Long Run Perfect Competition
with Heterogeneous Firms
Overheads
Summary of Long Run Competitive Equilibrium
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 (continued)
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
Long Run Equilibrium
$
SRAC
SRMC
LRAC
P = MR = Demand
LRMC
q*
Q
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
Will price fall to the minimum of LRAC?
For some firms but not others
Why doesn’t the low cost firm take over?
Capacity
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 entire
industry at low cost
Long Run Equilibrium for Low-cost Firm
$
LRACH
$
S
C
Profit
LRMC
LRAC
a
p*
c
b
D
P = MR = Demand
0
q*
q
Why don’t other firms enter the market?
Q
The value (Profit) attributed to the strategic
resource earns economic rent
LRACHC
$
$
S
LRMC
LRAC
a
p*
c
b
D
P = MR = Demand
0
q*
q
Economic Rent
Q
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 demand
Firms expand along SRMC
Other firms do not enter
Short-run Response to a Change in Demand
$
S
b
pb
pa
a
D2
D1
qa
qb
Q
Short Run Equilibrium
AVC
ATC
$
MC
pa
pb
0
qa
qb
Output
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
Long-run Supply Curve in a Constant-cost Industry
Long-run supply
$
$
SRAC
d
S1
SRMC
LRAC
pb
e
pa
S2
b
pb
pa
LRMC
b
a
c
D2
D1
0
qa qb
q
Qa
Qb
Q
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 p b.
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 S2,
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 price
of an input in the market to rise, we say
that the firm creates a pecuniary externality
When the actions of one firm cause the price
of an input in the market to fall, we say
that the firm creates a pecuniary economy
Pecuniary externalities
Use of all the “good” land or deposits
Hiring of all the skilled labor
Locking up a whole range of patents
Signing of all the good baseball players
Increasing cost industries
The costs of inputs rise
The cost of production rises
They rise because the demand for inputs
rises as industry output rises
Long-run Supply Curve in an Increasing-cost Industry
Long-run supply
$
$
S3
SRMC1 LRAC3
SRMC3
b
LRAC1
pb
pc
pa
pb
pc
pa
S2
c
a
b
D1
0
S1
qb
q
Qa
D2
Qc Q b
With profits to existing firms, other firms will enter
But input costs will rise with increased output
Q
Pecuniary economies
Economies of scale in input production
Increased competition among suppliers
Learning by doing
Decreasing cost industries
The costs of inputs fall
The cost of production falls
Long-run Supply Curve in a Decreasing-cost Industry
$
S1
$
SRMC1
LRAC1
pb
pb
pa
pa
b
a
D1 D2
0
qa
q
Qa
With higher prices, firms will expand output
With profits available, firms will enter the industry
Q
Long-run Supply Curve in a Decreasing-cost Industry
$
S1
$
SRMC1
SRMC3 LRAC1
pb
LRAC3 pb
pa
pc
pa
pc
S3
b
a
c
D1 D2
0
qa
q
Qa
Qc
Long-run supply
With higher prices, firms will expand output
With profits available, firms will enter the industry
But input costs will fall with increased output
Q
The End