Long Run Perfect Competition with Heterogeneous Firms Overheads

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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.

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Long Run Perfect Competition

with Heterogeneous Firms

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

SRMC

SRAC

LRAC

P = MR = Demand

LRMC

q*

Long Run Equilibrium

\$

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

LRACHC

Profit

S

LRMC

LRAC

a

p*

c

b

D

P = MR = Demand

q*

Long Run Equilibrium for Low-cost Firm

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q

Q

Why don’t other firms enter the market?

LRACHC

S

LRMC

LRAC

a

p*

c

b

D

P = MR = Demand

q*

Economic Rent

The value (Profit) attributed to the strategic

resource earns economic rent

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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

\$

b

pb

a

pa

D2

qa

qb

Q

Short-run Response to a Change in Demand

S

D1

AVC

ATC

MC

pa

pb

qa

qb

Short Run Equilibrium

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0

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

S1

d

SRAC

SRMC

S2

LRAC

b

pb

pb

e

b

a

pa

pa

LRMC

c

D2

D1

qa

qb

Qa

Qb

Long-run Supply Curve in a Constant-cost Industry

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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 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 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

S1

S3

LRAC3

SRMC1

SRMC3

S2

LRAC1

b

pb

pb

pc

pc

c

a

pa

pa

b

D1

D2

Qc

qa

qb

Qa

Qb

Long-run Supply Curve in an Increasing-cost Industry

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Q

With profits to existing firms, other firms will enter

But input costs will rise with increased output

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

S1

LRAC1

SRMC1

b

pb

pb

pa

pa

a

D1

D2

qa

Qa

Long-run Supply Curve in a Decreasing-cost Industry

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q

Q

With higher prices, firms will expand output

With profits available, firms will enter the industry

S1

LRAC1

SRMC3

S3

SRMC1

b

LRAC3

pb

pb

pa

pa

a

c

pc

pc

D1

D2

Qc

qa

Qa

Long-run supply

Long-run Supply Curve in a Decreasing-cost Industry

\$

\$

0

q

Q

With higher prices, firms will expand output

With profits available, firms will enter the industry

But input costs will fall with increased output