Long Run Perfect Competition

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Long Run Perfect Competition with Heterogeneous
Firms Overheads
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Summary of Long Run Competitive Equilibrium
1. In the long run, every competitive firm will
earn normal profit, that is, zero profit
2. In the long run, every competitive firm will
produce where price (P) is equal to marginal cost
(MC), P MC.
3. In the long run, every competitive firm will
produce where price (P) is equal to the minimum
of short run average cost (SRAC), P SRAC. This
implies zero economic profit.
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Summary (continued)
4. In the long run, every competitive firm will
produce where price (P) is equal to the minimum
of long run average cost (LRAC ATC), P
minimum LRAC. This implies that no identical
firms will want to enter or exit.
5. Putting it all together P MC min
SRAC min LRAC
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Long Run Equilibrium

Q
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Long run equilibrium for low cost firms
Not all firms are identical
Factors leading to different long run costs
Location
Control of strategic resources
Unique skills
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Different costs and competitive equilibrium
Price and minimum long run average cost
Will price fall to the minimum of LRAC?
For some firms but not others
Why doesnt the low cost firm take over?
Capacity
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Consider an industry with a low cost firm
This firm has inherently lower costs
Other firms have higher costs
Low cost firm cant supply entire industry at low
cost
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Long Run Equilibrium for Low-cost Firm


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Why dont other firms enter the market?
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The value (Profit) attributed to the
strategic resource earns economic rent


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q
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Economic rent is defined as what the supplier of
a good or service gets paid above and beyond the
amount necessary to induce it to supply the input
If this factor is special, the firm should be
able to sell it, because presumably, there is a
market for a factor that brings extra-normal
profits to its owner
Thus there is an opportunity cost to holding this
special factor
If we account for this opportunity cost, the firm
makes normal (zero) profit
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Changes in Market Equilibria
Short run changes in demand
Firms expand along SRMC
Other firms do not enter
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Short-run Response to a Change in Demand
S
D1
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Short Run Equilibrium

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Output
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Long run supply curves
Are they upward sloping?
It depends
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Constant cost industries
The costs of inputs are constant
Even if the industry uses lots more of them
Long run industry costs do not change
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Long-run Supply Curve in a Constant-cost Industry



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In the right panel of the figure, we see the
market supply and demand curves S1 and D1 for an
industry intersecting at point a and resulting in
an equilibrium price of pa. In the left panel of
this diagram we see the long-run and short-run
average and marginal cost curves for a
representative firm in the industry. To make
matters simple, let us assume that the cost
curves for all firms in the industry are
identical to these cost curves. Note that since
the price pa equals the minimum point on each
firm's long-run (and short-run) average cost
curve, price pa constitutes a long-run
equilibrium price for this market. Now, let
demand for this product shift to the right from
D1 to D2. In the short run, this increase in
demand will cause the price of the good to
increase from pa to pb. It will also cause each
firm in the industry to make extra-normal profits
equal to the area pbdce in the left panel of the
figure. Seeing these profits, other firms will
enter this industry, which will cause the supply
curve to shift to the right. As the supply curve
shifts to the right, the price of the good will
fall from its newly established level of pb.
How much the price will fall depends on what
happens to the cost of the inputs to production
for the firms in the industry as new firms enter.
In this figure it is assumed that as new firms
enter, the cost functions of all firms in the
industry will stay the same. This will be true
if inputs are in abundant supply and if the
industry we are looking at only consumes a small
share of the inputs in the market. In this case,
the expanded size of the industry will hardly be
noticed and input prices and costs will remain
unchanged. When costs do not change as new firms
enter an industry, the short-run market supply
curve will shift to S2, where the price of of the
good is reestablished at pa. Entry into the
industry will stop at this point. Note that the
resulting long-run supply curve (the dark arrowed
red line in the figure) is flat despite the fact
that each short-run supply curve is
upward-sloping. Industries such as this, in
which the long-run supply curve is flat, are
called constant-cost industries. In a constant
cost industry, the long run supply curve is
horizontal, because each firm's average total
cost curve is unaffected by changes in industry
supply.
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Pecuniary externalities
When the actions of one firm cause the price of
an input in the market to rise, we say that the
firm creates a pecuniary externality
When the actions of one firm cause the price of
an input in the market to fall, we say that the
firm creates a pecuniary economy
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Pecuniary externalities
Use of all the good land or deposits
Hiring of all the skilled labor
Locking up a whole range of patents
Signing of all the good baseball players
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Increasing cost industries
The costs of inputs rise
The cost of production rises
They rise because the demand for inputs rises as
industry output rises
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Long-run Supply Curve in an Increasing-cost
Industry


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With profits to existing firms, other firms will
enter
But input costs will rise with increased output
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Pecuniary economies
Economies of scale in input production
Increased competition among suppliers
Learning by doing
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Decreasing cost industries
The costs of inputs fall
The cost of production falls
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Long-run Supply Curve in a Decreasing-cost
Industry


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With higher prices, firms will expand output
With profits available, firms will enter the
industry
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Long-run Supply Curve in a Decreasing-cost
Industry


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q
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With higher prices, firms will expand output
With profits available, firms will enter the
industry
But input costs will fall with increased output
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The End