6.2 Short-run and long-run equilibrium in competitive markets

Competitive markets are all about balance. In the short run, firms can make profits or losses as they adjust to market conditions. But in the long run, things even out as companies enter or leave the market.

This balancing act is key to understanding how competitive markets work. We'll look at how firms make decisions in the short run and how markets reach equilibrium over time. It's all about finding that sweet spot where supply meets demand.

Short-run vs Long-run Equilibrium

Time Horizons and Market Dynamics

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• Short-run equilibrium occurs when market price equals short-run marginal cost
  • Firms cannot adjust fixed inputs (buildings, machinery)
  • Time frame varies by industry (weeks to months for restaurants, years for factories)
• Long-run equilibrium achieved when firms have no incentive to enter or exit market
  • All firms earn zero economic profit
  • Allows for adjustment of all inputs, including fixed costs
• Short run allows economic profits or losses while long run drives profits to zero
  • Free entry and exit of firms in long run eliminates above-normal profits

Supply Curves and Cost Structures

• Short-run supply curve sums individual firms' marginal cost curves above average variable cost
  • Reflects firms' ability to vary output with existing capacity
• Long-run supply curve characteristics depend on industry cost structure
  • Perfectly elastic (horizontal) in constant-cost industries (agriculture)
  • Upward-sloping in increasing-cost industries (manufacturing)
• Time horizons for equilibrium vary based on ease of adjusting fixed inputs
  • Quick adjustment in retail (weeks to months)
  • Slow adjustment in heavy industry (years to decades)

Output Determination in the Short Run

Profit Maximization and Decision Rules

• Firms in competitive markets act as price-takers
  • Cannot influence market price through individual production decisions
  • Price determined by market supply and demand
• Profit-maximizing output occurs where marginal revenue (MR) equals marginal cost (MC)
  • Condition: Price ≥ average variable cost (AVC)
  • Expressed mathematically as: $P = MR = MC$
• Firms use marginal decision rule for production
  • Produce additional units when marginal benefit (market price) exceeds marginal cost
  • Stop production when marginal cost exceeds market price
• Producer surplus helps determine optimal output
  • Measures difference between market price and marginal cost of production
  • Maximized at profit-maximizing output level

Supply Curves and Shutdown Decisions

• Firm's short-run supply curve MC curve above shutdown point
  • Shutdown point minimum of AVC curve
  • Firms produce when P ≥ min AVC
• Shutdown decision based on price-AVC relationship
  • If price falls below AVC, firm shuts down to minimize losses
  • Continue operating if price covers variable costs, even with overall losses
• Examples of shutdown decisions:
  • Seasonal businesses (beach rentals, ski resorts)
  • Temporary factory closures during economic downturns

Market Conditions and Firm Profits

Profit Analysis and Market Dynamics

• Economic profit calculated as total revenue minus total cost
  • Includes both explicit and implicit costs
  • Formula: $Economic Profit = TR - TC = TR - (Explicit Costs + Implicit Costs)$
• Short-run profit scenarios based on price-cost relationships
  • Positive economic profits: P > ATC
  • Zero economic profits: P = ATC
  • Economic losses: AVC < P < ATC
• Market changes impact firm profitability
  • Demand shifts (increased popularity of organic food)
  • Supply shifts (technological advancements in manufacturing)
• Producer surplus and economic rent quantify market condition impacts
  • Producer surplus area above supply curve, below price line
  • Economic rent payments to factors of production above opportunity cost

Industry-wide Effects and Profitability

• Market equilibrium shifts affect individual firms' profitability
  • Increased demand for smartphones benefits all manufacturers
  • Decreased demand for coal negatively impacts all coal mining companies
• Industry-wide shocks impact all firms simultaneously
  • Input price changes (oil price fluctuations affecting transportation industry)
  • Government regulations (emissions standards in automotive industry)
• Short-run profit variations lead to long-run adjustments
  • Profitable industries attract new entrants
  • Unprofitable industries experience firm exits

Long-run Equilibrium Adjustment

Market Entry and Exit Dynamics

• Long-run equilibrium achieved through firm entry and exit
  • Response to economic profits or losses in short run
• Positive economic profits attract new market entrants
  • Increases industry supply
  • Drives down market price
• Economic losses lead to firm exits
  • Decreases industry supply
  • Drives up market price
• Adjustment continues until zero economic profits reached
  • Price equals minimum point of long-run average cost (LAC) curve
  • Formula: $P = min LAC$

Efficiency and Industry Evolution

• Long-run equilibrium firms produce at most efficient scale
  • Operate at minimum point of short-run average total cost curves
  • Achieve optimal balance between economies and diseconomies of scale
• Adjustment speed depends on various factors
  • Entry and exit barriers (licensing requirements, capital investments)
  • Sunk costs (specialized equipment, brand development)
  • Time required to adjust fixed inputs (constructing new facilities)
• Creative destruction drives industry-wide productivity growth
  • Entry of more efficient firms (Amazon in retail)
  • Exit of less efficient firms (Blockbuster in video rental)
  • Contributes to overall economic progress and innovation