Today

1
Today

• SR market equilibrium
• Changes in equilibrium
• LR equilibrium

2
Short-Run Market Equilibrium

• The price must clear the market (QD QS).
• Every firm must be profit-maximizing, given its
  costs and the market price.
• Firms may be making profits or losses.

3
Graph of SR Market Equilibrium
P
P
Typical Firm
Industry or Market
SRS
MC
ATC
P
P
AVC
D
q
Q
Q
Does this firm produce in the short run? If so,
how much?
4
Graph of SR Market Equilibrium
P
P
Typical Firm
Industry or Market
SRS
MC
ATC
P
P MR
AVC
D
q
Q
q
Q
Does this firm make profits in the short run? If
so, how much?
5
Graph of SR Market Equilibrium
P
P
Typical Firm
Industry or Market
SRS
MC
ATC
P
P MR
AVC
D
q
Q
q
Q
P - ATC profit per unit. Does the rectangle go
to the bottom of ATC?
6
Decrease in Demand
P
P
Typical Firm
Industry or Market
SRS
MC
ATC
P
AVC
PMR
D
D
q
Q
q
q
Q
Q
ATC - P loss per unit. Does the rectangle go to
the bottom of ATC?
7
Results of Decrease in Demand

• Market price falls.
• Firm responds by cutting its output.
• This firm makes losses but still produces in the
  short run. (Why?)
• Market quantity falls.

8
Further Decrease in Demand
P
P
Typical Firm
Industry or Market
SRS
MC
ATC
P
AVC
P MR
D
D
D
q
q
Q
Q
q
q
Q
Q
What does this firm do in the short run? Why?
9
Firm Supply in the Long Run

• If price is less than ATC, a firm makes losses in
  the short run.
• Such a firm will shut down in the long run.
• Therefore, the firms long-run supply curve is
  its marginal cost curve above ATC.

10
Graphing the Firms Supply Curve
P
LRS
SRS
MC
ATC
P3
AVC
P2
P1
P0
q
11
Long-Run Equilibrium

• The key to understanding the LR is firm entry and
  exit.

12
The Key

• Profits are a signal for resources to flow into
  the industry new firms enter.
• Losses are a signal for resources to leave the
  industry firms exit.

13
Conditions for Long Run Equilibrium

• The market price clears the market.
• Firms must max. profits, given their SR
  constraints.
• Firms do not make profits or losses.
• Firms must be at their lowest SRAC, given their
  level of production.
• The assumption room for many firms implies
  firms produce at the lowest level of their LRAC
  curve.

14
Adjustment to LR Equilibrium
P
P
Typical Firm
Industry or Market
SRS
MC
ATC
P
P
D
q
Q
Q
What do you expect will happen in the long run?
15
Adjustment to LR Equilibrium
P
P
Typical Firm
Industry or Market
SRS
MC
SRS
ATC
P
P
P
D
q
Q
Q
Profits attract entry. Price falls. Firms
output falls, market output rises (why?). What
happens to the firms profits? Is this LR
equilibrium?
16
Adjustment to LR Equilibrium
P
P
Typical Firm
Industry or Market
SRS
MC
SRS
ATC
SRS
P
P
P
D
q
Q
q
Q
Q
Entry continues until the firm no longer earns
profits. Is this LR equilibrium?
17
LR Equilibrium
P
P
Typical Firm
Industry or Market
MC
LRATC
ATC
SRS
P
D
q
Q
q
Q
Q
In long run equilibrium, firms in a perfectly
competitive market will operate at the lowest
point on their LRAC curves.
18
Adjustment to LR equilibrium Case of Initial
Profits

• Profits attract new firms into the market,
  increasing market supply.
• Market price falls. All firms must cut back
  output and see lower profits.
• Market quantity rises, though, due to larger
  number of firms.
• Process continues until profits fall to zero.

19
Initial Losses
P
P
Typical Firm
Industry or Market
SRS
MC
ATC
P
AVC
PMR
D
q
Q
q
Q
Why is this not LR equilibrium? What will happen
in the LR?
20
Firm Exit

• If a firm is making losses, then it will get out
  of business as soon as possible
• expiration of lease, sale of property, etc.
• Exception if it expects market conditions to
  improve soon enough, it may decide to wait it
  out.
• May wait for others to exit first, or demand to
  increase. Note this could be quite costly. We
  usually ignore this possibility.

21
Initial Losses
P
P
Typical Firm
Industry or Market
SRS
SRS
MC
ATC
P
AVC
PMR
PMR
D
q
Q
q
Q
Firms exit. Market price rises. Remaining firms
produce more. Losses shrink. Market output falls.
Is this a LR equilibrium?
22
Initial Losses
P
P
Typical Firm
Industry or Market
SRS
SRS
SRS
MC
ATC
P
AVC
PMR
PMR
D
q
Q
Q
q
Q
q
Firms exit until none make losses. Is this a LR
equilibrium?
23
Coming Up

• LR Industry Supply3 Cases
• Market Efficiency

24
Group Work

• Problems on Handout
• LR supply
• Industry supply
• SR industry equilibrium