Chapter 10: Perfect Competition in the Long Run
LONG-RUN VS SHORT-RUN IN PERFECT COMPETITION
Profit Maximization in the Long Run:
Three key assumptions:
Easy entry and exit: This is the only long-run adjustment considered.
Identical costs: All firms within the industry have identical cost structures.
Constant-cost industry: Entry and exit do not affect factor prices.
THE LONG-RUN ADJUSTMENT PROCESS IN PERFECT COMPETITION
After completing long-run adjustments in a perfectly competitive industry:
Price equals each firm's minimum Average Total Cost (min ATC).
Production occurs at min ATC.
Conclusions drawn from two basic facts:
Firms consistently seek profits and aim to avoid losses.
Under conditions of perfect competition, firms have the freedom to enter and exit the market.
Entry and Exit Dynamics:
When profits exist (P > ATC):
Firms will enter the market.
This entry increases the total supply in the market.
As a result, the market price will decline.
When losses exist (P < ATC):
Firms will exit the market as a reaction.
This causes a decrease in total supply in the market.
Consequently, the market price will increase.
TEMPORARY PROFITS AND RE-ESTABLISHMENT OF LONG-RUN EQUILIBRIUM
Graphical Representation:
FIGURE 10.1 illustrates the relationship between an individual firm's conditions and industry conditions illustrating temporary profits.
(a) Individual Firm Graph:
Price (P) on the y-axis, Quantity (q) on the x-axis.
ATC curves showing the average total costs relative to marginal revenue (MR) and marginal cost (MC) intersecting to define equilibrium points.
(b) Industry Graph:
Plots aggregate industry data with similar axes as the individual firm graph.
Effects of Demand Shift (D1 to D2):
A favorable shift in the demand curve causes economic profits.
Positive profits will attract new firms into the industry, creating increased supply which shifts the supply curve from S1 to S2.
The resulting increase in supply will continue until economic profits are driven back to zero.
IMPACT OF UNFAVORABLE DEMAND SHIFTS
When demand shifts unfavorably (D1 to D3), it can lead to losses:
Economic losses indicate that firms are not covering average total costs (P < ATC).
This situation prompts firms to exit the industry, thus decreasing supply from S1 to S3.
A decrease in supply raises the product price until losses are eliminated.
This concept is demonstrated in FIGURE 10.2, which includes both individual firm and industry graphs.
SUMMARY OF THE ADJUSTMENT PROCESS IN PERFECT COMPETITION
The fundamental takeaway is through market adjustments, either entry or exit of firms, the price, and output will eventually align such that firms can cover their costs, reaching a long-run equilibrium.
This adjustment process highlights the self-regulating nature of competitive markets, where profit incentives lead to resource allocation towards efficiency and innovation.