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*