COMPETITION IN THE
LONG-RUN
In the short-run the number of firms in a competitive
industry is fixed.
In the long-run new firms can enter or existing firms can
leave a competitive industry.
Competition in the long-run
slide 1
The key to understanding when new firms will want to
come into an industry, or existing firms leave, lies in
role of profits.
Because profits are the difference between revenue and
opportunity cost, the existence of profit means a firm
is earning more on its invested resources than it could
get in its next best alternative.
Competition in the long-run
slide 2
On the other hand, if a firm earns losses (negative
profits) then it can earn more on its invested resources
in some alternative use.
Competition in the long-run
slide 3
If the typical firm in an industry is earning economic
profit, then this provides an incentive for other firms to
come into the industry to take advantage of the
opportunity.
If the best a typical firm in an industry can do is earn
losses, then that firm has a strong incentive to leave the
industry.
The objective here is to see what happens to a market
when this sort of entry and exit is possible.
Competition in the long-run
slide 4
The pizza market is in short-run equilibrium at a price p’.
There are currently 500 firms, and the typical pizza firm can
make economic profits.
The question to answer here is what will happen in the long-run,
that is, when new firms can come into the industry.
$/q
$/Q
S (500 firms)
mc
LRAC
p’
D
q’
q
Typical firm
Q
Q’
Industry
PIZZA MARKET
Competition in the long-run
slide 5
The supply provided by newly entering
firms will cause the market supply curve to
move to the right.
So Q rises and price falls.
$/q
$/Q
S (500 firms)
mc
LRAC
S (700 firms)
p’
p”
D
q’
q
Typical firm
Q
Q’
Industry
PIZZA MARKET
Competition in the long-run
slide 6
When and where will this process end?
Where is the new equilibrium?
A LONG-RUN EQUILIBRIUM
MUST HAVE ZERO
ECONOMIC PROFIT FOR THE
TYPICAL FIRM.
Competition in the long-run
slide 7
$/q
$/Q
S (500 firms)
LRAC
S (700 firms)
S (1000
firms)
p*
D
q*
Typical firm
q
Q’
Q*
Industry
PIZZA MARKET
Competition in the long-run
slide 8
Q
The LR equilibrium price is p*.
The firm’s LR equilibrium quantity
is q*.
The LR equilibrium market quantity
is Q*.
$/q
$/Q
LRAC
S (1000
firms)
p*
D
q*
Typical firm
q
Q*
Industry
PIZZA MARKET
Competition in the long-run
slide 9
Q
Competitive market equilibrium in the long-run:
1) Price must settle at the bottom of the firm’s long-run
average cost curve.
2) Profits of the typical firm must be zero.
3) The number of firms will adjust to provide the market
quantity demanded at that price.
4) Market price is still determined by short-run supply
and demand.
Competition in the long-run
slide 10
PROBLEMS TO WORK OUT
SETUP: Suppose a competitive market for pizza is in
long-run equilibrium. Then suppose there is an
increase in the market demand for pizza.
QUESTION: What happens in the market for pizza in
the long-run? That is, what is the new equilibrium
price, quantity for the industry, quantity for the typical
firm, and profits of the typical firm?
Competition in the long-run
slide 11
Always start to answer questions
about long-run equilibrium from this
template.
$/q
$/Q
SRS
LRAC
p*
D
q*
Typical firm
q
Industry
PIZZA MARKET
Competition in the long-run
Q
Q*
Hidden slides
slide 12
In the new equilibrium:
1) price is unchanged
2) firm’s quantity is unchanged
3) industry quantity is increased
4) firm’s profits are unchanged
Competition in the long-run
slide 15
Notice that in the competitive model resources flow to
their most valued uses.
In the last example, people demanded more pizza and
that’s what they got. More of society’s resources
flowed into the pizza industry.
Competition in the long-run
slide 16
ANOTHER PROBLEM TO WORK
OUT
SETUP: Suppose a competitive market for pizza is in
long-run equilibrium. Then suppose that the
government imposes a tax of $2 per pizza on all pizzas
sold.
QUESTION: What happens in the market for pizza in
the long-run? That is, what is the new equilibrium
price, quantity for the industry, quantity for the typical
firm, and profits of the typical firm?
Competition in the long-run
slide 17
[Notice that the questions are the same as in the first
problem, even though the setup is different.]
Competition in the long-run
slide 18
Once again, start from the same template.
The firm and industry are in long-run
equilibrium.
$/q
$/Q
SRS
LRAC
p*
D
q*
Typical firm
q
Q
Q*
Industry
PIZZA MARKET
Competition in the long-run
slide 19
The tax raises average cost and marginal cost by exactly
$2. The SRS curve rises by $2 because it is the sum of the
firms’ MC curves.
LRAC+2
$/q
SRS+2
$/Q
SRS=SRMC
LRAC
equal shifts
p*
D
q*
Typical firm
q
Q
Q*
Industry
PIZZA MARKET
Competition in the long-run
slide 20
WHAT WILL BE THE SHORT-RUN EFFECTS OF THE TAX?
Competition in the long-run
slide 21
Price will rise in the short-run, but by less than $2.
LRAC+2
$/q
SRS+2
$/Q
SRS
LRAC
p*
D
q*
q
Q
Q*
Industry
Typical firm
PIZZA MARKET
Competition in the long-run
slide 22
WHAT WILL BE THE LONG-RUN EFFECTS, AND WHY?
The typical firm is earning losses in the new short-run
equilibrium. Therefore there is an incentive for some firms
to leave the industry.
Competition in the long-run
slide 23
The new long-run equilibrium must have
the typical firm earning zero profits.
Firms leave the industry until price rises
enough to make profit equal to zero.
Competition in the long-run
slide 24
In the long-run firms will leave, and supply will
be reduced in the market.
SRS+2 but fewer firms
SRS+2
LRAC+2
$/q
$/Q
SRS
LRAC
p*
D
q*
q
Q
Q' Q*
Industry
Typical firm
PIZZA MARKET
Competition in the long-run
slide 25
Summary:
1) Price rises by $2
2) Firm quantity is unchanged
3) Industry quantity is less
4) Profits are unchanged (= 0 before & after)
5) There are fewer firms in the industry
Competition in the long-run
slide 26
We have assumed that the pizza industry was a constant
cost industry.
In a constant cost industry entry and exit of firms leaves
all input prices constant.
Competition in the long-run
slide 27
In an increasing cost industry entry of new firms drives
up input prices, raising everyone’s costs.
This is probably the most common case in practice.
Examples:
Hidden slide
Competition in the long-run
slide 28
In a decreasing cost industry the entry of new firms
actually causes some input prices to fall, lowering
everyone’s costs.
Occurs in practice, but examples are harder to find.
Example:
Competition in the long-run
slide 30
SUMMARY
In the long-run, profits are zero in a competitive
industry.
Entry and exit of firms is the important market
adjustment mechanism in the long-run.
Competition in the long-run
slide 31