Pure Competition in the Long Run 12 Pure Competition in the Long Run The long‑run equilibrium position for a competitive industry is shown by reviewing the process of entry and exit in response to relative profit levels in the industry. Long‑run supply curves and the conditions of constant, increasing, and decreasing costs are explored. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The Long Run in Pure Competition In the long run: Firms can expand or contract capacity Firms enter and exit the industry Recall that in the short run the industry is fixed in both the number of sellers and the plant size of existing sellers. In the long run all of these restrictions are relaxed. LO1

Profit Maximization in the Long Run Easy entry and exit The only long run adjustment we consider Identical costs All firms in the industry have identical costs Constant-cost industry Entry and exit do not affect resource prices In our model all firms have identical costs. Therefore, they will all make the same production decisions since they also all face the same market price. The goal of the firm is to make profits and avoid losses. This is easy to do in pure competition due to the easy entry into the industry and easy exit out of the industry. LO2

Entry eliminates profits Firms enter Supply increases Price falls Long-Run Equilibrium Entry eliminates profits Firms enter Supply increases Price falls Exit eliminates losses Firms exit Supply decreases Price rises Profits attract firms from less profitable industries and losses cause them to leave the unprofitable industry to find another more profitable one. This reflects the supply determinant, a change in the number of sellers. LO3

Entry Eliminates Economic Profits Single Firm (b) Industry P q Q 100 90,000 80,000 100,000 S1 MC $60 50 40 ATC $60 50 40 S2 MR D2 D1 These graphs show temporary profits and the re-establishment of long-run equilibrium in (a) a representative firm and (b) the industry. A favorable shift in demand (D1 to D2) will upset the original industry equilibrium and produce economic profits. As a result, those profits will entice new firms to enter the industry, increasing supply (S1 to S2) and lowering product price until economic profits are once again zero. In other words, an increase in demand temporarily raises price. Higher prices draw in new competitors. Increased supply returns price to equilibrium. LO3

Exit Eliminates Losses Single Firm (b) Industry P q Q 100 90,000 80,000 100,000 S3 MC $60 50 40 $60 50 40 ATC S1 MR D1 D3 Temporary losses and the re-establishment of long-run equilibrium in (a) a representative firm and (b) the industry. A decrease in demand temporarily lowers price. Lower prices drive away some competitors and the decrease in supply returns price to equilibrium LO3

Constant cost industry Entry/exit does not affect LR ATC Long Run Supply Constant cost industry Entry/exit does not affect LR ATC Constant resource price Special case Increasing cost industry Most industries LR ATC increases with expansion Specialized resources Decreasing cost industry In this first scenario, the constant-cost industry, the number of firms entering or leaving the industry do not affect costs. In this second scenario, entry or exit of firms does affect costs. When firms enter the industry, input costs will increase as firms enter the industry and input costs will fall as firms exit the industry. The long-run supply curve is upsloping. In the decreasing cost industry, as the number of firms increase or decrease due to entry or exit, the industry costs change inversely. If demand for their product falls, firms will leave the industry causing input costs to rise. If demand for their product increases, firms will enter the industry causing input costs to fall. The long-run supply curve is downsloping. LO4

LR Supply: Constant-Cost Industry Q P1 P2 P3 $50 S Z3 Z1 Z2 In a constant-cost industry, entry and exit of firms does not affect resource prices and therefore does not affect per-unit costs. So an increase in demand raises output but not price. Similarly, a decrease in demand reduces output but not price. Therefore, the long-run supply curve is horizontal. D3 D1 D2 Q3 Q1 Q2 90,000 100,000 110,000 LO4

LR Supply: Increasing-Cost Industry Q S P2 $55 Y2 P1 $50 Y1 P3 $40 Y3 The long-run supply curve for an increasing-cost industry is upsloping. In an increasing-cost industry, the entry of new firms in response to an increase in demand (D3 to D1 to D2) will bid up resource prices and thereby increase unit costs. As a result, an increased industry output (Q3 to Q1 to Q2) will be forthcoming only at higher prices ($55>$50 > $45). The long-run industry supply curve (S) therefore slopes upward through points Y3, Y1, and Y2. D2 D1 D3 Q3 Q1 Q2 90,000 100,000 110,000 LO4

LR Supply: Decreasing-Cost Industry Q X3 P3 $55 X1 P1 $50 X2 P2 $40 S The long-run supply curve for a decreasing-cost industry is downsloping. In a decreasing-cost industry, the entry of new firms in response to an increase in demand (D3 to D1 to D2) will lead to decreased input prices and, consequently, decreased unit costs. As a result, an increase in industry output (Q3 to Q1 to Q2) will be accompanied by lower prices ($55 > $50 > $45). The long-run industry supply curve (S) therefore slopes downward through points X3, X1, and X2. D3 D2 D1 Q3 Q1 Q2 90,000 100,000 110,000 LO4

Pure Competition and Efficiency In the long run, efficiency is achieved Productive efficiency Producing where P = min. ATC Allocative efficiency Producing where P = MC Productive efficiency is producing goods in the least costly way. Allocative efficiency is producing the mix of goods most desired by society. Another bonus is consumer surplus and producer surplus are maximized in the long run in pure competition. Note: P=min ATC=MC does not occur in decreasing cost industries. LO5

Pure Competition and Efficiency Single Firm Market Price Quantity P=MC=Minimum ATC (Normal Profit) MC Consumer Surplus S ATC P MR P Producer Surplus Productive Efficiency: Price=minimum ATC Allocative Efficiency: Price=MC Pure competition achieves both efficiencies in its long-run equilibrium. This is important because it indicates the firm is using the most efficient technology, charging the lowest price, and producing the greatest output consistent with its costs. The firm is using society’s scarce resources in accordance with consumer preferences. The sum of consumer surplus (green area) and producer surplus (blue area) is maximized. D Qf Qe LO5

Purely competitive markets will automatically adjust to: Dynamic Adjustments Purely competitive markets will automatically adjust to: Changes in consumer tastes Resource supplies Technology Recall the “Invisible Hand” Dynamic adjustments will occur automatically in pure competition when changes in demand, resource supplies, or technology occur. Disequilibrium will cause expansion or contraction of the industry until the new equilibrium at P = MC occurs. “The invisible hand” works in a competitive market system since no explicit orders are given to the industry to achieve the P = MC result. The profit motivation brings about highly desirable economic outcomes. LO6

Technological Advance: Competition Entrepreneurs would like to increase profits beyond just a normal profit Decrease costs by innovating New product development Innovation means using better technology or improved business organization. New product development means the firm may be first to the market with a new product but others will soon follow and may destroy the innovating firm’s position. LO6

Competition and innovation may lead to “creative destruction” Creation of new products and methods destroys the old products and methods Creative destruction refers to the idea that the creation of new products and new production methods destroys the market positions of firms committed to existing products and old ways of doing business. An example of creative destruction is the CD (compact disc) being replaced with music downloads. Faxes and emails have affected traditional postal service. Online retailers like Amazon have taken business away from traditional bricks-and-mortar retailers. LO6

Efficiency Gains from Entry Patent protected prescription drugs earn substantial economic profits for the pharmaceutical company. Generic drugs become available as the patent expires on the existing drug. Results in a 30-40% reduction price Greater consumer surplus and efficiency Patents give firms 20 years exclusive rights to a product. In medicine, the patent application may use up some of this time and once the product hits the market, it may have only some of that 20-year right left. Patents are used to encourage research and development of new drugs and provide the pharmaceutical company enough time to recoup the R&D expenditures invested in the drug. This new competition can result in a 30-40% reduction in the drug’s price. Consumer surplus increases and efficiency is enhanced as a result.

Efficiency Gains from Entry P1 b c d f P2 This new competition can result in a 30-40% reduction in the drug’s price. Consumer surplus increases and efficiency is enhanced as a result. D Q1 Q2