3.3 Short-run and long-run equilibrium in perfect competition

Perfect competition's short-run and long-run equilibrium are key to understanding market dynamics. In the short run, firms can only adjust variable inputs, leading to potential profits or losses. Prices equal marginal costs, but not necessarily average total costs.

The long run allows for entry and exit of firms, as well as adjustments to all inputs. This process continues until economic profits are zero, with prices equaling both marginal and average total costs. Understanding these equilibria is crucial for grasping market efficiency.

Short-run vs Long-run Equilibrium

Time Horizons and Input Adjustments

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• Short-run equilibrium occurs when firms maximize profits with fixed costs and market conditions
  • Firms can only adjust variable inputs (labor, raw materials)
  • Time horizon varies by industry (weeks to months for restaurants, years for manufacturing plants)
• Long-run equilibrium allows for entry/exit of firms and adjustment of all factors of production
  • All inputs become variable (capital, technology, labor)
  • Time horizon typically longer (months to years) depending on industry characteristics

Profit Conditions and Market Dynamics

• Short-run equilibrium may result in economic profits or losses for firms
  • Firms producing where marginal revenue equals marginal cost
  • Economic profits attract new entrants, losses may cause exits
• Long-run equilibrium leads to zero economic profit for all firms
  • Price equals both marginal cost and average total cost
  • No incentive for firms to enter or exit the market
• Number of firms remains constant in short-run, can change in long-run
  • Short-run: fixed number of competitors
  • Long-run: free entry and exit alters market structure

Short-run Equilibrium for Firms

Profit Maximization and Supply Curves

• Short-run equilibrium occurs when market price equals marginal cost of production
• Firms produce where marginal revenue (price in perfect competition) equals marginal cost
• Short-run supply curve is the firm's marginal cost curve above average variable cost
  • Represents the quantity supplied at each price level
• Industry supply curve is horizontal sum of all firms' marginal cost curves above AVC
  • Aggregates individual firm responses to price changes

Economic Outcomes and Production Decisions

• Firms may earn economic profits, incur losses, or break even in short-run
  • Depends on relationship between price and average total cost
  • Economic profit: Price > ATC
  • Economic loss: Price < ATC
  • Break-even: Price = ATC
• Production continues if price exceeds average variable cost
  • Firms cover variable costs and portion of fixed costs
  • Example: Restaurant operating during slow season to cover food and labor costs
• Shutdown point occurs when price falls below average variable cost
  • Firm minimizes losses by ceasing production
  • Example: Seasonal business closing during off-peak months

Long-run Adjustment in Perfect Competition

Market Entry and Exit Dynamics

• Long-run adjustment driven by firm entry/exit responding to profits/losses
• Economic profits attract new entrants to the market
  • Increases industry supply, driving down market price
  • Example: Surge in food delivery services during pandemic
• Economic losses cause firms to exit the market
  • Decreases industry supply, driving up market price
  • Example: Closure of brick-and-mortar retailers facing online competition
• Adjustment continues until zero economic profit achieved
  • Price equals marginal cost and minimum average total cost
  • No incentive for further entry or exit

Industry Supply and Production Scale

• Firms adjust production scale to minimize average total cost
  • Respond to changing market conditions and competition
  • Example: Automakers retooling factories for electric vehicle production
• Long-run industry supply curve derived from entry/exit and cost structures
  • Horizontal: Constant cost industry (agriculture)
  • Upward-sloping: Increasing cost industry (manufacturing)
  • Downward-sloping: Decreasing cost industry (technology)
• Industry reaches long-run equilibrium when all firms produce at efficient scale
  • Optimal balance of fixed and variable inputs
  • Example: Optimal farm size in agricultural production

Zero Economic Profit in Long-run Equilibrium

Economic vs Accounting Profit

• Zero economic profit means firms cover all opportunity costs
  • Includes explicit costs and normal return on investment
  • Does not imply zero accounting profit
• Firms earn just enough to justify continued operation
  • Cover costs of labor, capital, and entrepreneurship
  • Example: Small business owner earning market wage for their labor

Efficiency and Market Stability

• Long-run equilibrium ensures allocative and productive efficiency
  • Price equals marginal cost (allocative efficiency)
  • Firms produce at minimum average total cost (productive efficiency)
• Zero economic profit creates stable market equilibrium
  • No incentive for entry or exit
  • Resources allocated optimally across industries
• Serves as benchmark for comparing other market structures
  • Monopoly, oligopoly, monopolistic competition often deviate from this ideal

Factors Affecting Long-run Equilibrium

• Barriers to entry prevent zero economic profit equilibrium
  • Legal restrictions (patents, licenses)
  • High capital requirements (utilities, manufacturing)
• Product differentiation can create quasi-monopoly power
  • Brand loyalty, unique features
  • Example: Apple's ecosystem of products and services
• Government intervention may distort market outcomes
  • Subsidies, price controls, regulations
  • Example: Agricultural price supports affecting market equilibrium