8 Long Run Market Equilibrium

8.1 Free Entry and Exit

Many markets are characterized by substantial costs of entry or exit. Costs for exiting an industry
can include such things as severance pay for workers or disposal of inventory. Entry into a market
often involves substantial reduced costs for the purchase or rent of new equipment and advertising
expenditures to develop product awareness. Other common costs of entering a market, commonly
known as barriers-to-entry, include patent, licence ,etc.

Although such high entry and exit costs are standard in many markets, we assume that firms
do not face costs to either enter or exit a perfectly competitive market. In other words,
perfectly competitive firms are free to enter an industry if there is a potential for profit, or to exit
if there is a potential loss.

8.2 Zero Economic Profit in Long Run

• In long run, with free entry in a perfectly competitive market, the profit will attract new
firms into the industry. The entry will continue until all opportunity for positive economic
profit is reduced to zero.

• In long run, with free exit in a perfectly competitive market, the loss will drive incumbent
firms away the industry. The exit will continue until all opportunity for negative economic
profit is reduced to zero.

• Thus, in long run, all firms in a competitive market will earn zero economic profits.

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8.3 Profit in Diagram

We define profit as:

Profit = Total Revenue − Total Cost

In the diagram below, the the market price is P = P ∗ . When P = P ∗ , a competitive firm will
produce at Q = Q∗ . The firm’s total revenue is P ∗ × Q∗ , which is the pink rectangle.

When the competitive firm produce at Q = Q∗ , the firm’s average total cost is AT C = AT C ∗ .
The firms total cost is T C = AT C ∗ xQ∗ , which is the green rectangle.

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Profit is total revenue minus total cost. Thus, the firm’s profit is the blue rectangle.

8.4 Deriving the Long-Run Supply Curve

One of the key features of the long-run is the possibility of firms entering and/or exiting the
market. Economic profits will attract new entries to the market while economic losses will throw
firms out of it. Therefore, in perfect competition, profit must always equal zero in the long run.
In the figure below, the long run supply curve is the blue horizontal line.

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In long run, the economic profit of a firm is zero:

π = TR − TC = 0

TR = TC

Since
TR = PQ

Thus,
PQ = TC

Both sides divided by Q,

TC
P = = AT C
Q

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In addition, no matter it’s in long or short run, firms will maximize their profit using the Profit
Maximization Rule. Thus,
P = MC

Therefore, the long run competitive market equilibrium condition is,

P = M C = AT C

8.5 Demand Shock and the Long-Run Supply Curve

Let’s start from a long run competitive market equilibrium where the market price is P ∗ .

Suppose that there is a positive demand shock, causing the market demand curve shift to the
right. The market price increases to P 0 . A profit maximizing firm will produce Q0 when P = P 0
and earn positive profit.

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Since there is free entry, the potential positive profit will attract more firms into the market,
causing the market supply curve shift to the right. The entry will continue until all opportunity
for positive economic profit is reduced to zero. Thus, the market price will decrease back to P ∗ .

In long run, the market equilibrium price will be P ∗ . The long run supply curve is the horizontal
blue line.

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Example 1. Suppose there is a perfectly competitive industry where all the firms are identical
with identical cost curves. Furthermore, suppose that a representative firm’s total cost is given
by the equation T C = 100 + q 2 + q where q is the quantity of output produced by the firm. You
also know that the market demand for this product is given by the equation P = 1000 − 2Q where
Q is the market quantity. In addition you are told that the market supply curve is given by the
equation P = 100 + Q.

a What is the short run market equilibrium?

b What is the firm’s profit-maximizing level of output in short run?

c In long run, what is the quantity of output a representative firm will produce?

d. What is the long run supply curve?

e. How many units of this good will be produced in this market in long run?

Solution.

a In short run, the market equilibrium is determined by the market demand and short run market
supply curve
1000 − 2Q = 100 + Q

Q∗ = 300

P ∗ = 100 + 300 = 400

b The firm’s total revenue function is

T R = P × q = 400q

The firm’s profit function is

π = T R − T C = 400q − 100 − q 2 − q

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 π = 399q − q 2 − 100

To find the profit-maximizing level of output, we can use the first order condition:

dπ
= 399 − 2q = 0
dq

q ∗ = 199.5

Check the second order condition:

d2 π
= −2 < 0
dq 2

Thus, the profit-maximizing level of output is q = 199.5

c In long run, firm’s economic profit is zero:

π = TR − TC = 0

TR = TC

P = M C = AT C

The firm’s marginal cost function is:

dT C
MC = = 2q + 1
dq

The firm’s average total cost function is:

TC 100
AT C = = +q+1
q q

M C = AT C

100
2q + 1 = +q+1
q

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 q = 10

In long run, the firm will produce q = 10 units of output.

d. In long run, P = M C = AT C and q = 10

P = 2q + 1 = 21

The long run supply curve is P = 21

e. In order to find the long run market equilibrium quantity, we set the long run market supply
equals to the market demand:

Long run market supply: P = 21

market demand: P = 1000 − 2Q

21 = 1000 − 2Q

Q = 489.5

In long run, 489.5 units of this good are produced in this market.

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Practice Questions

1. Suppose there is a perfectly competitive industry where all the firms are identical with identical
cost curves. Furthermore, suppose that a representative firm’s total cost is given by the equation
T C = 100 + q 2 where q is the quantity of output produced by the firm. You also know that
the market demand for this product is given by the equation Q = 60 − 2P where Q is the
market quantity. In addition you are told that the market supply curve is given by the equation
Q = 3P − 20.

a What is the short run market equilibrium?

b What is the firm’s profit-maximizing level of output in short run?

c In long run, what is the quantity of output a representative firm will produce?

d. What is the long run supply curve?

e. How many units of this good will be produced in this market in long run?

Answers

1.

a In short run, the market equilibrium is determined by the market demand and short run market
supply curve
60 − 2P = 3P − 20

Q∗ = 28

P ∗ = 16

b The firm’s total revenue function is

T R = P × q = 16q

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 The firm’s profit function is

π = T R − T C = 16q − 100 − q 2

To find the profit-maximizing level of output, we can use the first order condition:

dπ
= 16 − 2q = 0
dq

q∗ = 8

Check the second order condition:

d2 π
= −2 < 0
dq 2

Thus, the profit-maximizing level of output is q = 8

c In long run, firm’s economic profit is zero:

π = TR − TC = 0

TR = TC

P = M C = AT C

The firm’s marginal cost function is:

dT C
MC = = 2q
dq

The firm’s average total cost function is:

TC 100
AT C = = +q
q q

M C = AT C

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 100
2q = +q
q

q = 10

In long run, the firm will produce q = 10 units of output.

d. In long run, P = M C = AT C and q = 10

P = 2q = 20

The long run supply curve is P = 20

e. In order to find the long run market equilibrium quantity, we set the long run market supply
equals to the market demand:

Long run market supply: P = 20

market demand: Q = 60 − 2P

Q = 60 − 2 × 20 = 20

In long run, 20 units of this good are produced in this market.

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