Perfect Competition Long Run Overheads Review of short

Review of short run equilibrium The number of firms is fixed The firm is

The market or industry supply curve, QS, is the horizontal summation of the individual

Industry Supply-Demand Equilibrium Demand for Individual Firm $ $ S(p) p 0 D(p) Q

Short run equilibrium $ AVC 300 ATC 250 MC 200 P = 120 150

Competitive markets in the long run The number of firms in the industry can

Conditions for a long run equilibrium 1. No individual firm wishes to change the

Plant size adjustment by the firm with no change in the market price Assumptions

y 0. 00 1. 00 2. 00 4. 00 5. 00 6. 00 7.

Conditions for short run equilibrium Price = MC Price AVC

y 6. 00 7. 00 8. 00 9. 00 10. 00 11. 00 12.

Short Run Equilibrium 1 500 450 400 350 300 250 200 150 100 50

Short Run Equilibrium 2 Profit 1026 500 P = 292 SRAC 5 SRMC 5

Short Run Equilibrium 3 Profit 1828. 98 $ 500 450 P = 292 400

Short Run Equilibrium 4 500 Profit 1944 P = 292 $ 450 400 350

Profits are higher with the size 18 plant than with the size 15 plant

y 0. 00 1. 00 5. 00 6. 00 8. 00 9. 00 10.

Short Run Equilibrium 5 Profit 1591. 39 500 P = 292 $ 450 400

Profits are lower with the size 23 plant than with the size 18 plant

When is the big plant optimal? Profit 8464 650 $ 600 550 500 450

What about lower prices? 650 $ 600 550 500 450 400 350 300 250

The long run cost curve For any given price (or output) , there is

Consider the family of short run cost curves 500 SRAC 5 SRMC 5 SRAC

We bound the short run curves with the long run curve 500 SRAC 5

SRMC = LRMC at “optimal” plant size 500 SRAC 5 SRMC 5 $ 450

SRMC = LRMC at “optimal” plant size 500 SRAC 5 SRMC 5 SRAC 9

SRMC = LRMC at “optimal” plant size 500 $ 450 400 350 300 250

SRMC = LRMC at “optimal” plant size 500 $ 450 400 350 SRAC 15

A less cluttered view 500 $ 450 400 350 300 250 200 150 ATC

Some clutter, some detail 500 SRAC 5 SRMC 5 $ 450 400 350 300

Profit and Loss, Entry and Exit In a competitive market, economic profit and loss

Assumptions about the industry structure 21 identical firms Each firm operates a size 18

Optimal output at various prices -- Plant size = 18 y* 16. 9410 17

Individual Firm Supply is equal to MC above the minimum of AVC Supply for

Aggregate Supply for 21 Firms with Plant Size = 18 700 600 500 Supply

Market and Individual Firm Supply, Price, and Average Cost Q 355. 76 357. 00

Putting supply and demand together P = $292 700 QS = 378 600 500

In equilibrium, at a given quantity, supply and demand price must be equal NOPE

In equilibrium, at a given quantity, supply and demand price must be equal P

Market and Individual Firm Supply, Supply Price, Average Cost and Demand Price Q 355.

What about profits? Looks good! Q 355. 76 357. 00 361. 30 369. 74

With high profits, other firms will want to enter Let the number of firms

Market and Individual Firm Supply, Supply Price, Average Cost and Demand Price Plant Size

Supply and Demand for 26 Firms, Plant Size = 18 700 600 500 400

Notice that price falls from $292 to $220 Firms will want to cut output

Suppose plant size declines to size 15 700 600 500 400 Supply - 26

Plant Size Number of Firms Price Q y* Supply - 26 390. 00 15

What about profits? Price Q y* Supply - 26 390. 00 15 175. 00

Prices are up Profits are good The plant is too small Now should the

Maybe? ? But with positive profits, other firms will keep entering the market

Long run equilibrium If there are profits, firms will enter and supply will increase

What if price is $292 and plant size is variable? C M R 400

What about profits? 400 Lots of profits 350 300 SRAC 18 SRMC 18 250

Why not a bigger plant? 400 350 300 250 200 Cost > Min 150

What if price drops to $256? SRAC 5 SRMC 5 400 350 300 SRAC

What about profits with this smaller plant? SRAC 5 SRMC 5 400 350 300

M C Instead pick a plant where SRMC = LR 400 SR M C

Pick a plant where SRMC = LRMC 400 350 SRAC 5 SRMC 5 300

Pick a plant where SRMC = LRMC LR M C 400 SRAC 17. 21

But with a price of $256, there are still profits 400 350 Profit SRAC

Only with a price of $175 are long run profits zero 400 350 SRAC

Long Run Equilibrium Consider a firm with long run average cost LRAC Industry Firm

Optimal Plant Size with Supply = S 1 Industry Firm PS 1 LRAC q

What about Profits? Industry Firm PS 1 LRAC q 1 Q S 1 Q

Firms will enter and supply will increase to S 2 Industry Firm PS 1

Profits are still quite good Industry Firm PS 1 LRAC q 1 Q More

Long Run Equilibrium Occurs When SRMC = LRMC And there is no incentive for

Long Run Equilibrium Occurs when there is no incentive for entry or exit Industry

What have we learned? Long Run Equilibrium Occurs When SRMC = LRMC Long Run

Summary 1. In the long run, every competitive firm will earn normal profit, that

Summary (continued) 4. In the long run, every competitive firm will produce where price

Long Run Equilibrium $ SRAC SRMC LRAC P = MR = Demand LRMC q*

Long Run Equilibrium ? ? 500 1944. 00 P = 292 SRAC 5 SRMC

P = 175 650 $ 600 550 500 450 400 350 300 250 200

Long Run Equilibrium SRAC 5 SRMC 5 SRAC 15 SRMC 15 SRAC 18 SRMC

400 350 SRAC 17. 21 5 SRAC SRMC 5 300 SRMC 17. 21 250

Only with a price of $175 are long run profits zero SRAC 5 SRMC

The short run and long run equilibrium for an individual firm with a price

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Perfect Competition Long Run Overheads

Review of short run equilibrium The number of firms is fixed The firm is operating on a short-run cost curve Some inputs are fixed

The market or industry supply curve, QS, is the horizontal summation of the individual firm supply curves

Industry Supply-Demand Equilibrium Demand for Individual Firm $ $ S(p) p 0 D(p) Q 0 Output p 0 D(p) Output

Short run equilibrium $ AVC 300 ATC 250 MC 200 P = 120 150 100 50 0 0 2 4 6 8 10 12 14 16 Output 18

Competitive markets in the long run The number of firms in the industry can vary The firm is operating on its long run cost curve

Conditions for a long run equilibrium 1. No individual firm wishes to change the amount of the good it is supplying to the market 2. No individual consumer wishes to change the amount of the good he or she is demanding 3. No individual firm in the market has an incentive to change the amount of any of the inputs it is using or to exit from the market 4. No firm outside the market has any incentive to enter it 5. The aggregate supply in the market equals the aggregate demand in the market

Plant size adjustment by the firm with no change in the market price Assumptions for example problem P = Price = $292 The firm is operating a plant with a capacity rating of 5 Short run average and marginal costs as in the table

y 0. 00 1. 00 2. 00 4. 00 5. 00 6. 00 7. 00 8. 00 9. 00 10. 00 11. 00 12. 00 13. 00 14. 00 15. 00 16. 00 17. 00 18. 00 19. 00 20. 00 22. 00 23. 00 SRAC SRMC Price 5 5 292 851. 00 103. 00 292 479. 00 112. 00 292 303. 50 148. 00 292 275. 00 175. 00 292 261. 00 208. 00 292 256. 14 247. 00 292 257. 75 292. 00 292 264. 33 343. 00 292 275. 00 400. 00 292 289. 18 463. 00 292 306. 50 532. 00 292 326. 69 607. 00 292 349. 57 688. 00 292 375. 00 775. 00 292 402. 88 868. 00 292 433. 12 967. 00 292 465. 67 1072. 00 292 500. 47 1183. 00 292 537. 50 1300. 00 292 618. 09 1552. 00 292 661. 61 1687. 00 SRAC 9 SRMC 9 SRAC 15 2291. 00 1079. 00 483. 50 371. 00 301. 00 256. 14 227. 75 211. 00 203. 00 201. 91 206. 50 215. 92 229. 57 247. 00 267. 88 291. 94 319. 00 348. 89 381. 50 454. 45 494. 65 6251. 00 2879. 00 1203. 50 875. 00 661. 00 7. 00 513. 29 52. 00 407. 75 103. 00 331. 00 160. 00 275. 00 223. 00 234. 64 292. 00 206. 50 367. 00 188. 23 448. 00 178. 14 535. 00 175. 00 628. 00 177. 88 727. 00 186. 06 832. 00 199. 00 943. 00 216. 26 1060. 00 237. 50 1312. 00 290. 82 1447. 00 322. 48 SRMC 15 SRAC 18 9041. 00 4184. 00 1766. 00 1289. 00 976. 00 757. 57 599. 00 481. 00 392. 00 324. 64 274. 00 7. 00 236. 69 88. 00 210. 29 175. 00 193. 00 268. 00 183. 50 367. 00 180. 76 472. 00 184. 00 583. 00 192. 58 700. 00 206. 00 952. 00 245. 82 1087. 00 271. 61 SRMC 18 88. 00 187. 00 292. 00 403. 00 520. 00 772. 00 907. 00

Conditions for short run equilibrium Price = MC Price AVC

y 6. 00 7. 00 8. 00 9. 00 10. 00 11. 00 12. 00 Price 292 292 SRAC 5 261. 00 256. 14 257. 75 264. 33 275. 00 289. 18 306. 50 SRMC 5 208. 00 247. 00 292. 00 343. 00 400. 00 463. 00 532. 00 SRAC 9 301. 00 256. 14 227. 75 211. 00 203. 00 201. 91 206. 50 SRMC 9 7. 00 52. 00 103. 00 160. 00 223. 00 292. 00

Short Run Equilibrium 1 500 450 400 350 300 250 200 150 100 50 0 Profit 274. 00 P = 292 SRAC 5 SRMC 5 0 5 10 15 20 MC = $292 y* = 8 25 30 35

Short Run Equilibrium 2 Profit 1026 500 P = 292 SRAC 5 SRMC 5 SRAC 9 SRMC 9 $ 450 400 350 300 250 200 150 100 50 0 0 5 10 15 20 25 30 35 Output MC = $292 y* = 12

Short Run Equilibrium 3 Profit 1828. 98 $ 500 450 P = 292 400 SRAC 9 SRMC 9 SRAC 15 SRMC 15 350 300 250 200 150 100 50 0 0 5 10 15 20 25 30 35 Output MC = $292 y* = 16. 25

Short Run Equilibrium 4 500 Profit 1944 P = 292 $ 450 400 350 SRAC 15 SRMC 15 SRAC 18 SRMC 18 300 250 200 150 100 50 0 0 5 10 15 20 25 30 35 Output MC = $292 y* = 18

Profits are higher with the size 18 plant than with the size 15 plant With a price of $292, a size 18 plant makes more sense than a size 15 plant

y 0. 00 1. 00 5. 00 6. 00 8. 00 9. 00 10. 00 12. 00 13. 00 14. 00 15. 00 16. 00 17. 00 18. 00 19. 00 20. 00 21. 00 22. 00 23. 00 25. 00 Price 292 292 292 292 292 SRAC SRMC 15 15 18 18 23 23 6251. 00 875. 00 661. 00 407. 75 331. 00 275. 00 206. 50 188. 23 178. 14 175. 00 177. 88 186. 06 199. 00 216. 26 237. 50 262. 43 290. 82 322. 48 395. 00 7. 00 88. 00 175. 00 268. 00 367. 00 472. 00 583. 00 700. 00 823. 00 952. 00 1087. 00 1375. 00 9041. 00 1289. 00 976. 00 599. 00 481. 00 392. 00 274. 00 236. 69 210. 29 193. 00 183. 50 180. 76 184. 00 192. 58 206. 00 223. 86 245. 82 271. 61 333. 80 88. 00 187. 00 292. 00 403. 00 520. 00 643. 00 772. 00 907. 00 1195. 00 14891. 00 2219. 00 1701. 00 1067. 75 864. 33 707. 00 486. 50 409. 77 349. 57 303. 00 267. 88 242. 53 225. 67 216. 26 103. 00 213. 50 220. 00 216. 71 343. 00 225. 36 472. 00 239. 00 607. 00 279. 80 895. 00

Short Run Equilibrium 5 Profit 1591. 39 500 P = 292 $ 450 400 350 300 250 SRAC 18 SRMC 18 SRAC 23 SRMC 23 200 150 100 50 0 0 5 10 15 20 25 30 35 Output MC = $292 y* = 20. 59

Profits are lower with the size 23 plant than with the size 18 plant We would not want the size 23 plant with prices of $292

When is the big plant optimal? Profit 8464 650 $ 600 550 500 450 400 350 300 250 200 150 100 50 0 P = 607 SRAC 18 SRMC 18 SRAC 23 SRMC 23 0 5 10 15 20 25 MC = $607 y* = 23 30 35 Output

What about lower prices? 650 $ 600 550 500 450 400 350 300 250 200 150 100 50 0 Profit 0. 00 P = 175 SRAC 9 SRMC 9 SRAC 15 SRMC 15 0 5 10 15 20 25 MC = $175 y* = 15 30 35 Output

The long run cost curve For any given price (or output) , there is an “optimal” plant size that gives the lowest level of costs (highest level of profits) The long run average total cost curve (LRATC) is an envelope curve that touches all the short run average total cost curves (SRATC) from below

Consider the family of short run cost curves 500 SRAC 5 SRMC 5 SRAC 9 SRMC 9 SRAC 15 SRMC 15 SRAC 18 SRMC 18 SRAC 23 SRMC 23 $ 450 400 350 300 250 200 150 100 50 0 0 5 10 15 20 25 30 35 Output

We bound the short run curves with the long run curve 500 SRAC 5 SRMC 5 SRAC 9 SRMC 9 SRAC 15 SRMC 15 SRAC 18 SRMC 18 SRAC 23 SRMC 23 ATC MC $ 450 400 350 300 250 200 150 100 50 0 0 5 10 15 20 25 30 35 Output SRMC = LRMC at “optimal” plant size

SRMC = LRMC at “optimal” plant size 500 SRAC 5 SRMC 5 $ 450 400 350 300 250 200 150 ATC MC 100 50 0 0 5 10 15 20 25 30 35 Output SRMC = LRMC SRAC = LRAC

SRMC = LRMC at “optimal” plant size 500 SRAC 5 SRMC 5 SRAC 9 SRMC 9 $ 450 400 350 300 250 200 150 ATC MC 100 50 0 0 5 10 15 20 25 30 35 Output SRMC = LRMC SRAC = LRAC

SRMC = LRMC at “optimal” plant size 500 $ 450 400 350 300 250 SRAC 18 SRMC 18 200 150 ATC MC 100 50 0 0 5 10 15 20 25 30 35 Output SRMC = LRMC SRAC = LRAC

SRMC = LRMC at “optimal” plant size 500 $ 450 400 350 SRAC 15 SRMC 15 SRAC 18 SRMC 18 300 250 200 150 ATC MC 100 50 0 0 5 10 15 20 25 30 35 Output SRMC = LRMC = SRAC = LRAC

A less cluttered view 500 $ 450 400 350 300 250 200 150 ATC MC 100 50 0 0 5 10 15 20 25 30 35 Output

Some clutter, some detail 500 SRAC 5 SRMC 5 $ 450 400 350 300 250 SRAC 18 SRMC 18 SRAC 23 SRMC 23 ATC MC 200 150 100 50 0 0 5 10 15 20 25 30 35 Output

Profit and Loss, Entry and Exit In a competitive market, economic profit and loss are the forces driving long run change The expectation of continued economic profit causes outsiders to enter the market; The expectation of continued economic losses causes firms in the market to exit

Demand for the example market

Assumptions about the industry structure 21 identical firms Each firm operates a size 18 plant

Optimal output at various prices -- Plant size = 18 y* 16. 9410 17 17. 2046 17. 6068 Price Supply 181. 00 187. 00 208. 00 250. 00 Cost 3062. 16 3073. 00 3113. 41 3205. 48 AC 180. 75 180. 76 180. 96 182. 06 18 19 20 21 22 292. 00 403. 00 520. 00 643. 00 772. 00 3312. 00 3659. 00 4120. 00 4701. 00 5408. 00 184. 00 192. 58 206. 00 223. 86 245. 82

Optimal output at various prices -- Plant size = 18 y* 16. 9410 17 17. 2046 17. 6068 18 19 20 21 22 Price Supply 181. 00 187. 00 208. 00 250. 00 292. 00 403. 00 520. 00 643. 00 772. 00 Cost 3062. 16 3073. 00 3113. 41 3205. 48 3312. 00 3659. 00 4120. 00 4701. 00 5408. 00 AC 180. 75 180. 76 180. 96 182. 06 184. 00 192. 58 206. 00 223. 86 245. 82 Supply is equal to MC above the minimum of AVC

Individual Firm Supply is equal to MC above the minimum of AVC Supply for One Firm with Plant Size = 18 500 400 Supply - 1 300 200 100 0 0 5 10 15 20 25 30 35

Aggregate Supply for 21 Firms with Plant Size = 18 700 600 500 Supply - 1 Supply - 21 400 300 200 100 0 0 100 200 300 400 500

Market and Individual Firm Supply, Price, and Average Cost Q 355. 76 357. 00 361. 30 369. 74 378. 00 399. 00 420. 00 441. 00 462. 00 y* 16. 941074 17 17. 204651 17. 606817 18 19 20 21 22 Supply Price 21 Firms 181. 00 187. 00 208. 00 250. 00 292. 00 403. 00 520. 00 643. 00 772. 00 AC 180. 75 180. 76 180. 96 182. 06 184. 00 192. 58 206. 00 223. 86 245. 82

Putting supply and demand together P = $292 700 QS = 378 600 500 400 Supply - 21 D 300 200 yi = 18 100 0 0 100 200 300 400 500 i = $1944

In equilibrium, at a given quantity, supply and demand price must be equal NOPE 700 600 500 400 Supply - 21 D 300 200 100 0 0 100 200 300 400 500

In equilibrium, at a given quantity, supply and demand price must be equal P = $292 700 QS = 378 600 500 400 Supply - 21 D 300 200 yi = 18 100 0 0 100 200 300 400 500

Market and Individual Firm Supply, Supply Price, Average Cost and Demand Price Q 355. 76 357. 00 361. 30 369. 74 378. 00 399. 00 420. 00 441. 00 462. 00 y* 16. 941074 17 17. 204651 17. 606817 18 19 20 21 22 Supply Price 21 Firms 181. 00 187. 00 208. 00 250. 00 292. 00 403. 00 520. 00 643. 00 772. 00 AC 180. 75 180. 76 180. 96 182. 06 184. 00 192. 58 206. 00 223. 86 245. 82 Demand Price 314. 24 313. 00 308. 70 300. 26 292. 00 271. 00 250. 00 229. 00 208. 00

What about profits? Looks good! Q 355. 76 357. 00 361. 30 369. 74 378. 00 399. 00 420. 00 441. 00 462. 00 y* 16. 941074 17 17. 204651 17. 606817 18 19 20 21 22 Supply Price 21 Firms 181. 00 187. 00 208. 00 250. 00 292. 00 403. 00 520. 00 643. 00 772. 00 AC 180. 75 180. 76 180. 96 182. 06 184. 00 192. 58 206. 00 223. 86 245. 82 Demand Price 314. 24 313. 00 308. 70 300. 26 292. 00 271. 00 250. 00 229. 00 208. 00

With high profits, other firms will want to enter Let the number of firms increase to 26

Market and Individual Firm Supply, Supply Price, Average Cost and Demand Price Plant Size 18 Number of firms 26 Q 440. 47 442. 00 450. 33 468. 00 494. 00 520. 00 546. 00 572. 00 y* 16. 941 17 17. 320 18 19 20 21 22 Price Supply - 26 181. 00 187. 00 220. 00 292. 00 403. 00 520. 00 643. 00 772. 00 AC 180. 75 180. 76 181. 18 184. 00 192. 58 206. 00 223. 86 245. 82 Price Demand 229. 53 228. 00 219. 67 202. 00 176. 00 150. 00 124. 00 98. 00

Supply and Demand for 26 Firms, Plant Size = 18 700 600 500 400 Supply - 26 300 D 200 100 0 0 100 200 300 400 500 P $220, QS 450

Notice that price falls from $292 to $220 Firms will want to cut output and change plant size

Suppose plant size declines to size 15 700 600 500 400 Supply - 26 D 300 200 100 0 0 100 200 300 400 500 P $257, QS 413

Plant Size Number of Firms Price Q y* Supply - 26 390. 00 15 175. 00 397. 72 15. 297 202. 00 413. 01 15. 885 257. 00 416. 00 16 268. 00 422. 45 16. 248 292. 00 442. 00 17 367. 00 468. 00 18 472. 00 494. 00 19 583. 00 520. 00 20 700. 00 15 26 AC 175. 00 175. 26 177. 88 179. 43 186. 06 199. 00 216. 26 237. 50 Price Demand 280. 00 272. 28 256. 99 254. 00 247. 55 228. 00 202. 00 176. 00 150. 00

What about profits? Price Q y* Supply - 26 390. 00 15 175. 00 397. 72 15. 297 202. 00 413. 01 15. 885 257. 00 416. 00 16 268. 00 422. 45 16. 248 292. 00 442. 00 17 367. 00 468. 00 18 472. 00 494. 00 19 583. 00 520. 00 20 700. 00 AC 175. 00 175. 26 177. 88 179. 43 186. 06 199. 00 216. 26 237. 50 Price Demand 280. 00 272. 28 256. 99 254. 00 247. 55 228. 00 202. 00 176. 00 150. 00

Prices are up Profits are good The plant is too small Now should the firm consider expanding again?

Maybe? ? But with positive profits, other firms will keep entering the market

Long run equilibrium If there are profits, firms will enter and supply will increase If the firm does not have the optimal size plant, it will modify plant size so that it is producing using the “optimal” long run technology. This implies that long and short run marginal costs will be equal This will go on until there are no profits and all firms have their optimal plant size

What if price is $292 and plant size is variable? C M R 400 350 S 300 L = C M R SRAC 18 SRMC 18 250 200 150 ATC MC P = 292 100 50 0 0 5 10 15 20 25 30 The firm produces 18 units of output The optimal long run plant size is 18 35

What about profits? 400 Lots of profits 350 300 SRAC 18 SRMC 18 250 200 150 ATC MC P = 292 100 50 0 0 5 10 15 20 25 30 The firm produces 18 units of output The optimal long run plant size is 18 35

Why not a bigger plant? 400 350 300 250 200 Cost > Min 150 100 50 0 0 5 10 15 20 25 30 35 SRAC 18 SRMC 18 SRAC 23 SRMC 23 ATC MC P = 292

What if price drops to $256? SRAC 5 SRMC 5 400 350 300 SRAC 18 SRMC 18 250 200 150 ATC MC P = 292 P = 256 100 50 0 0 5 10 15 20 25 30 35 The firm could reduce size to a smaller plant Try size 5

What about profits with this smaller plant? SRAC 5 SRMC 5 400 350 300 SRAC 18 SRMC 18 250 200 150 ATC MC P = 292 P = 256 100 50 0 0 5 10 15 P = SRMC LRMC 20 25 30 P = SRAC Not a good decision 35 Profit = 0

M C Instead pick a plant where SRMC = LR 400 SR M C 350 300 92 2 P = 256 P= 250 SRAC 5 200 SRMC 5 SRAC 18 150 SRMC 18 ATC 100 50 0 MC Is a size 5 plant a good choice with P = 256? 5 10 15 20 25

Pick a plant where SRMC = LRMC 400 350 SRAC 5 SRMC 5 300 250 SRAC 5 SR C M 200 SRMC 5 SRAC 18 LR MC C 0 ATC M 100 50 SRMC 18 150 A size 5 plant is not optimal with P = 256 5 10 15 20 25

Pick a plant where SRMC = LRMC LR M C 400 SRAC 17. 21 C = 350 M 300 SR SRMC 17. 21 250 SRAC 5 SR C M 200 SRMC 5 SRAC 18 SRMC 18 LR 150 M ATC MC C 100 50 0 5 10 15 20 25

But with a price of $256, there are still profits 400 350 Profit SRAC 17. 21 300 SRMC 17. 21 250 200 150 ATC 100 MC 50 0 5 10 15 20 25

Only with a price of $175 are long run profits zero 400 350 SRAC 15 SRMC 15 300 250 LRMC = SRMC = LRAC 200 150 ATC MC 100 50 0 P = 175 0 5 10 15 20 25 30 35

Long Run Equilibrium Consider a firm with long run average cost LRAC Industry Firm PS 0 LRAC S 1 D Q Q Suppose demand is given by D and industry supply is S 1 Is the plant size PS 0 an equilibrium size for the firm? NO!!

Optimal Plant Size with Supply = S 1 Industry Firm PS 1 LRAC q 1 Q S 1 Q

What about Profits? Industry Firm PS 1 LRAC q 1 Q S 1 Q Profits are high and so firms will want to enter the market

Firms will enter and supply will increase to S 2 Industry Firm PS 1 LRAC q 1 Q S 1 S 2 Q Prices in the market will fall Firm level output will fall The firm will want a slightly smaller plant in the long run

Profits are still quite good Industry Firm PS 1 LRAC q 1 Q More firms will enter the market S 1 S 2 Q

Long Run Equilibrium Occurs When SRMC = LRMC And there is no incentive for entry or exit -- profits are zero Industry Firm S 1 PS 1 LRAC S 2 S* q* q 1 Q With supply = S 2, there are still profits Supply will increase until Price is equal to LRAC Q

Long Run Equilibrium Occurs when there is no incentive for entry or exit Industry Firm PS* S 1 PS 1 LRAC S 2 S* Price =LRAC q* q 1 Q Q Long Run Equilibrium Occurs When SRMC = LRMC

What have we learned? Long Run Equilibrium Occurs When SRMC = LRMC Long Run Equilibrium Occurs when there is no incentive for entry or exit In the long run, the firm will have zero profits and will operate at the minimum on the long run average cost curve

Summary 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

The End

Long Run Equilibrium ? ? 500 1944. 00 P = 292 SRAC 5 SRMC 5 SRAC 9 SRMC 9 SRAC 15 SRMC 15 SRAC 18 SRMC 18 SRAC 23 SRMC 23 ATC MC 450 $ Profit 400 350 300 250 200 150 100 50 0 0 5 10 15 20 25 30 35 Output

P = 175 650 $ 600 550 500 450 400 350 300 250 200 150 100 50 0 P = 607 SRAC 9 SRMC 9 SRAC 15 SRMC 15 SRAC 18 SRMC 18 SRAC 23 SRMC 23 0 5 10 15 20 25 30 35 Output

Long Run Equilibrium SRAC 5 SRMC 5 SRAC 15 SRMC 15 SRAC 18 SRMC 18 SRAC 23 SRMC 23 ATC MC P = 292 P = 256 400 350 300 250 200 150 100 50 0 P = 175 0 5 10 15 20 25 30 35

400 350 SRAC 17. 21 5 SRAC SRMC 5 300 SRMC 17. 21 250 SRAC 5 200 SRMC 5 SRAC 18 150 SRMC 18 ATC 100 MC 50 0 5 10 15 20 25

SRAC 15 SRMC 15

Only with a price of $175 are long run profits zero SRAC 5 SRMC 5 SRAC 15 SRMC 15 SRAC 18 SRMC 18 SRAC 23 SRMC 23 400 350 300 250 200 150 ATC MC P = 292 P = 256 100 50 0 P = 175 0 5 10 15 20 25 30 35

The short run and long run equilibrium for an individual firm with a price of 292 is output and a plant size of 18. Here the long and short run marginal cost curves are equivalent. But this price and output combination gives large profits. A larger plant size of 23 will give positive but smaller profits. If price drops to $256, then the firm will want to cut output. If it cuts all the way back to a size 5 plant, it will have zero profits and no firms will want to enter. But with a price of $256, the firm would prefer a larger plant so that SRMC = LRMC. If the firm increases to a size 18 plant it will have zero profits with a price of 175.

Long Run Equilibrium Occurs when there is no incentive for entry or exit Industry Firm PS* S 1 PS 1 LRAC S 2 S* q* q 1 Q Long Run Equilibrium Occurs When SRMC = LRMC Supply will increase until Price is equal to LRAC Q

Long Run Equilibrium Consider a firm with long run average cost LRAC Industry Firm PS* PS 1 PS 0 LRAC S 1 S 2 S* q*q 2 q 1 Q Q Suppose the industry supply is S 1. If the plant size is PS 0 and the firm produces qhat_1, the firm is not in an equilibrium position because this is not the best plant size for the market price.