3.3 Short-run and long-run equilibrium in perfect competition
4 min read•august 16, 2024
Perfect competition's short-run and are key to understanding market dynamics. In the short run, firms can only adjust variable inputs, leading to potential profits or losses. Prices equal marginal costs, but not necessarily average total costs.
The long run allows for entry and exit of firms, as well as adjustments to all inputs. This process continues until economic profits are zero, with prices equaling both marginal and average total costs. Understanding these equilibria is crucial for grasping market efficiency.
Short-run vs Long-run Equilibrium
Time Horizons and Input Adjustments
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- occurs when firms maximize profits with fixed costs and market conditions
- Firms can only adjust variable inputs (labor, raw materials)
- Time horizon varies by industry (weeks to months for restaurants, years for manufacturing plants)
- Long-run equilibrium allows for entry/exit of firms and adjustment of all factors of production
- All inputs become variable (capital, technology, labor)
- Time horizon typically longer (months to years) depending on industry characteristics
Profit Conditions and Market Dynamics
- Short-run equilibrium may result in economic profits or losses for firms
- Firms producing where marginal revenue equals
- Economic profits attract new entrants, losses may cause exits
- Long-run equilibrium leads to zero for all firms
- Price equals both marginal cost and
- No incentive for firms to enter or exit the market
- Number of firms remains constant in short-run, can change in long-run
- Short-run: fixed number of competitors
- Long-run: alters market structure
Short-run Equilibrium for Firms
Profit Maximization and Supply Curves
- Short-run equilibrium occurs when market price equals marginal cost of production
- Firms produce where marginal revenue (price in perfect competition) equals marginal cost
- Short-run supply curve is the firm's marginal cost curve above average variable cost
- Represents the quantity supplied at each price level
- Industry supply curve is horizontal sum of all firms' marginal cost curves above AVC
- Aggregates individual firm responses to price changes
Economic Outcomes and Production Decisions
- Firms may earn economic profits, incur losses, or break even in short-run
- Depends on relationship between price and average total cost
- Economic profit: Price > ATC
- Economic loss: Price < ATC
- Break-even: Price = ATC
- Production continues if price exceeds average variable cost
- Firms cover variable costs and portion of fixed costs
- Example: Restaurant operating during slow season to cover food and labor costs
- Shutdown point occurs when price falls below average variable cost
- Firm minimizes losses by ceasing production
- Example: Seasonal business closing during off-peak months
Long-run Adjustment in Perfect Competition
Market Entry and Exit Dynamics
- Long-run adjustment driven by firm entry/exit responding to profits/losses
- Economic profits attract new entrants to the market
- Increases industry supply, driving down market price
- Example: Surge in food delivery services during pandemic
- Economic losses cause firms to exit the market
- Decreases industry supply, driving up market price
- Example: Closure of brick-and-mortar retailers facing online competition
- Adjustment continues until zero economic profit achieved
- Price equals marginal cost and minimum average total cost
- No incentive for further entry or exit
Industry Supply and Production Scale
- Firms adjust production scale to minimize average total cost
- Respond to changing market conditions and competition
- Example: Automakers retooling factories for electric vehicle production
- Long-run industry supply curve derived from entry/exit and cost structures
- Horizontal: Constant cost industry (agriculture)
- Upward-sloping: Increasing cost industry (manufacturing)
- Downward-sloping: Decreasing cost industry (technology)
- Industry reaches long-run equilibrium when all firms produce at efficient scale
- Optimal balance of fixed and variable inputs
- Example: Optimal farm size in agricultural production
Zero Economic Profit in Long-run Equilibrium
Economic vs Accounting Profit
- Zero economic profit means firms cover all opportunity costs
- Includes explicit costs and normal return on investment
- Does not imply zero accounting profit
- Firms earn just enough to justify continued operation
- Cover costs of labor, capital, and entrepreneurship
- Example: Small business owner earning market wage for their labor
Efficiency and Market Stability
- Long-run equilibrium ensures allocative and
- Price equals marginal cost ()
- Firms produce at minimum average total cost (productive efficiency)
- Zero economic profit creates stable market equilibrium
- No incentive for entry or exit
- Resources allocated optimally across industries
- Serves as benchmark for comparing other market structures
- Monopoly, oligopoly, monopolistic competition often deviate from this ideal
Factors Affecting Long-run Equilibrium
- Barriers to entry prevent zero economic profit equilibrium
- Legal restrictions (patents, licenses)
- High capital requirements (utilities, manufacturing)
- Product differentiation can create quasi-monopoly power
- Brand loyalty, unique features
- Example: Apple's ecosystem of products and services
- Government intervention may distort market outcomes
- Subsidies, price controls, regulations
- Example: Agricultural price supports affecting market equilibrium
Key Terms to Review (16)
Allocative Efficiency: Allocative efficiency occurs when resources are distributed in a way that maximizes the total benefit to society, meaning that goods and services are produced at the level where consumer demand equals the cost of production. This condition is met when the price of a good or service reflects the marginal cost of producing it, ensuring that resources are allocated to their most valued uses.
Average Total Cost: Average total cost (ATC) is the total cost of production divided by the quantity of output produced, representing the per-unit cost of production. It includes both fixed and variable costs, giving a comprehensive view of the cost structure a firm faces. Understanding ATC is crucial for firms as it influences pricing decisions and profitability in different market conditions, especially under perfect competition where firms aim to minimize costs to remain competitive.
Consumer Surplus: Consumer surplus is the difference between what consumers are willing to pay for a good or service and what they actually pay. It reflects the extra benefit or utility consumers receive when they purchase a product at a lower price than they were prepared to pay.
Economic Profit: Economic profit is the difference between total revenue and total costs, including both explicit and implicit costs. It goes beyond simple accounting profit by considering opportunity costs, which are the benefits missed when choosing one alternative over another. This measure helps understand how well resources are being utilized in an economy, affecting decisions in various market structures, including the dynamics of competition and monopoly.
Free Entry and Exit: Free entry and exit refers to the unrestricted ability of firms to enter or leave a market without significant barriers, influencing competition and market dynamics. This concept is crucial for maintaining competition, as it allows new firms to enter when profits are high and exit when they incur losses, leading to an efficient allocation of resources. The presence of free entry and exit is a defining feature of perfectly competitive markets and significantly impacts the behavior of firms in monopolistic competition.
Homogeneous Products: Homogeneous products are goods that are identical in nature and quality, making them perfect substitutes for each other. In a market characterized by homogeneous products, consumers perceive no difference between the offerings of different firms, which leads to price being the only competitive factor. This quality is fundamental to understanding how firms operate in a perfectly competitive market where efficiency, equilibrium, and profit maximization are crucial elements.
Long-run equilibrium: Long-run equilibrium is a state in a market where firms have had enough time to enter or exit, resulting in no economic profits or losses, and where the quantity supplied equals the quantity demanded. In this state, firms produce at an output level where their average total costs are minimized, and consumers are satisfied with the price and quality of the goods available. This concept is crucial for understanding how different market structures function over time, particularly in the dynamics of competition and the ability for firms to adjust their operations.
Marginal Cost: Marginal cost is the additional cost incurred by producing one more unit of a good or service. It plays a crucial role in decision-making for firms, as it helps determine optimal production levels, pricing strategies, and resource allocation. Understanding marginal cost also relates to how firms behave in various market structures and influences overall market efficiency and economic growth.
Market Supply and Demand: Market supply and demand refer to the relationship between the quantity of a good or service that producers are willing to sell at different prices (supply) and the quantity that consumers are willing to purchase at those prices (demand). This interaction determines the market price and quantity of goods sold, and is crucial for understanding short-run and long-run equilibrium in perfect competition, where the market reaches a point where supply equals demand.
Normal Profit: Normal profit is the minimum level of profit needed for a company to remain competitive in the market, where total revenue equals total costs, including both explicit and implicit costs. This concept reflects the idea that firms must cover all their opportunity costs, which means earning enough to compensate for the resources used, including the entrepreneur's time and investment. In equilibrium, normal profit signals that firms are neither making economic profits nor incurring losses, maintaining a stable market environment.
Price Taker: A price taker is an individual or firm that must accept the prevailing market price for a product or service, rather than being able to influence that price through their own actions. This concept is vital in markets characterized by perfect competition, where numerous buyers and sellers exist, ensuring that no single entity has the power to affect the market price. Price takers face a horizontal demand curve at the market price, meaning they can sell any quantity of goods at that price but cannot sell at a higher price due to competition.
Producer Surplus: Producer surplus is the difference between what producers are willing to accept for a good or service and what they actually receive, often represented graphically as the area above the supply curve and below the market price. It measures the benefit producers gain from selling at a market price that is higher than their minimum acceptable price, reflecting their overall profitability and efficiency in production.
Productive efficiency: Productive efficiency occurs when a firm produces its goods at the lowest possible cost, utilizing resources in the most effective way without wasting any. Achieving this means that a firm is operating on its production possibilities frontier, where it cannot produce more of one good without sacrificing the production of another, making it a crucial concept in understanding how firms can maximize their output and minimize costs.
Shifts in Demand: Shifts in demand refer to a change in the quantity demanded of a good or service at every price level, caused by factors other than the good's price. This can occur due to changes in consumer preferences, income levels, the prices of related goods, or demographic shifts, leading to a new demand curve that is either positioned to the right (increase in demand) or to the left (decrease in demand). Understanding shifts in demand is crucial for analyzing how markets adjust in both the short run and long run, particularly within competitive markets.
Shifts in Supply: Shifts in supply refer to the changes in the quantity of a good or service that producers are willing and able to sell at various prices, caused by factors other than the good's price. This concept is crucial in understanding how market dynamics operate, especially when analyzing the balance between supply and demand in perfect competition. An outward shift indicates an increase in supply, often due to lower production costs or advancements in technology, while an inward shift signifies a decrease, reflecting higher costs or unfavorable conditions.
Short-run equilibrium: Short-run equilibrium is a market condition where the quantity supplied equals the quantity demanded at a specific price level, with firms unable to fully adjust their resources and production levels due to fixed factors. In this scenario, firms may earn economic profits or losses, but they will typically not change their number of firms in the market until long-run adjustments take place. This concept is crucial in understanding how different market structures operate in the short run, particularly in contexts of monopolistic competition and perfect competition.