6.2 Short-run and long-run equilibrium in competitive markets
4 min read•july 30, 2024
Competitive markets are all about balance. In the short run, firms can make profits or losses as they adjust to market conditions. But in the long run, things even out as companies enter or leave the market.
This balancing act is key to understanding how competitive markets work. We'll look at how firms make decisions in the short run and how markets reach equilibrium over time. It's all about finding that sweet spot where supply meets demand.
Short-run vs Long-run Equilibrium
Time Horizons and Market Dynamics
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- occurs when market price equals short-run
- Firms cannot adjust fixed inputs (buildings, machinery)
- Time frame varies by industry (weeks to months for restaurants, years for factories)
- achieved when firms have no incentive to enter or exit market
- All firms earn
- Allows for adjustment of all inputs, including fixed costs
- Short run allows economic profits or losses while long run drives profits to zero
- Free entry and exit of firms in long run eliminates above-normal profits
Supply Curves and Cost Structures
- Short-run supply curve sums individual firms' marginal cost curves above average variable cost
- Reflects firms' ability to vary output with existing capacity
- Long-run supply curve characteristics depend on industry cost structure
- Perfectly elastic (horizontal) in constant-cost industries (agriculture)
- Upward-sloping in increasing-cost industries (manufacturing)
- Time horizons for equilibrium vary based on ease of adjusting fixed inputs
- Quick adjustment in retail (weeks to months)
- Slow adjustment in heavy industry (years to decades)
Output Determination in the Short Run
Profit Maximization and Decision Rules
- Firms in competitive markets act as price-takers
- Cannot influence market price through individual production decisions
- Price determined by and demand
- Profit-maximizing output occurs where (MR) equals marginal cost (MC)
- Condition: Price ≥ average variable cost (AVC)
- Expressed mathematically as:
- Firms use marginal decision rule for production
- Produce additional units when marginal benefit (market price) exceeds marginal cost
- Stop production when marginal cost exceeds market price
- Producer surplus helps determine optimal output
- Measures difference between market price and marginal cost of production
- Maximized at profit-maximizing output level
Supply Curves and Shutdown Decisions
- Firm's short-run supply curve MC curve above shutdown point
- Shutdown point minimum of AVC curve
- Firms produce when P ≥ min AVC
- Shutdown decision based on price-AVC relationship
- If price falls below AVC, firm shuts down to minimize losses
- Continue operating if price covers variable costs, even with overall losses
- Examples of shutdown decisions:
- Seasonal businesses (beach rentals, ski resorts)
- Temporary factory closures during economic downturns
Market Conditions and Firm Profits
Profit Analysis and Market Dynamics
- Economic profit calculated as total revenue minus total cost
- Includes both explicit and implicit costs
- Formula:
- Short-run profit scenarios based on price-cost relationships
- Positive economic profits: P > ATC
- Zero economic profits: P = ATC
- Economic losses: AVC < P < ATC
- Market changes impact firm profitability
- Demand shifts (increased popularity of organic food)
- Supply shifts (technological advancements in manufacturing)
- Producer surplus and economic rent quantify market condition impacts
- Producer surplus area above supply curve, below price line
- Economic rent payments to factors of production above opportunity cost
Industry-wide Effects and Profitability
- Market equilibrium shifts affect individual firms' profitability
- Increased demand for smartphones benefits all manufacturers
- Decreased demand for coal negatively impacts all coal mining companies
- Industry-wide shocks impact all firms simultaneously
- Input price changes (oil price fluctuations affecting transportation industry)
- Government regulations (emissions standards in automotive industry)
- Short-run profit variations lead to long-run adjustments
- Profitable industries attract new entrants
- Unprofitable industries experience firm exits
Long-run Equilibrium Adjustment
Market Entry and Exit Dynamics
- Long-run equilibrium achieved through firm entry and exit
- Response to economic profits or losses in short run
- Positive economic profits attract new market entrants
- Increases industry supply
- Drives down market price
- Economic losses lead to firm exits
- Decreases industry supply
- Drives up market price
- Adjustment continues until zero economic profits reached
- Price equals minimum point of long-run average cost (LAC) curve
- Formula:
Efficiency and Industry Evolution
- Long-run equilibrium firms produce at most efficient scale
- Operate at minimum point of short-run average total cost curves
- Achieve optimal balance between economies and diseconomies of scale
- Adjustment speed depends on various factors
- Entry and exit barriers (licensing requirements, capital investments)
- Sunk costs (specialized equipment, brand development)
- Time required to adjust fixed inputs (constructing new facilities)
- Creative destruction drives industry-wide productivity growth
- Entry of more efficient firms (Amazon in retail)
- Exit of less efficient firms (Blockbuster in video rental)
- Contributes to overall economic progress and innovation
Key Terms to Review (18)
Allocative Efficiency: Allocative efficiency occurs when resources are distributed in such a way that maximizes the overall benefit to society. It implies that the production of goods and services aligns perfectly with consumer preferences, meaning that the price of a good reflects its marginal cost of production. Achieving allocative efficiency ensures that resources are not wasted and that society’s needs are met effectively.
Equilibrium Price: Equilibrium price is the price at which the quantity of a good demanded by consumers equals the quantity supplied by producers, resulting in a balanced market. This price point is crucial as it determines how resources are allocated in an economy, allowing for maximum efficiency in the market. Understanding equilibrium price helps to analyze consumer surplus, market demand, and the shifts that occur in both short-run and long-run competitive markets.
Equilibrium Restoration: Equilibrium restoration refers to the process through which a market returns to its equilibrium state after a disturbance, such as a shift in supply or demand. This concept is crucial in understanding how competitive markets operate over both the short run and the long run, as it highlights the adjustments that firms and consumers make in response to changes in market conditions to achieve balance between quantity supplied and quantity demanded.
Long-run equilibrium: Long-run equilibrium refers to a state in a perfectly competitive market where firms have adjusted their output to the point where economic profits are zero. In this situation, all firms in the market earn just enough revenue to cover their costs, including a normal return on investment. The long-run equilibrium is characterized by firms entering and exiting the market freely, which leads to the price of the product equaling the minimum point of the average total cost curve.
Marginal Cost: Marginal cost refers to the additional cost incurred when producing one more unit of a good or service. This concept is vital in understanding production decisions, as it helps businesses assess how much to produce while considering the trade-offs between production levels and costs.
Marginal Revenue: Marginal revenue is the additional income generated from selling one more unit of a good or service. It plays a crucial role in helping businesses make decisions about pricing, output levels, and overall profitability, as firms aim to maximize their revenue by analyzing how changes in production levels affect their income.
Market Adjustment: Market adjustment refers to the process through which supply and demand in a market reach a new equilibrium after experiencing changes, such as shifts in consumer preferences or production costs. This process is essential in competitive markets, as it helps restore balance by moving prices and quantities towards an efficient allocation of resources. The speed and effectiveness of market adjustment can significantly impact short-run and long-run equilibriums.
Market Demand: Market demand refers to the total quantity of a good or service that all consumers in a market are willing and able to purchase at various price levels during a given time period. It reflects consumer preferences, income levels, and the prices of related goods, creating a comprehensive view of how much product is wanted in the marketplace. Understanding market demand is crucial for analyzing consumer surplus and for determining equilibrium in both short-run and long-run competitive markets.
Market Supply: Market supply refers to the total quantity of a good or service that producers are willing and able to sell at various prices in a given market over a specified period. It reflects the combined output of all firms in the market and is influenced by factors such as production costs, technology, and the number of suppliers. Understanding market supply is essential for analyzing how competitive markets reach equilibrium in both the short-run and long-run.
Monopolistic Competition: Monopolistic competition is a market structure characterized by many firms selling similar but not identical products, allowing for product differentiation and some degree of market power. This type of competition results in firms competing on factors such as price, quality, and brand image, leading to a unique equilibrium in both the short-run and long-run contexts.
Normal Profit: Normal profit is the minimum level of profit needed for a company to remain competitive in the market, equal to the opportunity cost of resources used in production. It represents the earnings that cover all explicit and implicit costs, ensuring that the firm can sustain its operations in both the short run and long run. When a firm achieves normal profit, it is not making economic profit but is also not incurring losses, allowing it to stay in the market without exiting.
Perfect Competition: Perfect competition is a market structure characterized by a large number of small firms competing against each other, where no single firm can influence the market price. In this environment, products are homogeneous, information is perfect, and there are no barriers to entry or exit, leading to an efficient allocation of resources and optimal consumer outcomes.
Productive Efficiency: Productive efficiency occurs when an economy or firm produces goods and services at the lowest possible cost, utilizing resources in the most effective manner. This concept is closely tied to the idea of maximizing output with given inputs, ensuring that resources are not wasted. Achieving productive efficiency implies that a firm is operating on its production possibilities frontier, where it cannot produce more of one good without reducing the output of another.
Shifts in demand: Shifts in demand refer to changes in the quantity of a product that consumers are willing and able to purchase at any given price due to factors other than the price of the product itself. These shifts can occur because of changes in consumer preferences, income levels, prices of related goods, or expectations about future prices. Understanding how these shifts affect short-run and long-run equilibrium helps businesses anticipate market changes and adjust their strategies accordingly.
Shifts in Supply: Shifts in supply refer to changes in the quantity of a good or service that producers are willing and able to sell at various prices, resulting from factors other than price. These shifts can occur due to changes in production costs, technology, the number of sellers in the market, and government regulations. Understanding these shifts is crucial because they directly affect market equilibrium and can lead to changes in both the short-run and long-run dynamics of competitive markets, as well as influence outcomes in scenarios involving government intervention.
Short-run equilibrium: Short-run equilibrium refers to a market condition where the quantity of goods supplied equals the quantity of goods demanded at a specific price level, with at least one factor of production being fixed. In this state, firms may be earning profits or incurring losses, as they have not yet adjusted all inputs to reach a long-run sustainable level of output. This situation emphasizes the temporary nature of market dynamics, reflecting how businesses react to changes in demand and cost structures.
Supply and demand model: The supply and demand model is a fundamental economic framework that illustrates how the quantity of a good or service available in the market (supply) interacts with the desire of consumers to purchase that good or service (demand) to determine its price and quantity traded. This model helps analyze how changes in market conditions can lead to shifts in equilibrium, impacting decision-making in various economic scenarios.
Zero economic profit: Zero economic profit occurs when a firm's total revenues equal its total costs, including both explicit and implicit costs. In this situation, firms cover all their costs but do not make any excess profit over and above what is required to keep them in business. This concept highlights the point where firms are earning just enough to continue operating in a competitive market, balancing between short-run profits and long-run sustainability.