Long Run Perfect Competition

with Heterogeneous Firms

Overheads

1. In the long run, every competitive firm will earn normal profit, that is, zero profit

2. In the long run, every competitive firm will produce where price (P) is equal to marginal cost (MC), P = MC.

3. In the long run, every competitive firm will produce where price (P) is equal to the minimum of short run average cost (SRAC), P = SRAC. This implies zero economic profit.

Summary of Long Run Competitive EquilibriumSummary of Long Run Competitive Equilibrium

4. In the long run, every competitive firm will produce where price (P) is equal to the minimum of long run average cost (LRAC = ATC), P = minimum LRAC.This implies that no identical firms will want to enter or exit.

5. Putting it all together:

P = MC = min SRAC = min LRAC

Summary (continued)

P = MR = Demand

SRACSRMC

q*

LRMC

LRAC

Q

$

Long Run Equilibrium

Long run equilibrium for low cost firms

Not all firms are identical

Factors leading to different long run costs

Location

Control of strategic resources

Unique skills

Different costs and competitive equilibrium

Price and minimum long run average cost

Why doesn’t the low cost firm take over?

Capacity

Will price fall to the minimum of LRAC?

For some firms but not others

Consider an industry with a low cost firm

This firm has inherently lower costs

Other firms have higher costs

Low cost firm can’t supply entireindustry at low cost

Long Run Equilibrium for Low-cost Firm

0 Q

$

q*

a

bc

q

S

D

$

P = MR = Demand

p*

LRACLRMC

Why don’t other firms enter the market?

LRACHC

Profit

0 Q

$

a

bc

q

$

q*

S

DP = MR = Demand

p*

LRACLRMC

Economic Rent

The value (Profit) attributed to the strategicresource earns economic rent

LRACHC

Economic rent is defined as what the supplier of a good or service gets paid above and beyond the amount necessary to induce it to supply the input

If this factor is special, the firm should be able to sell it, because presumably, there is a market for a factor that brings extra-normal profits to its owner

Thus there is an opportunity cost to holding this special factor

If we account for this opportunity cost, the firm makes normal (zero) profit

Changes in Market Equilibria

Short run changes in demandShort run changes in demand

Firms expand along SRMC

Other firms do not enter

Q

$

S

D1

D2

Short-run Response to a Change in Demand

pa

qa

apb

qb

b

qb

Short Run Equilibrium

0

Output

$

AVC

ATC

MC

pb

pa

qa

Long run supply curves

Are they upward sloping?

It depends

Constant cost industries

The costs of inputs are constant

Even if the industry uses lots more of them

Long run industry costs do not change

pa pa

S1

D1

LRAC

Long-run Supply Curve in a Constant-cost Industry

0 Q

$

q

$

a

Qa

SRAC SRMC

qb

D2

b

b

Qb

S2

Long-run supply

pbpb

d

c

e

LRMC

qa

In the right panel of the figure, we see the market supply and demand curves S1 and D1 for an industry intersecting at point a and resulting in an equilibrium price of pa. In the left panel of this diagram we see the long-run and short-run average and marginal cost curves for a representative firm in the industry. To make matters simple, let us assume that the cost curves for all firms in the industry are identical to these cost curves. Note that since the price pa equals the minimum point on each firm's long-run (and short-run) average cost curve, price pa constitutes a long-run equilibrium price for this market.

Now, let demand for this product shift to the right from D1 to D2. In the short run, this increase in demand will cause the price of the good to increase from pa to pb. It will also cause each firm in the industry to make extra-normal profits equal to the area pbdce in the left panel of the figure. Seeing these profits, other firms will enter this industry, which will cause the supply curve to shift to the right. As the supply curve shifts to the right, the price of the good will fall from its newly established level of pb.

How much the price will fall depends on what happens to the cost of the inputs to production for the firms in the industry as new firms enter. In this figure it is assumed that as new firms enter, the cost functions of all firms in the industry will stay the same. This will be true if inputs are in abundant supply and if the industry we are looking at only consumes a small share of the inputs in the market. In this case, the expanded size of the industry will hardly be noticed and input prices and costs will remain unchanged. When costs do not change as new firms enter an industry, the short-run market supply curve will shift to S 2, where the price of of the good is reestablished at pa. Entry into the industry will stop at this point. Note that the resulting long-run supply curve (the dark arrowed red line in the figure) is flat despite the fact that each short-run supply curve is upward-sloping. Industries such as this, in which the long-run supply curve is flat, are called constant-cost industries.

In a constant cost industry, the long run supply curve is horizontal, because each firm's average total cost curve is unaffected by changes in industry supply.

Pecuniary externalities

When the actions of one firm cause the priceof an input in the market to rise, we saythat the firm creates a pecuniary externality

When the actions of one firm cause the priceof an input in the market to fall, we saythat the firm creates a pecuniary economy

Pecuniary externalities

Use of all the “good” land or deposits

Hiring of all the skilled labor

Signing of all the good baseball players

Locking up a whole range of patents

Increasing cost industries

The costs of inputs rise

They rise because the demand for inputs rises as industry output rises

The cost of production rises

cpc pc

SRMC1

paa

pa

S2

Qb

b

LRAC1

S1

D1

Long-run Supply Curve in an Increasing-cost Industry

0 Q

$

q

$

Qa

pbpb

D2

b

LRAC3SRMC3

S3

Long-run supply

Qcqb

With profits to existing firms, other firms will enter

qa

But input costs will rise with increased output

Pecuniary economies

Economies of scale in input production

Learning by doing

Increased competition among suppliers

Decreasing cost industries

The costs of inputs fall

The cost of production falls

qa

pa pa

LRAC1SRMC1b

D2

Long-run Supply Curve in a Decreasing-cost Industry

0 Q

$

q

$S1

D1

pbpb

a

Qa

With higher prices, firms will expand output

With profits available, firms will enter the industry

qa

SRMC3

pa pa

LRAC1SRMC1b

D2

Long-run Supply Curve in a Decreasing-cost Industry

0 Q

$

q

$

pc pc

S1

D1

c

Qc

S3

Long-run supply

pbpb

LRAC3

a

Qa

With higher prices, firms will expand output

But input costs will fall with increased output

With profits available, firms will enter the industry

The End