1. 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
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2. 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.
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3. 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.
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4. 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.
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5. Long Run Equilibrium 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.
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6. 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 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.
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7. 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
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8. Long Run Supply Curves 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.
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9. LR Supply: Constant-Cost IndustryQ 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
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10. LR Supply: Increasing-Cost IndustryQ S P2
$55 Y2 P1
$50 Y1 P3
$45
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 ($45<$50 <$55). The long-run industry supply curve (S) therefore slopes upward through points Y3, Y1, and Y2. Y3 D2 D1 D3 Q3 Q1 Q2
90,000
100,000
110,000
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11. LR Supply: Decreasing-Cost IndustryQ X3 P3
$55 X1 P1
$50 X2 P2
$45 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
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12. 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.
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13. 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
For productive efficiency to be realized, price must equal minimum ATC and the condition for allocative efficiency is that price equal marginal cost.
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
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14. 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.
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15. 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.
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16. 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 s have affected traditional postal service. Online retailers like Amazon have taken business away from traditional bricks-and-mortar retailers.
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17. A Patent Failure?
Patents give the inventor exclusive rights to market and sell their product for 20 years
May hinder “creative destruction”
Eliminate patents on complicated, hard to copy products
Speed up innovation by increasing the opportunities of potential new competitors
Potential rival firms are hindered in their quest to bring new product to the market because of the fear of a patent infringement lawsuit. Some economists believe that eliminating patents on complicated consumer products, like iPhones, will increase innovation by eliminating the prospect of getting sued when producing product that may consist of thousands of different technologies that many other companies may hold a patent on. However, some economists do find it appropriate to continue to provide patent protection for those products that would be easy to copy and produce, such as pharmaceutical products.