In the short-run the number of firms in a competitive industry is fixed.

1. COMPETITION IN THE LONG-RUN • In the short-run the number of firms in a competitive industry is fixed. • In the long-run new firms can enter or existing firms can leave a competitive industry.

2. The key to understanding when new firms will want to come into an industry, or existing firms leave, lies in role of profits. • Because profits are the difference between revenue and opportunity cost, the existence of profit means a firm is earning more on its invested resources than it could get in its next best alternative.

3. On the other hand, if a firm earns losses (negative profits) then it can earn more on its invested resources in some alternative use.

4. If the typical firm in an industry is earning economic profit, then this provides an incentive for other firms to come into the industry to take advantage of the opportunity. • If the best a typical firm in an industry can do is earn losses, then that firm has a strong incentive to leave the industry. • The objective here is to see what happens to a market when this sort of entry and exit is possible.

5. The pizza market is in short-run equilibrium at a price p’. There are currently 500 firms, and the typical pizza firm can make economic profits. The question to answer here is what will happen in the long-run, that is, when new firms can come into the industry. $/q $/Q S (500 firms) LRAC mc p’ D q Q q’ Q’ Typical firm Industry PIZZA MARKET

6. S (700 firms) p” The supply provided by newly entering firms will cause the market supply curve to move to the right. So Q rises and price falls. $/q $/Q S (500 firms) LRAC mc p’ D q Q q’ Q’ Typical firm Industry PIZZA MARKET

7. When and where will this process end? Where is the new equilibrium? A LONG-RUN EQUILIBRIUM MUST HAVE ZERO ECONOMIC PROFIT FOR THE TYPICAL FIRM.

8. S (700 firms) S (1000 firms) p* q* Q* $/q $/Q S (500 firms) LRAC D q Q Q’ Typical firm Industry PIZZA MARKET

9. The LR equilibrium price is p*. The firm’s LR equilibrium quantity is q*. The LR equilibrium market quantity is Q*. $/q $/Q LRAC S (1000 firms) p* D q Q q* Q* Typical firm Industry PIZZA MARKET

10. Competitive market equilibrium in the long-run: • 1) Price must settle at the bottom of the firm’s long-run average cost curve. • 2) Profits of the typical firm must be zero. • 3) The number of firms will adjust to provide the market quantity demanded at that price. • 4) Market price is still determined by short-run supply and demand.

11. PROBLEMS TO WORK OUT • SETUP: Suppose a competitive market for pizza is in long-run equilibrium. Then suppose there is an increase in the market demand for pizza. • QUESTION: What happens in the market for pizza in the long-run? That is, what is the new equilibrium price, quantity for the industry, quantity for the typical firm, and profits of the typical firm?

12. Always start to answer questions about long-run equilibrium from this template. $/q $/Q SRS LRAC p* D q Q q* Q* Typical firm Industry Hidden slides PIZZA MARKET

13. In the new equilibrium: • 1) price is unchanged • 2) firm’s quantity is unchanged • 3) industry quantity is increased • 4) firm’s profits are unchanged

14. Notice that in the competitive model resources flow to their most valued uses. • In the last example, people demanded more pizza and that’s what they got. More of society’s resources flowed into the pizza industry.

15. ANOTHER PROBLEM TO WORK OUT • SETUP: Suppose a competitive market for pizza is in long-run equilibrium. Then suppose that the government imposes a tax of $2 per pizza on all pizzas sold. • QUESTION: What happens in the market for pizza in the long-run? That is, what is the new equilibrium price, quantity for the industry, quantity for the typical firm, and profits of the typical firm?

16. [Notice that the questions are the same as in the first problem, even though the setup is different.]

17. Once again, start from the same template. The firm and industry are in long-run equilibrium. $/q $/Q SRS LRAC p* D q Q q* Q* Typical firm Industry PIZZA MARKET

18. LRAC+2 SRS+2 equal shifts The tax raises average cost and marginal cost by exactly $2. The SRS curve rises by $2 because it is the sum of the firms’ MC curves. $/q $/Q SRS=SRMC LRAC p* D q Q q* Q* Typical firm Industry PIZZA MARKET

19. WHAT WILL BE THE SHORT-RUN EFFECTS OF THE TAX?

20. Price will rise in the short-run, but by less than $2. LRAC+2 SRS+2 $/q $/Q SRS LRAC p* D q Q q* Q* Industry Typical firm PIZZA MARKET

21. WHAT WILL BE THE LONG-RUN EFFECTS, AND WHY? The typical firm is earning losses in the new short-run equilibrium. Therefore there is an incentive for some firms to leave the industry.

22. The new long-run equilibrium must have the typical firm earning zero profits. Firms leave the industry until price rises enough to make profit equal to zero.

23. SRS+2 but fewer firms LRAC+2 SRS+2 Q' In the long-run firms will leave, and supply will be reduced in the market. $/q $/Q SRS LRAC p* D q Q q* Q* Industry Typical firm PIZZA MARKET

24. Summary: 1) Price rises by $2 2) Firm quantity is unchanged 3) Industry quantity is less 4) Profits are unchanged (= 0 before & after) 5) There are fewer firms in the industry

25. We have assumed that the pizza industry was a constant cost industry. • In a constant cost industry entry and exit of firms leaves all input prices constant.

26. In an increasing cost industry entry of new firms drives up input prices, raising everyone’s costs. • This is probably the most common case in practice. • Examples: Hidden slide

27. In a decreasing cost industry the entry of new firms actually causes some input prices to fall, lowering everyone’s costs. • Occurs in practice, but examples are harder to find. • Example:

28. SUMMARY • In the long-run, profits are zero in a competitive industry. • Entry and exit of firms is the important market adjustment mechanism in the long-run.