Transcript Lec 20

Perfect
Competition
Profit and Loss and the Long Run
• In a competitive market, economic profit and loss are the
forces driving long-run change
– Expectation of continued economic profit (losses) causes
outsiders (insiders) to enter (exit) the market
• In real world entry and exit occur literally every day
– In some cases, we see entry occur through formation of an
entirely new firm
– Entry can also occur when an existing firm adds a new product
to its line
• Exit can occur in different ways
– Firm may go out of business entirely, selling off its assets and
freeing itself once and for all from all costs
– Firm switches out of a particular product line, even as it
continues to produce other things
From Short-Run Profit to Long-Run
Equilibrium
• As we enter long-run, much will change
– Economic profit will attract new entrants
• Increasing number of firms in market
– As number of firms increases, market supply curve will
shift rightward causing several things to happen
» Market price begins to fall
» As market price falls, demand curve facing each firm
shifts downward
» Each firm—striving as always to maximize profit—will
slide down its marginal cost curve, decreasing output
From Short-Run Profit to Long-Run
Equilibrium
• This process of adjustment—in the market and
the firm—continues until…well, until when?
– When the reason for entry—positive profit—no longer
exits
– Requires market supply curve to shift rightward
enough, and the price to fall enough
• So that each existing firm is earning zero economic profit
• In a competitive market, positive economic profit
continues to attract new entrants until economic
profit is reduced to zero
Figure 8(a/b): From Short-Run
Profit To Long-Run Equilibrium
Market
Firm
S1
Price per
Bushel
A
$4.50
Dollars
With initial supply
curve S1, market
price is $4.50…
$4.50
So each firm
earns an
economic profit.
MC
A
d
ATC 1
D
900,000
Bushels
per Year
9,000
Bushels
per Year
Figure 8(c/d): From Short-Run
Profit To Long-Run Equilibrium
Market
Firm
S1
Price per
Bushel
S2
Dollars
MC
A
$4.50
A
d
ATC 1
$4.50
E
E
2.50
d1
2.50
D
900,000 1,200,000Bushels
per Year
Profit attracts entry, shifting
the supply curve rightward…
5,000
9,000
until market price falls to
$2.50 and each firm earns
zero economic profit.
Bushels
per Year
From Short-Run Loss to Long-Run
Equilibrium
• What if we begin from a position of loss?
– Same type of adjustments will occur, only in the
opposite direction
• In a competitive market, economic losses
continue to cause exit until losses are reduced to
zero
• When there are no significant barriers to exit
– Economic loss will eventually drive firms from the
industry
• Raising market price until typical firm breaks even again
Distinguishing Short-Run from
Long-Run Outcomes
• In short-run equilibrium, competitive firms can earn
profits or suffer losses
– In long-run equilibrium, after entry or exit has occurred,
economic profit is always zero
• When economists look at a market, they automatically
think of short-run versus long-run
– Choose the period more appropriate for the question at hand
• Basic Principle #7: Short-Run versus Long-Run
Outcomes
– Markets behave differently in the short-run and the long run
– In solving a problem, we must always know which of these time
horizons we are analyzing
The Notion of Zero Profit in Perfect
Competition
• We have not yet discussed plant size of
competitive firm
• The same forces—entry and exit—that
cause all firms to earn zero economic
profit also ensure
– In long-run equilibrium, every competitive firm
will select its plant size and output level so
that it operates at minimum point of its LRATC
curve
Perfect Competition and Plant Size
• Figure 9(a) illustrates a firm in a perfectly competitive
market
– But panel (a) does not show a true long-run equilibrium
– How do we know this?
• In long-run typical firm will want to expand
• Why?
– Because by increasing its plant size, it could slide down its LRATC
curve and produce more output at a lower cost per unit
– By expanding firm could potentially earn an economic profit
• Same opportunity to earn positive economic profit will attract new
entrants that will establish larger plants from the outset
• Entry and expansion must continue in this market until
the price falls to P*
– Because only then will each firm—doing the best that it can do—
earn zero economic profit
Figure 9: Perfect Competition and
Plant Size
1. With its current plant and ATC
curve, this firm earns zero
economic profit.
Dollars
3. As all firms increase plant size and
output, market price falls to its lowest
possible level . . .
Dollars
MC1
LRATC
LRATC
ATC1
d1 = MR1
MC2 ATC
P1
2
E
P*
2. The firm could earn
positive profit with a
Output per 4. and all firms earn
q1 larger plant,
q*
Period
producing here.
zero .economic profit
and produce at
minimum LRATC.
d2 = MR2
Output per
Period
A Summary of the Competitive
Firm in the Long-Run
• Can put it all together with a very simple
statement
– At each competitive firm in long-run equilibrium
• P = MC = minimum ATC = minimum LRATC
• In figure 9(b), this equality is satisfied when the
typical firm produces at point E
– Where its demand, marginal cost, ATC, and LRATC
curves all intersect
• In perfect competition, consumers are getting
the best deal they could possibly get
A Change in Demand
• Short-run impact of an increase in demand is
– Rise in market price
– Rise in market quantity
– Economic profits
• What happens in long-run after demand curve
shifts rightward?
– Market equilibrium will move from point A to point C
• Long-run supply curve
– Curve indicating quantity of output that all sellers in a
market will produce at different prices
• After all long-run adjustments have taken place
Figure 10: An Increasing-Cost
Industry
INITIAL EQUILIBRIUM
Market
Price
per Unit
Firm
Dollars
MC
S1
ATC1
P1
P1
A
A
d1 = MR1
D1
Q1
Output per
Period
q1
Output per
Period
Figure 10: An Increasing-Cost
Industry
NEW EQUILIBRIUM
Price
per Unit
Market
S1
B
PSR
P1
MC
B
S2
PSR
dSR = MRSR
C
SLR
P2
Firm
Dollars
P2
C
P1
A
A
ATC2
ATC1d = MR
2
2
d1 = MR1
D2
D1
Q1 QSR Q2
Output per
Period
q1 q1 q1
Output per
Period
Increasing, Decreasing, and
Constant Cost Industries
• Increase in demand for inputs causes
price of those inputs to rise
• This type of industry (which is the most
common) is called an increasing cost
industry
– Entry causes input prices to rise
• Shifts up typical firm’s ATC curve
– Raises market price at which firms earn zero economic
profit
» As a result, long-run supply curve slopes upward
Increasing, Decreasing, and
Constant Cost Industries
• Other possibilities
– Industry might use such a small percentage of total inputs that—
even as new firms enter—there is no noticeable effect on input
prices
• Called a constant cost industry
– Entry has no effect on input prices, so typical firm’s ATC curve stays
put
» Market price at which firms earn zero economic profit does not
change
» Long-run supply curve is horizontal
– Decreasing cost industry, in which entry by new firms actually
decreases input prices
• Entry causes input prices to fall
– Causes typical firm’s ATC curve to shift downward
» Lowers market price at which firms earn zero economic profit
» As a result, long-run supply curve slopes downward
Market Signals and the Economy
• In real world, demand curves for different goods and
services are constantly shifting
• As demand increases or decreases in a market, prices
change
• Economy is driven to produce whatever collection of
goods consumers prefer
• In a market economy, price changes act as market
signals, ensuring that pattern of production matches
pattern of consumer demands
– When demand increases, a rise in price signals firms to enter
market, increasing industry output
– When demand decreases, a fall in price signals firms to exit
market, decreasing industry output
Market Signals and the Economy
• Market signal
– Price changes that cause firms to change their
production to more closely match consumer demand
• No single person or government agency directs
this process
– This is what Adam Smith meant when he suggested
that individual decision makers act for the overall
benefit of society
• Even though, as individuals, they are merely trying to satisfy
their own desires
• As if guided by an invisible hand
Reference: Introduction to
Economics
by
Lieberman & Hall
Chapter seven: Perfect
Competition
Slides by John F. Hall