Here is an elaborated discussion on the process by which a firm in perfect competition attains equilibrium in the short run and long run.
In Fig 21.11, the competitive firm facing the price P2 maximises long-run profits by producing output Q3 with the plant size denoted by SAC2. As a result, the firm has no incentive to alter anything; it is in equilibrium.
Although this firm is in long-run equilibrium, the industry is not. The industry is said to be in long-run equilibrium when there is no incentive for firms to enter or exit the industry. The positive profit being earned in this industry will attract additional firms into the industry.
We first note that P2 exceeds SAC2 at an output Q3. Consequently, the firm makes a positive profit, which is equal to (P2 – C2) Q3 and is shown by the shaded rectangle. Since positive profits represent payments beyond those that must be made to keep resources employed in this industry, positive profits are sometimes called “excess” profits. Firms with positive profits earn a return that exceeds the next alternative investment for the firm’s asset, and are said to earn economic rent.
There are several sources of economic rent. In the short run, firms in industries with too few firms earn economic rent. The entry of new firms into these industries in the long run tends to dissipate profits and thus economic rents, too.
Constant Input Prices and Constant Cost Industry:
In Fig. 21.15 we consider the case where input prices remain constant to the industry and where there are an infinite number of potential firms with identical cost curves In part (i), industry supply and demand curves are shown. In part (ii), we examine a competitive firm’s reactions to price changes.
Initially, the market demand curve is D1 and the short-run industry supply curve is S1. Since we have assumed that input prices are constant, the industry’s short-run supply curve is the horizontal sum of the relevant sections of the short-run marginal cost curves of n1 firms that are producing in this industry.
A short-run competitive equilibrium occurs where the demand curve D1 intersects the short-run supply curve S1. Here Q1 units of output are produced at the price P1. At higher prices, the quantity supplied would exceed the quantity demanded, and this excess supply would lead to price fall.
At prices below P1, the quantity demanded would exceed the quantity supplied, and the unsatisfied demand would push the price up. Only at P1 the quantity demanded is equals to the quantity supplied.
At this price, each firm decides to produce q1 units of output, thereby earning only normal profit. Since no positive or economic rent is made in such a situation, firms have no incentive to leave or enter the industry; therefore, the industry is also in long-run equilibrium.
Now suppose that the demand curve shifts to the right from D1 to D2 perhaps because of an increase in income or the price of a substitute. Initially, with the number of firms fixed at the price rises from P1 to P2, where the short-run supply curve S1 intersects demand curve D2. In response to the price rise, our representative firm in part (ii) has increased its output from q1 to q2 and industry output has risen to Q2.
Since P2 exceeds the firm’s short- run average costs, profits will be positive, and other firms will enter the industry. The effect of entry will cause the short-run industry supply curve to shift to the right. As it does so, the price will fall; the individual firm will move back along its short-run marginal cost curve. As long as the price exceeds P1, the firms in the industry will make excess (i.e., positive) profits; consequently, still more firms will enter.
The incentive for further entry disappears only when the short-run industry supply curve shifts to S2 and price falls back to P1. Now industry output will be Q3; the firm’s output will be q1, which is back where the firm started. The increase in the industry output of Q2 – Q1 is due solely to more firms joining the industry; each firm’s long-run equilibrium output is q1.
Although many firms may have been attracted into the industry by the prospect of positive profits, firms earn no profit when the industry is in equilibrium. Then the number of firms adjusts until only normal profit is earned.
The long-run industry supply curve is made up of long-run equilibrium positions. In long-run equilibrium, firms have no incentive to enter or leave the industry. Thus, we see that the points (Q1, P1) and (Q3, P1) are long-run equilibrium points and, therefore, lie on the long-run supply curve. In Fig. 21.15 we have labeled the long-run supply curve LRS.
When input prices are constant and firms are identical, the long-run supply curve is horizontal.
The firm in part (ii) of Fig. 21.15 produce q1 units of output when the industry is in long-run equilibrium. We can conclude that if an industry made up identical firms is in long run equilibrium, then
P = LMC = SMC = LAC = SAC
That is price equals both short-run and long-run marginal cost and equals both short- run and long-run average cost. If any of the equalities does not hold, either the firm has faded to maximise profit or the industry is not in equilibrium.
Rising Input Prices and Increasing Cost Industry:
To simplify the discussion, let us return to the assumption that there are an infinite number of identical potential firms. In many instances, input prices will rise as the industry expands which we deal with in Fig. 21.16. In part (i), we have industry supply and demand, and, in part (ii), we have a firm’s long-run cost curve. We have deleted the corresponding short-run cost curves in order to reduce congestion in the diagram.
Initially, the demand curve is D1, and the industry short-run curve is S,. The industry short-run supply curve is the horizontal of the n1 short-run firm supply curves. We have constructed S1 so that the effects of changes in the output of these n1 firms on input prices are already incorporated into S1.
The initial equilibrium occurs at price P1 and quantity Q1 where S1 and D1 intersect. When the industry is producing Q1, each firm’s cost curves are LAC1 and LMC1. Consequently, in such a situation, each firm is making zero excess profits. So there is no incentive for firms to enter or leave the industry. Thus, the industry in long- run equilibrium.
Suppose that demand shifts to D2. The immediate response by the n1 firms in the industry is to increase output to Q2 and price to P2. But this new price exceeds the average cost and, consequently, each firm then earns profit.
This brings new firms into the industry. Consequently, industry output increased and input price rises. As a result, the firm’s costs increase. Entry continues until each firm in the industry earns only normal profit. In Fig. 21.16, this occurs when the short-run supply curve has shifted to S2 and when LAC2 and LAC2 are each firm’s cost curves.
Thus, the increase in demand from D1 to D2 results in an expansion of industry output form Q1 to Q2 and an increase in price to P3. Price does not return to the original level, because the expansion in industry output caused at least some input prices to rise.
The firm’s output could increase, remain the same, or fall, as input prices rise. In Fig. 21.16 we examined the special case where the minimum points on LAC, and LAC2 occurred at the same output level. Under these circumstances, the firm’s output remains the same; its costs rise; its total revenue rises; and its profits remain at the competitive level (zero).
This need not always be the case. Clearly, if the long-run average cost curve shifts up and to the right, then the firm would produce a higher output, and there would be fewer entrants.
The long-run supply curve is made up of long-run equilibrium points such as ((Q1, P1) and (Q3, P3) and is labeled LRS in part (i) of Fig. 21.16. It is positively sloped, because input prices increase as industry output expands. With positively sloped supply curve, a shift to the right in the demand curve results in long-run increases in price and output.
Falling Input Prices and Decreasing Cost Industry:
If input prices fall, the cost of production of each firm will fall with expansion of output. In such a situation the long-run industry supply curve will be downward sloping.
This point is discussed below:
In the decreasing cost industry long run increases in industry output (due to demand shift and price increases) would lead to fall in LAC of each firm. This, in its turn, will surely lead to a fall in market price, even in the face of rising demand for the output of the industry.
As more and more firms join the industry, total profit increases, cost per unit falls and price falls. In such a situation each firm’s LAC falls as the industry reaches higher and higher long- run equilibrium levels of output. Such cases are, of course, rare. Lipsey has cited the example of automobile industry in this context.
He has pointed out that if the demand for cars increases in the long run the demand for tyres will also rise. So the tyre manufacturing companies will be able to produce tyres on a much larger scale than before. If these firms are able to enjoy economies of scale, their cost per unit will fall in the long run.
A fall in the market price of tyres will, it its turn, lead to a fall in the price of motor cars also. Thus it is clear that in order to have a case of decreasing cost, the presence of new firms in an industry must bring about the lower LAC for all the firms in that market.
We may now examine the case of decreasing cost in graph form. As in the last two cases, we start from a position of industry equilibrium in the long run. In part (i) of Fig. 21.17 we see that the industry is in long-run equilibrium at point E, where the industry supply curve S1 and the industry demand curve D1 meet.
The equilibrium output is Q1 units per day and the price is P2 per unit. Since its average cost curve (LAC) is just tangent to its average revenue curve (D1 = AR1 = MR1) it is able to make only normal profit.
Now again we assume that this long-run equilibrium is disturbed by a rise in demand for the product of the industry. As the industry demand curve shifts to the right in part (ii) from D1 to D2 the market price rises to P3 and industry output increases to Q2 units.
As usual the typical firm reacts to the higher market price by producing more (Q2 units per period). It is now able to make an excess profit. However, this excess profit will attract new firms into the industry in the long run. As a result the industry supply curve shifts from S1 to S2, as is shown in part (ii) of Fig. 21.17.
A new industry equilibrium is reached at point E. The equilibrium output is now Q3 units and equilibrium price is P1 per unit. Now we observe that unlike the other two cases, the new long-run equilibrium price (P1) is less than the original long-run equilibrium price (P2).
This is because the entry of new firms into the industry led to a fall in LAC for all the firms belonging to the industry. The effect of this on the typical firm is shown in part (ii) of the same diagram. Its average cost curve has now shifted down from LAC1 to LAC2, and its marginal cost curve shifted down from LMC1 to LMC2.
The firm, now faced with a new market price of P3, is once more in long run equilibrium. But this time its equilibrium occurs at a point (f) where its new marginal cost curve (LMC2) intersects its new marginal revenue curve (MR3) from below. Since , new average cost curve (LAC2) is just tangent to its new average revenue curve which is also the MR, curve, from below it is again making only normal profit as is expected.
Here also we have been able to identify two points on a long-run industry supply curve E (corresponding to an output of Q1 units and a price of P1) and F (corresponding to an output of Q3 units and a price of P3). The locus of these two points is obviously the long-run industry supply curve. But this time it slopes downward from the left to the right.
It is because an increase in industry output this time led to a fall in market price: Q change and P change are in the opposite direction.
This is no doubt an important exception to the empirical law of supply. Thus, our final prediction is that, whenever LAC continues to fall with an increase in the volume of output of an industry, the long-run supply curve of the industry will be negatively sloped.
So the shape of the long-run industry supply curve depends only on external economies and diseconomies. Internal economies and diseconomies are not relevant in this context.