Long-run Outcomes in Perfect Competition Micro: Econ: 24 60 Module Long-run Outcomes in Perfect Competition KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: Why does industry behavior differ between the short run and the long run? What determines the industry supply curve in both the short run and the long run? Is perfect competition efficient or not and why? The purpose of this module is to describe how the model of perfect competition adjusts to either profits or losses in the short run. This long-run adjustment process ensures each firm earns a normal profit and that the efficient level of resources is allocated to the production of the good.

The Industry Supply Curve Each identical firm’s short-run supply curve is their MC curve starting from the shut-down point (AVC curve) The short-run supply curve for the market is the summation of the firm supply curves The assumptions of perfect competition tell us that there are many small firms each producing an identical product. The implication of these assumptions is that each firm’s cost curves are identical as well.   The last module showed how, at least above the shut-down point, the marginal cost curve is each firm’s short-run supply curve. The firm will always observe the market price and then find the output level where P=MR=MC. If the price rises, output rises along the MC curve. If the price falls, output falls along the MC curve.

SR Industry Supply Curve Individual firms supply the profit-maximizing level of output determined by their MC curve (where P = MC, above AVC) Total output supplied in the market is equal to the output level of the firm times the number of firms in the industry. In the previous module we showed how the marginal cost curve is the short-run supply curve for each perfectly competitive firm. The assumptions of perfect competition tell us that there are many small firms each producing an identical product. The implication of these assumptions is that each firm’s cost curves are identical as well.   The last module showed how, at least above the shut-down point, the marginal cost curve is each firm’s short-run supply curve. The firm will always observe the market price and then find the output level where P=MR=MC. If the price rises, output rises along the MC curve. If the price falls, output falls along the MC curve. Total output supplied in the market is simply the summation of individual supply decisions.

Long-run Equilibrium At the long-run equilibrium in a perfectly competitive industry, firms earn a normal profit If the current price is high enough for firms to earn short-run economic profits, the profits will not last in the long run. Why not?   Note: this process is referred to as the long-run adjustment. Describe it first, and then adjust the graphs accordingly. Profits exist in the short run. -The market sees entry of new firms. -More producers in the market shift the short-run market supply curve to the right. -The price begins to fall in the market. -As the price falls, each firm produces less along the MC curve. -Profits for each firm fall. -When the price reaches the break-even point at the minimum of ATC, entry stops. As the short-run market supply shifts to the right, the price falls in the market. The firm responds by moving downward along the MC curve. The last firm enters when the price drops to where firms earn only normal profits (where P=ATC). Note: while each firm produces less, more total output is produced in the market because more firms now exist in the market. If the current price leads to losses for the firm, the losses will not last in the long run. Why not? Losses exist in the short run. -Firms exit -Fewer producers in the market shift the short-run market supply curve to the left. -The price begins to rise in the market. -As the price rises, each firm produces more along the MC curve. -Losses for each firm fall. -When the price reaches the break-even point at the minimum of ATC, exit stops. This is referred to as long-run equilibrium in the perfectly competitive market and for the firm.

Long-run Adjustment Process ATC S2 MC At P = $8, P > ATC, profit, firms enter, Supply shifts right, P falls, firm Q falls. MR 5 3 D Q Q 20,000

LR Industry Supply Curve When the entry of new firms does no affect the input costs in the industry it is called a constant cost industry and the long-run supply curve is horizontal   It is probably more realistic to assume an increasing cost industry. Entry of new firms increases the input costs for all firms. it is also possible for a market to have a downward sloping LRS curve. This is when a market is a decreasing cost industry. This would occur if entry of new firms actually caused inputs to become less costly. The text provides the market for electric cars as potentially a good example. As more firms produce the cars, the infant industry of lithium batteries explodes and average costs (due to economies of scale) fall as more batteries are produced.

Efficiency in Long-run Equilibrium The perfectly competitive outcome is efficient REVIEW: terms of efficiency – small group Productive efficiency – a firm is productively efficient if it makes the most goods at the lowest possible cost. What is our evidence for this? Allocative efficiency – a firm is allocatively efficient if they produce as many goods as possible at no loss to themselves In other words, both firms and buyers are maximally better off. What is our evidence for this? Recall that we use perfect competition as a benchmark. We will measure other market structures against the long-run outcome on three criteria.   1. Marginal cost is the same for all producers because price is the same for all producers. 2. Economic profit is equal to zero for all producers. All firms earn a normal profit in the long run. Because this can only happen at the minimum of ATC, we can say that firms produce this product at the lowest possible average cost. 3. The market is efficient. All consumers who are willing to pay the price that is greater than or equal to the sellers’ marginal cost will get to buy the good. In other words, there is no deadweight loss in perfect competition because all mutually beneficial transactions are made.

Practice Small group work – show how short run losses in perfect competition will drive up prices for consumers in the long run. Graph accurately, with all labels and relevant prices and quantities. Recall that we use perfect competition as a benchmark. We will measure other market structures against the long-run outcome on three criteria.   1. Marginal cost is the same for all producers because price is the same for all producers. 2. Economic profit is equal to zero for all producers. All firms earn a normal profit in the long run. Because this can only happen at the minimum of ATC, we can say that firms produce this product at the lowest possible average cost. 3. The market is efficient. All consumers who are willing to pay the price that is greater than or equal to the sellers’ marginal cost will get to buy the good. In other words, there is no deadweight loss in perfect competition because all mutually beneficial transactions are made.