Chapter 10Pure Competition in the Long Run

The long-run equilibrium position for a competitive industry is shown by reviewing the process of entry and exit in response to profit levels in the industry. Long run supply curves and the conditions of constant, increasing, and decreasing costs are explored. The benefits of a competitive environment that brings new products and technological advancement is discussed along with an interesting look at the desirability of patents in the Last Word.

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Key Terms• pure competition• pure monopoly• monopolistic

competition• oligopoly• imperfect

competition• price taker• average revenue• total revenue• marginal revenue• break-even point• MR=MC rule• short-run supply

curve

• long-run supply curve• constant-cost

industry• increasing-cost

industry• decreasing-cost

industry• productive efficiency• allocative efficiency• consumer surplus• producer surplus

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The Long Run in Pure Competition• In the long run• Firms can expand or contract capacity• Firms can enter or exit the industry

• Decisions are based on the incentives of profits or losses

• Long run supply curve

LO1

Recall that in the short run the industry is fixed in both the number of sellers and the plant size of existing sellers. In the long run, all of these limits are relaxed. Firms will chose to expand or enter an industry that is experiencing profits, while firms will chose to contract or exit industries experiencing losses. The long run supply curve is defined as a curve showing the prices at which a purely competitive industry will make various quantities of the product available in the long run when all inputs are variable.

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Profit Maximization in the Long Run• Easy entry and exit• The only long run adjustment we

consider in this analysis• Identical costs• All firms in the industry have identical

costs• Constant-cost industry• Entry and exit of firms does not affect

resource pricesLO1

In our model we assume all firms have identical costs. Therefore they will all make the same production decisions since they also all face the same market price. The goal of the firm is to make profits and avoid losses. This is easy to do in pure competition due to the easy entry into the industry and easy exit out of the industry. Begin by assuming entry and exit of firms does not affect the prices of the resources used by those in the industry.

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Long Run Adjustment Process

• Adjustment process in pure competition• Firms seek profits and shun losses• Firms are free to enter or to exit• Production will occur at firm’s minimum

average total cost• Price will equal minimum average total

cost

LO2

As firms seek profits, they will be attracted to industries that are experiencing economic profits. As firms enter the market, the supply curve shifts to the right creating downward pressure on price. As the price falls, economic profits diminish and eventually are reduced to zero and only a normal profit is realized for the firm and Price = minimum ATC.

If the industry is experiencing economic losses, firms will leave causing the supply curve to shift to the left. As supply falls, the product price rises until the economic losses are eliminated and Price equals minimum ATC.

Once the industry has completed the long-run adjustment process, it is in long-run equilibrium.

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Long Run Equilibrium• Entry eliminates profits• Firms enter• Supply increases• Price falls

• Exit eliminates losses• Firms leave• Supply decreases• Price rises

LO2

Profits attract firms from less profitable industries and losses cause them to leave the unprofitable industry to find another more profitable one. This reflects a determinant of supply, namely, a change in the number of sellers.

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Entry Eliminates Economic Profits

(a)Single firm

(b)Industry

P P

q Q0 0100 100,00090,000 110,000

ATC

MR

MC

$60

50

40D1

S1

D2

$60

50

40

S2

LO2

These graphs show temporary profits and the re-establishment of long-run equilibrium in a representative firm and the industry. A favorable shift in demand (D1 to D2) will upset the original industry equilibrium and produce economic profits. As a result, those profits will entice new firms to enter the industry, increasing supply (S1 to S2) and lowering product price until economic profits are once again zero. In other words, an increase in demand temporarily raises price. Higher prices draw in new competitors. Increased supply returns price to equilibrium.

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Exit Eliminates Losses

(a)Single firm

(b)Industry

P P

q Q0 0100 90,000 100,000

ATC

MR

MC

$60

50

40

D3

S3

D1

$60

50

40

S1

LO2

Temporary losses and the re-establishment of long run equilibrium in a single firm and in the industry. A decrease in demand temporarily lowers price. Lower prices drive away some competitors and the decrease in supply returns price to equilibrium.

Long Run Supply Curves• Constant-cost industry• Entry or exit does not affect LR ATC• Constant resource prices• Special case

• Increasing-cost industry• Most industries• LR ATC increases with expansion• Specialized resources

• Decreasing-cost industryLO3

In the first scenario, the constant-cost industry, the number of firms entering or leaving the industry does not affect costs.

In the second scenario, entry or exit of firms does affect costs. Input costs will increase as firms enter the industry and input costs will fall as firms exit the industry. The long run supply curve is upsloping.

In the decreasing-cost industry, as the number of firms increase or decrease due to entry or exit, the industry costs change inversely. If demand for their product falls, firms will leave the industry causing input costs to rise. If demand for the product increases, firms will enter the industry causing input costs to fall. The long run supply curve is downsloping. Examples include the personal computer industry and the shoe manufacturers in America.

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LR Supply: Constant-CostIndustry

P

0 Q90,000 100,000 110,000Q3 Q1 Q2

$50

P1

P2

P3

SZ1 Z2Z3

D3 D1 D2

LO3

In a constant-cost industry, entry and exit of firms does not affect resource prices and therefore does not affect per-unit costs. So an increase in demand raises output but not the product’s price. Similarly, a decrease in demand reduces output but not the product’s price. Therefore, the long-run supply curve is horizontal.

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LR Supply: Increasing-CostIndustry

P

0 Q90,000 100,000 110,000Q3 Q1 Q2

$50P1

S

Y1

Y2

Y3

D3D1

D2

$45

$55P2

P3

LO3

The long run supply curve for an increasing-cost industry is upsloping. In an increasing-cost industry, the entry of new firms in response to an increase in demand (D3 to D1 to D2) will bid up resource prices and thereby increase unit costs. As a result, an increased industry output (Q3 to Q1 to Q2) will be forthcoming only at higher prices ($45<$50 <$55). The long-run industry supply curve (S) therefore slopes upward through points Y3, Y1, and Y2.

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LR Supply: Decreasing-Cost Industry

P

0 Q90,000 100,000 110,000Q3 Q1 Q2

$50P1

S

X1

X2

X3

D3

D1

D2

$45

$55P3

P2

LO3

The long run supply curve for a decreasing-cost industry is downsloping. In a decreasing-cost industry, the entry of new firms in response to an increase in demand (D3 to D1 to D2) will lead to decreased input prices and, consequently, decreased unit costs. As a result, an increase in industry output (Q3 to Q1 to Q2) will be accompanied by lower prices ($55 > $50 > $45). The long-run industry supply curve (S) therefore slopes downward through points X3, X1, and X2.

Pure Competition and Efficiency• In the long run, efficiency is achieved• Productive efficiency• Producing where P = minimum ATC

• Allocative efficiency• Producing where P = MC

• Triple equality• P = MC = minimum ATC

• Consumer surplus and producer surplus are maximized

LO4

Productive efficiency is producing goods in the least costly way. Allocative efficiency is producing the mix of goods most desired by society. The triple equality means that pure competition leads to the most efficient use of society’s resources. Another bonus is consumer surplus and producer surplus are maximized in the long run in pure competition. Consumer surplus is defined as the difference between the maximum that consumers would be willing to pay and the market price. Producer surplus is the difference between the minimum producers would be willing to accept for their product and the market price.

Note: P = min ATC = MC does not occur in decreasing cost industries.

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Consumer and Producer Surplus

Single Firm Market

Pric

e

Pric

eQuantity Quantity

0 0

P MR

D

S

QeQf

ATC

MCP = MC = MinimumATC (normal profit)

P

Consumer surplus

Producer surplus

LO4

For productive efficiency to be realized, price must equal minimum ATC and the condition for allocative efficiency is that price equal marginal cost.Pure competition achieves both efficiencies in its long-run equilibrium. This is important because it indicates the firm is using the most efficient technology, charging the lowest price, and producing the greatest output consistent with its costs. The firm is using society’s scarce resources in accordance with consumer preferences. The sum of consumer surplus (green area) and producer surplus (blue area) is maximized.

Dynamic Adjustments

• Purely competitive markets will automatically adjust to:• Changes in consumer tastes• Resource supplies• Technology• Recall the “invisible hand”

LO4

Dynamic adjustments will occur automatically in pure competition when changes in demand, resource supplies, or technology occur. Disequilibrium will cause expansion or contraction of the industry until the new equilibrium at P = MC occurs. The “invisible hand” works in a competitive market system since no explicit orders are given to the industry to achieve the P = MC result. The profit motivation brings about highly desirable economic outcomes.

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Technological Advance and Competition• Entrepreneurs would like to increase

profits beyond just a normal profit• Decrease costs by innovating• New product development

LO5

Innovation means using better technology or improved business organization. New product development means the firm may be first to the market with a new product, but others will soon follow and may destroy the innovating firm’s position.

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Creative Destruction

• Competition and innovation may lead to “creative destruction”

• Creation of new products and methods may destroy the old products and methods

LO5

Creative destruction refers to the idea that the creation of new products and new production methods destroys the market positions of firms committed to existing products and old ways of doing business. An example of creative destruction is the CD (compact disc) being replaced with iPods which in turn are being replaced with smartphones and their ability to play music. Faxes and emails have affected traditional postal service. Online retailers like Amazon have taken business away from traditional brick-and-mortar retailers.

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A Patent Failure?

• Patents give the inventor exclusive rights to market and sell their product for 20 years

• May hinder “creative destruction”• Eliminate patents on complicated, hard to

copy products• Speed up innovation by increasing the

opportunities of potential new competitors

Potential rival firms are hindered in their quest to bring new product to the market because of the fear of a patent infringement lawsuit. Some economists believe that eliminating patents on complicated consumer products, like iPhones, will increase innovation by eliminating the prospect of getting sued; especially when companies are producing products that may consist of thousands of different technologies that many other companies hold a patent on. However, some economists do find it appropriate to continue to provide patent protection for those products that would be easy to copy and produce, such as pharmaceutical products.

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