Competitive Industry Equilibrium and Response to Changes in its Environment

Industry Equilibrium Short Run (SRE) –Each firm is maximizing profit –Supply = Demand Long Run (LRE) –Short run conditions plus –Firms making zero economic profit

The Adjustment Process Consider an industry in LRE that experiences an increase in demand This results in an increase in price and quantity through a movement along the SR supply curve. Existing firms increase output and earn economic profits. Economic profits attract resources because new firms find it profitable to enter.

Entry of firms shifts the supply curve to the right, lowering price and profits Entry continues until price is such that economic profit is zero Typical firm’s output returns to original level in a constant factor industry Short run adjustment is by existing firms increasing output while long term adjustment is caused by entry of new firms.

The Effects of a Specific Tax Have to keep the typical firm and the market in view Key point is that the firm’s per unit costs will increase by the amount of the tax but in the short run, the price of the product will increase by less than the tax unless demand is perfectly inelastic.

If the industry was in long run equilibrium (LRE), the typical firms now find that it is suffering economic losses. It also finds it profitable to produce less output than before. As a result, industry output declines. Over the long run firms leave the industry, shifting the supply curve to the left. This continues until economic profit is zero and the tax is borne fully by consumers. Typical firm output is back to the original

Effects in the Long Run Over the long run firms leave the industry, shifting the supply curve to the left. This continues until economic profit is zero and the tax is borne fully by consumers. Typical firm output is back to the original

Adjustment in a Competitive Industry Profit plays the key role: resources are attracted by positive profit and repelled by losses Existing firms do the adjusting in the short run Entry or exit responsible for adjustment over the long run

The Effects of a Lump-sum Tax Example of lump-sum tax: license fee, property tax. Since the tax is, in effect, an addition to fixed cost, it raises the output at which minimum average total cost occurs. Since it has no effect on variable cost, it will not affect output in the short run. So, no effect on price in short run. Tax borne by seller.

Effect in the Long Run Because of negative profits, firms will leave the industry Exit of firms shifts the supply curve to the left. This will continue until economic profits are restored to zero There will be reduced output, increased price, and the typical firm will be larger

Other Comments Contrast Specific versus Lump-sum Tax A $9 increase in AVC would have the same effects as a $9 per unit tax A $1,000 increase in FC would have the same effect as a $1,000 lump-sum tax.