3.3 Short-run and long-run equilibrium in perfect competition
4 min read•august 16, 2024
Perfect competition's short-run and 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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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
Economic profits attract new entrants, losses may cause exits
Long-run equilibrium leads to zero for all firms
Price equals both marginal cost and
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: 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
Price equals marginal cost ()
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