustment to a long-run equilibrium Price, Cost LRMC (a) (b) d b LRAC f SRACK1 S* S2 S1 SRMCK1 p* p1’ p1 D q1K1’ q1K1 q* 0 0 Quantity Quantity Positive profits attract the entry and shift the supply curve to the right until each firm has a capacity of K* and the market supply curve is S*. In a long-run equilibrium, each firm produces q* units and earns zero profits

  6. Long-Run Equilibrium for Identical Firms • Long-run equilibrium • (1) Firms - Quantity supplied - no change • (2) Consumers • Quantity demanded - no change • (3) Existing firms • Inputs - no change • No exit • (4) New firms – don’t enter • (5) Aggregate supply = Aggregate demand

  7. The Long-Run Equilibrium forHeterogeneous Firms • Difference in long-run costs • Location / assets

  8. Price Price Price Price Heterogeneous Firms FIRM 1 FIRM 2 FIRM 3 ATC ATC ATC S MC MC MC π2 π1 pe pe D 0 0 0 0 qe=q1e+q2e+q3e q3e q1e q2e Why do firms have different ATC curves?

  9. The Long-Run Equilibrium forHeterogeneous Firms • Economic rent • Return to an input • Over and above • Need to secure it • Rent-inclusive average cost • Average cost • Economic rent - included as a cost

  10. Rent and long-run competitive equilibria (a) (b) Price, Cost Price LRAC LRAC’ MC a b S p* c p* D 0 0 Quantity Quantity LRAC’ includes the opportunity cost of the firm’s special asset or location

  11. Dynamic Changes in Market Equilibria • In the short run • Supply is upward sloping • The long run supply can be • Flat • Upward sloping • Downward sloping • The shape of the LR supply will depend on how entry affects the costs of production

  12. Dynamic Changes in Market Equilibria • Constant-cost industries • Flat long-run supply curve • As new firms enter • No change in cost functions

  13. Constant-cost industries b a Cost Price LRAC Long-run supply curve SRMC SRAC S2 S1 pb pa D1 D2 0 0 Quantity Quantity With constant costs, the long-run response to an increase in demand re-establishes the original price of pa.

  14. Increasing-cost industries • Pecuniary externality • Action of one agent • Other agents: increase in price • Increasing-cost industries • Upward sloping long-run supply curve • As new firms enter • Increase costs of inputs • LRAC curves – shift up

  15. Increasing-cost industries b c Cost Price Long-run supply curve a LRAC1 LRAC2 S3 S1 pa pb pc D1 D2 0 0 Quantity Quantity With increasing costs, the long-run response results in a higher price

  16. Decreasing-cost industries • Downward sloping long-run supply curve • As new firms enter • Decrease costs of inputs • LRAC curves – shift down

  17. Decreasing-cost industries b c Cost Price Long-run supply curve a LRAC1 LRAC2 S1 S2 pa pc D2 D1 0 0 Quantity Quantity With decreasing costs, the long-run response results in a lower price.

  18. Why Are Long-Run CompetitiveEquilibria So Good? • Welfare Proposition # 1: Consumer & producer surplus are maximized • No deadweight loss • Welfare Proposition # 2: Price is set at marginal cost • Welfare Proposition # 3: Goods are produced at the lowest possible cost and the most efficient manner

  19. Welfare Proposition # 1: Consumer & producer surplus are maximized e f Price g d c S p1 A p* B D 0 Quantity q1 q1’ q*

  20. Welfare Proposition #2: Price is set at marginal cost • Firms maximize profit • Take prices as given in a competitive market • Produce until P=MC

  21. Welfare Proposition #3: Goods produced at lowest possible cost Price Price (a) (b) p* K* S p* D q* 0 0 Quantity Quantity

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