The Long Run and Industry Changes
LR perfect competition
The Long Run and Industry Changes
Assume all firms have same costs
All firms have same technology – same MC, ATC, AVC
Long-run equilibrium
In the long-run, profit=0. Why? If profits were greater than zero other firms would enter because this market must be earning greater profits than other markets. (Think: free entry ants – profits are like food left out at a picnic)
Assume we have a constant cost industry. This means that a change in the number of firms has no effect on input prices. This is most reasonable when firms consume a small portion of inputs (ie, taxi market). If the number of taxis increase we don’t expect that this will bid up prices in the car market, thus increasing the cost of cars. So with a constant cost industry, when the number of firms change, there is no effect on the cost curves.
As firms enter, this causes the market supply to shift right. An increase in market supply causes the price in the market to drop, resulting in a lower MR curve. The perfectly competitive firm reoptimizes and sets MR=MC and now produces a smaller quantity than before. Profits are now smaller but still positive. So the process continues. More firms enter, market supply shifts right, the price falls further until the point of 0 profits. At this point, firms have no more incentive to enter.
The same story holds for if profits were negative. Firms will exit, causing supply to shift left. Cost curves don’t change because we’re assuming this is a constant cost industry. This causes price to increase, therefore MR decreases, firm repoptimizes and loss is decreased. Firms exit until 0 profits.
Market changes
Constant cost industry with increase in demand
Market demand increases. As a result, price increases and the quantity supplied by a firm increases. This firm is making positive profits.
Seeing that firms in this particular market are making a positive profit, other firms will enter causing supply to increase. As a result, price decreases.
Firms can enter b/c of perfect competition
B/c it is a constant cost industry, an increase in number of firms does not cause cost curves to change
This process will continue until profits are zero and the market is again at a long-run equilibrium. In the end, there are more firms in this market and each is producing qo.
Ex) Suppose there is a constant cost industry where firms are making 0 profit. Suppose demand decreases. Over the long run, we expect ___________ firms and ________ price in the market.
Fewer; lower
More; higher
The same; the same
Fewer; higher
Fewer; the same
Results of perfect competition
Good is produced is lowest possible cost in LR.
Produce at minimum ATC in LR
Why?
0 profits imply P=ATC
Profit maximization implies P=MR=MC
Therefore, MC=ATC, which we know occurs at minimum point on ATC curve
Free entry and exit allows efficient allocation of capital among industries
Summarize main results from this section.
Thacher Econ 106 4
