2. slide 1Competition in the long-run In the short-run the number of firms in a competitive industry is fixed. In the long-run new firms can enter or existing firms can leave a competitive industry. COMPETITION IN THE LONG-RUN

3. slide 2Competition in the long-run The key to understanding when new firms will want to come into an industry, or existing firms leave, lies in role of profits. Because profits are the difference between revenue and opportunity cost, the existence of profit means a firm is earning more on its invested resources than it could get in its next best alternative.

4. slide 3Competition in the long-run On the other hand, if a firm earns losses (negative profits) then it can earn more on its invested resources in some alternative use.

5. slide 4Competition in the long-run If the typical firm in an industry is earning economic profit, then this provides an incentive for other firms to come into the industry to take advantage of the opportunity. If the best a typical firm in an industry can do is earn losses, then that firm has a strong incentive to leave the industry. The objective here is to see what happens to a market when this sort of entry and exit is possible.

6. slide 5Competition in the long-run Typical firmIndustry PIZZA MARKET $/q $/Q qQ LRAC S (500 firms) D Q’ The pizza market is in short-run equilibrium at a price p’. There are currently 500 firms, and the typical pizza firm can make economic profits. p’ q’ mc The question to answer here is what will happen in the long-run, that is, when new firms can come into the industry.

7. slide 6Competition in the long-run Typical firmIndustry PIZZA MARKET $/q $/Q qQ LRAC S (500 firms) D Q’ p’ q’ mc S (700 firms) The supply provided by newly entering firms will cause the market supply curve to move to the right. So Q rises and price falls. p”

8. slide 7Competition in the long-run A LONG-RUN EQUILIBRIUM MUST HAVE ZERO ECONOMIC PROFIT FOR THE TYPICAL FIRM. When and where will this process end? Where is the new equilibrium?

9. slide 8Competition in the long-run Typical firmIndustry PIZZA MARKET $/q $/Q qQ LRAC S (500 firms) D Q’ p* q*Q* S (700 firms) S (1000 firms)

10. slide 9Competition in the long-run Typical firm Industry PIZZA MARKET $/q $/Q qQ LRAC D S (1000 firms) p* q*Q* The LR equilibrium price is p*. The firm’s LR equilibrium quantity is q*. The LR equilibrium market quantity is Q*.

11. slide 10Competition in the long-run Competitive market equilibrium in the long-run: 1) Price must settle at the bottom of the firm’s long-run average cost curve. 2) Profits of the typical firm must be zero. 3) The number of firms will adjust to provide the market quantity demanded at that price. 4) Market price is still determined by short-run supply and demand.

12. slide 11Competition in the long-run PROBLEMS TO WORK OUT SETUP: Suppose a competitive market for pizza is in long-run equilibrium. Then suppose there is an increase in the market demand for pizza. QUESTION: What happens in the market for pizza in the long-run? That is, what is the new equilibrium price, quantity for the industry, quantity for the typical firm, and profits of the typical firm?

13. slide 12Competition in the long-run Typical firm Industry PIZZA MARKET $/q $/Q qQ LRAC p* q*Q* SRS D Always start to answer questions about long-run equilibrium from this template. Hidden slides

14. slide 13Competition in the long-run Typical firm Industry PIZZA MARKET $/q $/Q qQ LRAC p* q*Q* SRS D D’ SRS’ Q’ Demand increases. So P and Q rise at first. Supply increases as the number of firms grows. So market Q is higher, but P is unchanged.

15. slide 14Competition in the long-run Typical firm Industry PIZZA MARKET $/q $/Q qQ LRAC p* q*Q* SRS D D’ SRS’ Q’ LRS Industry Long-run Supply Curve Here’s the industry long-run supply curve.

16. slide 15Competition in the long-run In the new equilibrium: 1) price is unchanged 2) firm’s quantity is unchanged 3) industry quantity is increased 4) firm’s profits are unchanged

17. slide 16Competition in the long-run Notice that in the competitive model resources flow to their most valued uses. In the last example, people demanded more pizza and that’s what they got. More of society’s resources flowed into the pizza industry.

18. slide 17Competition in the long-run ANOTHER PROBLEM TO WORK OUT SETUP: Suppose a competitive market for pizza is in long-run equilibrium. Then suppose that the government imposes a tax of $2 per pizza on all pizzas sold. QUESTION: What happens in the market for pizza in the long-run? That is, what is the new equilibrium price, quantity for the industry, quantity for the typical firm, and profits of the typical firm?

19. slide 18Competition in the long-run [Notice that the questions are the same as in the first problem, even though the setup is different.]

20. slide 19Competition in the long-run Typical firm Industry PIZZA MARKET $/q $/Q qQ LRAC p* q*Q* SRS D Once again, start from the same template. The firm and industry are in long-run equilibrium.

21. slide 20Competition in the long-run Typical firm Industry PIZZA MARKET $/q $/Q qQ LRAC p* q*Q* SRS= SR MC D LRAC+2 SRS+2 The tax raises average cost and marginal cost by exactly $2. The SRS curve rises by $2 because it is the sum of the firms’ MC curves. equal shifts

22. slide 21Competition in the long-run WHAT WILL BE THE SHORT-RUN EFFECTS OF THE TAX?

23. slide 22Competition in the long-run Typical firm Industry PIZZA MARKET $/q $/Q qQ LRAC p* q*Q* SRS D LRAC+2 SRS+2 Price will rise in the short-run, but by less than $2.

24. slide 23Competition in the long-run WHAT WILL BE THE LONG-RUN EFFECTS, AND WHY? The typical firm is earning losses in the new short-run equilibrium. Therefore there is an incentive for some firms to leave the industry.

25. slide 24Competition in the long-run The new long-run equilibrium must have the typical firm earning zero profits. Firms leave the industry until price rises enough to make profit equal to zero.

26. slide 25Competition in the long-run Typical firm Industry PIZZA MARKET $/q $/Q qQ LRAC p* q*Q* SRS D In the long-run firms will leave, and supply will be reduced in the market. LRAC+2 SRS+2 Q' SRS+2 but fewer firms

27. slide 26Competition in the long-run Summary: 1) Price rises by $2 2) Firm quantity is unchanged 3) Industry quantity is less 4) Profits are unchanged (= 0 before & after) 5) There are fewer firms in the industry

28. slide 27Competition in the long-run We have assumed that the pizza industry was a constant cost industry. In a constant cost industry entry and exit of firms leaves all input prices constant.

29. slide 28Competition in the long-run In an increasing cost industry entry of new firms drives up input prices, raising everyone’s costs. This is probably the most common case in practice. Examples: Hidden slide

30. slide 29Competition in the long-run Typical firm Industry PIZZA MARKET $/q $/Q qQ LRAC p* q*Q* SRS D Q’ D’ Demand increases. So P and Q rise at first. SR Supply increases as the number of firms grows. So market Q is higher, and P is higher. SRS’ LRAC’ LRS But input prices rise, causing costs to increase. AN INCREASING COST INDUSTRY The long-run supply curve is positively sloped!

31. slide 30Competition in the long-run In a decreasing cost industry the entry of new firms actually causes some input prices to fall, lowering everyone’s costs. Occurs in practice, but examples are harder to find. Example:

32. slide 31Competition in the long-run SUMMARY In the long-run, profits are zero in a competitive industry. Entry and exit of firms is the important market adjustment mechanism in the long-run.