Perfect Competition in the Long-run

Entry & Exit Dynamics Recall, the long-run is the time period in which all inputs can be adjusted and new firms can enter and existing firms can exit the market There are three key scenarios, If Profit < 0 (i.e. P < AC) then existing firms exit This decreases the supply and the market supply curve shifts left Price (P) increases and quantity (Q) decreases Price continues to increase and quantity continues to decrease until no firms have incentives to exit (i.e. until existing firms earn zero profits. That is, P = AC)

If Profit = 0 (i.e. P = AC) then no firms have an incentive to enter or exit the market If Profit > 0 (i.e. P > AC) then new firms enter This increases the supply and the market supply curve shifts right Price (P) decreases and quantity (Q) increases Price continues to decrease and quantity continues to increase until no firms have incentives to enter (i.e. until existing firms earn zero profit. That is, P = AC)

Long-run Equilibrium There are several conditions of long-run equilibrium for perfect competition Economic profit is zero for individual firms and the industry. There is no tendency for firms to enter or leave the industry All existing firms are earning normal profit For a single firm, long-run equilibrium occurs at the point where MR = MC = P = ATC

Changes in Demand & Equilibrium Changes in demand temporarily change the equilibrium quantity and price. Increase in demand An Increase in demand temporarily raises price Higher prices draw in new competitors Increased supply returns price to equilibrium Decrease in demand A decrease in demand temporarily lowers price Lower prices drive away some competitors Decreased supply returns price to equilibrium

Example; Long-run Equilibrium Example; Suppose at the initial equilibrium, we have P1 and Q1 Each firm earns zero profit since P = AC Now, suppose that there is an increase in demand The market demand curve shifts to the right and price increases Now, P > AC and existing firms earn positive profit New firms enter the market The market supply increases and shifts the supply curve to the right Price decreases and quantity increases

Price will continue to decrease and quantity will continue to increase until P = AC

Pure Competition & Efficiency In purely competitive markets both productive and allocative efficiency are achieved in the long-run Productive Efficiency: the production of a good in the least costly way In the long-run, pure competition forces firms to produce at the minimum average total cost of production Price = Minimum ATC Allocative Efficiency: the particular mix of goods and services produced is the most highly valued by society In pure competition, profit-motivated firms produce each good or service to the point where price (marginal benefit) and marginal cost are equal Price = MC

Consumer and Producer Surplus After long-run adjustments, purely competitive markets maximize the combined amounts of consumer surplus and producer surplus Consumer Surplus: is the difference between the maximum price a consumer is willing to pay and the market price Producer Surplus: is the difference between the minimum price that producers are willing to accept and the market price

Solution- (10 Marks/20 Minutes) Example; Efficiency Question: Using a diagram, explain how allocative and productive efficiency will be achieved in long-run equilibrium in perfect competition. Solution- (10 Marks/20 Minutes) Productive Efficiency: is the production of a good or service in the least costly way In the long-run, a perfectly competitive firm produces at the minimum average total cost of production (i.e. Price = min ATC) Allocative Efficiency: the goods and service that are produced are those that are most highly valued by society Price = MC

In the long-run, competitive forces drive the price towards equilibrium where P = MC = min ATC This is illustrated in the diagram below, There are three different scenarios in the short-run, If a firm is losing money in the short-run then in the long-run it will exit the industry, thereby driving prices higher as fewer firms will be producing the good.

Weaker firms with higher costs can’t compete and exit the industry. This promotes productive efficiency because firms are forced to try to minimize their costs of production In contrast, if a firm is earning supernormal profits in the short-run, where explicit and implicit costs are covered and exceeded ,then more firms enter the industry This drives the price down as more firms begins to compete and produce the good or service This ensures allocative efficiency because prices are driven down to the point where the marginal benefit is just equal to the marginal cost (i.e. P = MC ) Lastly, if a firm is earning zero economic profit, where implicit and explicit costs are just covered ,then it is in the long-run equilibrium.

No firm has any incentive to enter or exit the industry This occurs where P = MC = min ATC Perfect competition ensures productive and allocative efficiency in the long run because competitive forces allocate resources where they are most highly-valued.

Study Questions 1) Why do individual firms in a perfectly competitive market face horizontal demand curve? 2) Willy’s Diner, a perfectly competitive firm, sells its “breakfast special” for $5. The average variable cost (e.g. waiters, cooks, power and food) is $3.95 per meal and the average fixed cost (e.g. the lease, insurance, and costs of equipment) is $1.25 per meal. What should Willy’s Diner do in the short-run and in the long-run? 3) Merck is a pharmaceutical company in the US. Assume the American drug market is perfectly competitive Draw a graph and show the equilibrium price and quantity Suppose the firm is making a positive profit in the short-run. Show this on a graph with the demand curve, MC and AC curve