Post on 25-Feb-2016
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Chapter 15
Competitive Markets in the Long Run
Objective•Long Run Equilibrium
▫Identical firms▫Heterogeneous firms
•Constant / Increasing/ Decreasing cost industries
•Welfare properties of competitive markets
LR or SR equilibrium?3
Price
FIRM 1 Market
0
Price
0
MC
q1e
ATC
π1
Q
S
D
pepe
Short-Run Equilibrium•Short run: A period of time not long
enough for▫Existing firms to adjust all factors of
production Firms will not be able to contract their
capital stock if they are making losses Firms will not be able to expand their capital
stock if they are making profits▫Outside firms to enter the market
4
q1K
1’ q1K1
The adjustment to a long-run equilibrium
5
Positive profits attract the entry and shift the supply curve to the right until each firm has a capacity of K* and the market supply curve is S*. In a long-run equilibrium, each firm produces q* units and earns zero profits
Quantity 0
Price, Cost
d
Quantity 0
Price, Cost
LRACSRACK
1
SRMCK1
LRMC
p*
q*
p1’b
f
p1
(a) (b)
D
S*
S2
S1
Long-Run Equilibrium for Identical Firms•Long-run equilibrium
▫(1) Firms - Quantity supplied - no change ▫(2) Consumers
Quantity demanded - no change ▫(3) Existing firms
Inputs - no change No exit
▫(4) New firms – don’t enter▫(5) Aggregate supply = Aggregate demand
6
The Long-Run Equilibrium forHeterogeneous Firms
•Difference in long-run costs▫Location / assets
7
Heterogeneous Firms8
Why do firms have different ATC curves?
PriceFIRM 1
PriceFIRM 2
PriceFIRM 3
0
Price
0 00
MC MC MC
q1e
ATC
π1
ATC
q2e
π2
ATC
q3e qe=q1
e+q2e+q3
e
S
D
pepe
The Long-Run Equilibrium forHeterogeneous Firms
•Economic rent▫Return to an input
Over and above Need to secure it
•Rent-inclusive average cost▫Average cost ▫Economic rent - included as a cost
9
Rent and long-run competitive equilibria
10
LRAC’ includes the opportunity cost of the firm’s special asset or location
Quantity 0
Price, Cost
Quantity 0
Price(a) (b)
D
S
p*p*
LRAC’
LRACMC
a
bc
Dynamic Changes in Market Equilibria•In the short run
▫Supply is upward sloping•The long run supply can be
▫Flat▫Upward sloping▫Downward sloping
• The shape of the LR supply will depend on how entry affects the costs of production
11
Dynamic Changes in Market Equilibria•Constant-cost industries
▫Flat long-run supply curve▫As new firms enter
No change in cost functions
12
Constant-cost industries13
With constant costs, the long-run response to an increase in demand re-establishes the original price of pa.
Quantity 0 Quantity 0
Price
D1
S1
paa
Cost
SRAC
LRAC
SRMC
D2
bpb
S2
Long-run supply curve
Increasing-cost industries•Pecuniary externality
▫Action of one agent Other agents: increase in price
•Increasing-cost industries▫Upward sloping long-run supply curve▫As new firms enter
Increase costs of inputs LRAC curves – shift up
14
Increasing-cost industries15
With increasing costs, the long-run response results in a higher price
Quantity 0 Quantity 0
Price
D1
S1
pa
a
Cost LRAC1
D2
bpb
Long-run supply curve
LRAC2
S3
pcc
Decreasing-cost industries▫Downward sloping long-run supply curve▫As new firms enter
Decrease costs of inputs LRAC curves – shift down
16
Decreasing-cost industries17
With decreasing costs, the long-run response results in a lower price.
Quantity 0 Quantity 0
Price
D1
S1
pa
a
Cost LRAC1
D2
bS2
Long-run supply curve
LRAC2
pcc
Why Are Long-Run Competitive Equilibria So Good?
•Welfare Proposition # 1: Consumer & producer surplus are maximized▫No deadweight loss
•Welfare Proposition # 2: Price is set at marginal cost
•Welfare Proposition # 3: Goods are produced at the lowest possible cost and the most efficient manner
18
B
A
Welfare Proposition # 1: Consumer & producer surplus are maximized
19
Quantity 0
Price
D
S
g
q*
p* d
p1
e f
q1’
c
q1
Welfare Proposition #2: Price is set at marginal cost
•Firms maximize profit▫Take prices as given in a competitive
market▫Produce until P=MC
Welfare Proposition #3: Goods produced at lowest possible cost
21
Quantity 0
Price
Quantity 0
Price
K*
q*
(a) (b)
D
S
p*p*