Pure Competition in the Long Run Chapter 11 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. The benefits of a competitive environment that brings new products and technological advancement is discussed along with an interesting look at the desirability of patents in the Last Word. Pure Competition in the Long Run

The Long Run in Pure Competition In the long-run Firms can expand or contract capacity Firms can enter or 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 limits 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 of firms do not affect resource prices In our model we assume 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. Begin by assuming entry and exit of firms do not affect the prices of the resources used by those in the industry. LO1

Long Run Adjustment Process Adjustment process in pure competition Firms seek profits and shun losses Firms are free to enter or to exit Production will occur at firm’s minimum average total cost Price will equal minimum average total cost As firms seek profits, they will be attracted to industries that are experiencing economic profits. As firms enter the market, the supply curve shifts to the right creating downward pressure on price. As the price falls, economic profits diminish and eventually are reduced to zero. This leaves the firm with a normal profit which is a part of total costs and thus a part of average total costs and Price equals minimum ATC. If an industry is experiencing economic losses, firms will leave causing the supply curve to shift to the left. As supply falls, the product price rises until the economic losses are eliminated and Price equals minimum ATC. Once the industry has completed the long-run adjustment process, it is in long-run equilibrium. LO2

Long Run Equilibrium Firms enter Supply increases Price falls Entry eliminates profits Firms enter Supply increases Price falls Exit eliminates losses Firms leave 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. LO2

Entry Eliminates Economic Profits Single firm (b) Industry P q Q 100 90,000 80,000 100,000 ATC MR MC $60 50 40 D1 S1 D2 S2 These graphs show temporary profits and the re-establishment of long-run equilibrium in a representative firm and 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. LO2

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 Temporary losses and the re-establishment of long-run equilibrium in a single firm and in the industry. A decrease in demand temporarily lowers price. Lower prices drive away some competitors and the decrease in supply returns price to equilibrium. D3 LO2

Long Run Supply Curves Entry/exit does not affect LR ATC Constant-cost industry Entry/exit does not affect LR ATC Constant resource prices Special case Increasing-cost industry Most industries LR ATC increases with expansion Specialized resources Decreasing-cost industry In the first scenario, the constant-cost industry, the number of firms entering or leaving the industry do not affect costs. In the 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 the product increases, firms will enter the industry causing input costs to fall. The long-run supply curve is downsloping. LO3

Pure Competition and Efficiency In the long run, efficiency is achieved Productive efficiency Producing where P = minimum ATC Allocative efficiency Producing where P = MC Triple equality P= MC= minimum ATC Consumer surplus and producer surplus are maximized Productive efficiency is producing goods in the least costly way. Allocative efficiency is producing the mix of goods most desired by society. This triple equality means that pure competition leads to the most efficient use of society’s resources. Another bonus is consumer surplus and producer surplus are maximized in the long run in pure competition. Consumer surplus is defined as the difference between the maximum that consumers would be willing to pay and the market price. Producer surplus is the difference between the minimum producers would be willing to accept for their product and the market price. Note: P=min ATC=MC does not occur in decreasing cost industries. LO4

Dynamic Adjustments Changes in consumer tastes Resource supplies 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. LO4

Technological Advance and 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. LO5

Creative Destruction Competition and innovation may lead to “creative destruction” Creation of new products and methods may destroy 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. LO5