Long Run Competitive Equilibrium In An

Economy With Production

• Theoretically, in the long run firms can enter and exit the industry.
• A situation is a long run equilibrium if
• no firm in the industry wants to leave
• no potential firm wants to enter.
Assuming that the technology (and
hence cost functions) of every firm are
the same, and ignoring the discrete
change that may occur in the firms'
maximal profits when a firm enters, the
theory thus implies that
in a long run equilibrium every firm's
maximal profit is zero
or, equivalently,
price is equal to minimum average cost.
The output at which LAC is minimal is the efficient
LAC - Long-Run Average Cost scale of production. LAC at the efficient scale of
production is thus the minimum average cost. In the
LMC - Long-Run Marginal Cost following figure, y* is the efficient scale of
production and p* is the minimum average cost.
• Given this terminology, another implicaton of the theory is:
every firm produces at the efficient scale of production.
• What determines the equilibrium number of firms? Given the
equilibrium price (minimum average cost), the aggregate demand
function Qd gives us the total amount Y* = Qd(p*) that must be
produced in equilibrium. We know how much each firm produces in
equilibrium (y*, the output equal to its efficient scale of production),
so if we divide Y* by this amount we obtain the equilibrium number
of firms.
Short-Run Equilibrium

• A short run competitive equilibrium is a

situation in which, given the firms in the
market, the price is such that that total
amount the firms wish to supply is equal
to the total amount the consumers wish
to demand.
• More precisely, a short run competitive
equilibrium consists of a price p and an
output yi for each firm i such that, given
the price p, the amount each firm i wishes
to supply is yi and the sum iyi of all the
firms outputs is equal to the total amount
Qd(p) demanded.
• Now suppose that there are n firms, all with the same cost function,
and hence the same short run supply function, say ys. Then a short
run competitive equilibrium is a price p and an output y for each firm
such that:

y = ys(p) and ny = Qd(p).

Efficiency Of Short-Run Equilibrium
• In a competitive equilibrium, price is equal to short run marginal cost, so
no firm can sell an extra unit at a price that covers its short run marginal
cost.
• Short run marginal cost is the market value of the variable inputs needed
to produce the extra unit of output, so in an equilibrium it is not possible
to sell another unit at a price that covers the market value of the inputs
needed to produce that unit.
• If the market value of the variable inputs needed to produce an extra unit
of output measures their social cost and the price at which a unit can be
sold measures the social value of the unit, then in an equilibrium the
socially optimal amount of the good is produced.
• A rough measure of the consumers' gains
from trade is the area under the demand
curve and above the price, indicated by the
light purple area in the figure at the right.
This area is called the consumers' surplus. A
measure of the gain to the producers is the
difference between their revenue and their
variable cost (since fixed cost is fixed!); this
measure is called the producers' surplus.
The total variable cost is the area under the
supply function (which is the marginal cost
function) up to the equilibrium output; so
the producers' surplus is equal to the area
between the supply function and the price,
indicated by the pink area in the following
figure.