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The long-run industry supply price under perfect competition depends only on external economies and diseconomies of scale. Market price will remain constant if, and only if the industry output can be expanded or contracted by increasing and reducing the number of firms without affecting minimum long-run average cost.
This condition in its turn will exist if, and only if, all resources used by the industry are of an unspecialized nature. This means that the prices the firms must pay for all resources do not change with the level of resource use.
In other words, the supply curve of each resource used in the industry must be perfectly elastic so far as firms in that industry are concerned. This means that the resource market has to be perfectly competitive, in which case each firm is a price-taker. It can buy any quantity of resource without causing the price of the resource to rise.
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The shape of a firm’s long-run average cost curve depends on returns to scale Let us suppose all resource prices are constant. If a firm’s production function first shows increasing and then decreasing returns to scale, its long-run average cost curve will have a U-shape; but the long-run industry supply price will be constant due to constancy of resource prices.
Even if the number of firms increases the LAC of each firm will remain constant. This happens when another condition is satisfied, viz., inputs are perfectly divisible. There is no indivisible (lumpy) input. In such a situation a firm’s short-run and long-run average cost curves look dissimilar as shown in Fig. 21.25. While the SAC curves are U-shaped the LAC curve is horizontal.
The shape of a firms long-run average cost curve depends on returns to scale. Let us suppose all resource prices are constant. If a firms production function first shows increasing and then decreasing returns to scale, its long-run average cost curve will have a U-shape; but the long-run industry supply price will be constant due to constancy of resource prices.
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Even if the number of firms increases the LAC of each firm will remain constant. This happens when another condition is satisfied, viz., inputs are perfectly divisible. There is no indivisible (lumpy) input. In such a situation a firm’s short- run and long-run average cost curves look dissimilar, as shown in Fig. 21.25. While the SAC curves are U-shaped the LAC curve is horizontal.
The term ‘constant cost industry’ refers to one which has neither pecuniary (monetary) or technological externalities. This means that the cost curves of individual firms are unaffected by the level of industry output.
Paul Samuelson has pointed out that if all resource prices are constant and that the production function of each firm in an industry exhibits constant returns to scale there will be no limit to the size of the firm. This is known as the indeterminacy of pure (perfect) competition.
Samuelson’s View:
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While making an overall assessment of perfect competition Samuelson referred to its theoretically indeterminacy.
Three issues are involved here:
1. Indeterminate Output:
If commodity and factor markets are perfectly competitive and the production function is homogeneous of degree one, then optimisation under perfect competition cannot be determined in true sense.
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Since long-run average costs curves are constant and the demand curve is horizontal (implying fixed price of the product), there are three possibilities:
(a) If price is everywhere greater than MC it will pay the firm to expand its output indefinitely. In this case there is breakdown of perfect competition in the sense that perfect competition will cease to exist. It will yield place to natural monopoly. If P = MR > MC, Q → ∞. Thus there will no limit to the size of the firm.
(b) If P < MC, no output will be produced.
(c) If P ≡ MC the exact output of the firm will be a matter of indifference for a firm. In Samuelson’s language, “What is usually regarded as the most favourable case for perfect competition in the long run and fulfilment of Pareto optimality condition turns out to yield indeterminate output for each firm”.
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These three cases are shown in Fig. 21.26.
A qualifying statement:
The above paradox can be easily resolved. Even though the output of every firm may be indeterminate, their sum may be determinate. The reason for this is that if many low-cost firms expand output, others may contract simply because price will fall along industry’s demand curve.
It may be noted that even if all firms face the same market price, they are not subject to the same cost conditions. On the one hand the efficient firms will expand. This will cause price to fall. On the other hand, this forces the inefficient firms to contract and so price fall may be partly offset (moderated).
2. The Possibility of Breakdown of Perfect Competition:
The possibility of breakdown of perfect competition implies the argument that perfect competition will disappear if any one firm with obstacles to its expansion continues to grow until it becomes a significant part of the market, i.e., it is able to affect the price of its product In fact if production takes place under IRS, perfect competition will come to an end The inevitable outcome of this is the emergence of natural monopoly.
However, it is wrong to suggest that decreasing MC within a firm will lead to a monopoly The reason is that the demand curve of any firm is equal to the demand curve of the industry minus the supply curve of the remaining firms.
Thus the demand curve for a firm is horizontal even though it produces and sells 99.9% of industry’s output. In such a situation the long- run supply curve of potential rivals is horizontal and a horizontal curve, subtracted from any other curve, must always yield a horizontal curve.
If a typical firm starts restricting output so as to gain excess profits, it will cease to sell 99.9% of output – even any positive quantity. Consequently it win not try to do so but would derive the possible advantage of a decline in MC by behaving like a pure competitor.
3. Stability of Equilibrium:
Finally we refer to the issue of stability of equilibrium. Let us suppose that the industry is subject to oscillation around its equilibrium. However, once displaced output will tend to return to the original value. So the equilibrium is stable even though a small firm may not have any incentive to keep it constant.
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