Chapter 11

PERFECT COMPETITION (PART II – LONG-RUN)

ECON1021A - Perfect Competition (Part II)

 After studying this chapter, you will be able to: 2

• Define perfect competition

• Explain how price and output are determined in perfect competition

• Explain why firms enter and leave a market

• Predict the effects of technological change in a competitive market

• Explain why perfect competition is efficient

ECON1021A - Perfect Competition (Part II)

 Output, Price, and Profit in the Short Run 3
• Recall: In short-run equilibrium, a firm might make an economic profit, break
even, or incur an economic loss.

In long-run equilibrium, firms

break even because firms
can enter or exit the market.
LONG RUN

ECON1021A - Perfect Competition (Part II)

 Output, Price, and Profit in the Long Run 4

• Entry and Exit

– Entry occurs in a market when new firms come into the market and the
number of firms increases.
– New firms enter an industry in which existing firms make an
economic profit.
– Exit occurs when existing firms leave a market and the number of firms
decreases.
– Firms exit an industry in which they incur an economic loss.

ECON1021A - Perfect Competition (Part II)

 Output, Price, and Profit in the Long Run 5

• New firms enter a market in which existing firms are making an

economic profit.
– As new firms enter a market, the market price falls and the
economic profit of each firm decreases.

• Firms exit a market in which they are incurring an economic loss.

– As firms leave a market, the market price rises and the economic
loss incurred by the remaining firms decreases.

• Entry and exit stop when firms make zero economic profit.

ECON1021A - Perfect Competition (Part II)

 Output, Price, and Profit in the Long Run 6
• A Closer Look at Entry

• When the market price is $25 a sweater, firms in the market are making economic
profit.

Profit

Profit =(P –ATC) ×Q*

ECON1021A - Perfect Competition (Part II)

 Output, Price, and Profit in the Long Run 7
• This economic profit is a signal for new firms to enter the market.

• As entry takes place, supply increases and the market supply curve shifts
rightward toward.

• The market supply increases and the market price falls.

ECON1021A - Perfect Competition (Part II)

 Output, Price, and Profit in the Long Run 8
• Firms enter as long as firms are making economic profits.

• In the long run, the market price falls until firms are making zero economic profit.

P =ATC

ECON1021A - Perfect Competition (Part II)

 Output, Price, and Profit in the Long Run 9
• A Closer Look at Exit

• When the market price is $17 a sweater, firms in the market are incurring
economic loss.

Profit =(P –ATC) ×Q*

Here P < ATC at Q*
So economic loss

Loss

ECON1021A - Perfect Competition (Part II)

 Output, Price, and Profit in the Long Run 10
• Firms have an incentive to exit the market.

• When they do, the market supply decreases and the market price rises.

ECON1021A - Perfect Competition (Part II)

 Output, Price, and Profit in the Long Run 11
• Firms exit as long as firms are incurring economic losses.

• In the long run, the price continues to rise until firms make zero economic profit.

P =ATC

ECON1021A - Perfect Competition (Part II)

 Long-Run Equilibrium 12
• When economic profit and economic loss have been eliminated and entry and exit have
stopped:

• A competitive market is in long-run equilibrium.

• Markets are constantly adjusting to keep up with changes in tastes, which change
demand, and changes in technology, which change costs.

• Thus, a competitive market is rarely in a state of long-run equilibrium.

– Instead, it is constantly and restlessly evolving toward long-run equilibrium.

• Let’s now see how a competitive market reacts to changes tastes and technology.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 13

• An Increase in Demand

– An increase in demand shifts the market demand curve

rightward.
– The price rises and the quantity increases.

– Starting from long-run equilibrium, firms make economic profits.

– Figure 11.10 illustrates the effects of an increase in demand.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 14
• The market demand curve shifts rightward, the market price rises, and each firm
increases the quantity it produces.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 15
• The market price is now above the firm’s minimum average total cost, so firms
make economic profit.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 16
• Economic profit induces some firms to enter the market, which increases the
market supply and the price starts to fall.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 17
• As the price falls, the quantity produced by all firms starts to decrease and each
firm’s economic profit starts to fall.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 18
• Eventually, enough firms have entered for the supply and increased demand to be
in balance and firms make zero economic profit. Firms no longer enter the market.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 19
• The main difference between the initial and new long-run equilibrium is the
number of firms in the market.

• More firms produce the equilibrium quantity.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 20
• A decrease in demand has the opposite effects
to those just described and shown in Figure
11.10.

– A decrease in demand shifts the demand

curve leftward.

– The price falls and the quantity decreases.

– Firms incur economic losses.

– Economic loss induces exit.

– The short-run market supply curve shifts

leftward.

– As the market supply decreases, the price

stops falling and starts to rise.
ECON1021A - Perfect Competition (Part II)
 Technological Advances Change Supply 21
• We just looked at changes in demand  holding cost curves unchanged.

• Now let’s see what happens if supply changes.

• Technological Advances Change Supply

– Starting from a long-run equilibrium, when a new technology becomes available that lowers

production costs, the first firms to use it make economic profit.

– The firms that do not use the new technology make losses.

– Eventually, all the old-technology firms have exited and enough new-technology firms have

entered to increase the market supply to a level that lowers the price to equal the minimum ATC.

– Let’s illustrate this in a diagram.

ECON1021A - Perfect Competition (Part II)
 Changes in Demand 22
• Part (a) shows the market.

• Part (b) shows a firm using the original old technology.

• Firms are making zero economic profit.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 23
• When a new technology becomes available, the ATC and MC curves shift
downward.

• Firms that use the new technology make economic profit.

Profit

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 24
• Economic profit induces some new-technology firms to enter the market.

• The market supply increases and the price starts to fall.

Profit

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 25
– With the lower price, old-technology firms incur economic losses.

– Some exit the market; others switch to the new technology.

Loss Profit

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 26
– With the lower price, old-technology firms incur economic losses.

– Some exit the market; others switch to the new technology.

ECON1021A - Perfect Competition (Part II)

 Changes in Demand 27
– Eventually all firms are using new technology.

– The market supply has increased.

– All firms are now making zero economic profit

P =ATC

ECON1021A - Perfect Competition (Part II)

 Competition and Efficiency 28
• Efficient Use of Resources

– Resource use is efficient when we produce the goods and services that people value
most highly.

– If it is possible to make someone better off without anyone else becoming worse off,
resources are not being used efficiently.

– E.g. suppose we produce typewriters that no one wants and no one will ever use and, at
the same time, many people want new tablets.

– If we produce fewer typewriters and reallocate the unused resources to produce

more tablets, some people will be better off and no one will be worse off.

– So the initial resource allocation (with typewriters) was inefficient.

– Inefficient if (MSB) ≠ MSC.

ECON1021A - Perfect Competition (Part II)
 Recall from Chapter 5
29

• When production is …

– less than the equilibrium quantity

– MSB > MSC.

– greater than the equilibrium quantity

– MSC > MSB.

– equal to the equilibrium quantity

– MSC = MSB.

ECON1021A - Perfect Competition (Part II)

 Recall from Chapter 5
30
Deadweight loss
• Resources are used efficiently when marginal
social benefit equals marginal social cost.

• When the efficient quantity is produced, total

surplus (the sum of consumer surplus and
producer surplus) is maximized.

– The gain from trade for consumers is

measured by consumer surplus.

– The gain from trade for producers is

measured by producer surplus.
Q<10 Q>10
– Total gains from trade equal total surplus.

• A deadweight loss will occur if you produce

above or below the equilibrium quantity.
ECON1021A - Perfect Competition (Part II)
 Competition and Efficiency 31

• Efficiency in the Sweater Market

• At the market equilibrium:

• Marginal social benefit equals marginal

social cost.

– MSB=MSC

• Resources are allocated efficiently.

• Total surplus is maximized.

ECON1021A - Perfect Competition (Part II)

 Conditions for Long-Run Equilibrium
32
• The previous discussion suggests four conditions for a competitive industry to be in long-run equilibrium:

1. Existing firms must be maximizing their profits, given their existing capital.

– Thus, short-run marginal costs of production must be equal to market price (P = MC).

2. Existing firms must not be suffering losses.

– If they are suffering losses, the size of the industry will decline.

3. Existing firms must not be earning profits.

– If they are earning profits, then new firms will enter the industry and the size of industry will increase.
over time.

4. Existing firms must not be able to increase their profits by changing the size of their production
facilities.

– Thus, each existing firm must be at the minimum point of its long-run average cost (LRAC) curve.

ECON1021A - Perfect Competition (Part II)

 Conditions for Long-Run Equilibrium
33
• A competitive firm that is not at the minimum point on its LRAC
curve is not maximizing its long-run profits.
– A competitive firm with short-run cost curves SRATC and MC faces
a market price of po.

– The firm produces Qo, where MC equals price and total costs are
just being covered.
– However, the firm's long-run average cost curve lies below its
short-run curve at output Qo.

– The firm could produce output Qo at cost co by building a larger

plant so as to take advantage of economies of scale.
– The firm cannot be maximizing its long-run profits at any output
below Qm because, with any such output:
– Average total costs can be reduced by building a larger plant.
– The output Qm is the minimum efficient scale of the firm.
ECON1021A - Perfect Competition (Part II)
 Competition and Efficiency 34
• A TYPICAL COMPETITIVE FIRM WHEN THE
INDUSTRY IS IN LONG-RUN EQUILIBRIUM
Individual Firm
• Campus Sweaters makes zero economic profit.

– Each firm in the market has the plant that enables it

to produce at the lowest possible average total cost.

– Consumers are as well off as possible because the

good cannot be produced at a lower cost and the
price equals that least possible cost.
When firms in perfect competition are away
from long-run equilibrium, either entry or exit
moves the market toward the situation depicted
in the figure on the right.

ECON1021A - Perfect Competition (Part II)

 Next Class 35

• Chapter 12 - Monopoly

ECON1021A - Perfect Competition (Part II)