Long Run Supply and the Analysis of Competitive Markets. 1 Long Run Competitive Equilibrium

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1 Long Run Competitive Equilibrium. rinciples of Microeconomics, Fall 7 Chia-Hui Chen October 9, 7 Lecture 6 Long Run Supply and the Analysis of Competitive Markets Outline. Chap 8: Long Run Equilibrium. Chap 8: Long Run Market Supply. Chap 9: Gains and Losses from Government olicies Long Run Competitive Equilibrium In Figure, an existing firm s marginal cost and average total cost are SMC and SAC. The short-run market price is 7, so existing firms are making profits. In the long run, capital can be changed; old firms expand, new firms enter the market, thus the supply increases, which leads to price decreasing. The price will decrease until = =, so that firms have no economic profit. In the long run, firms earn zero profit, and in the short run, firms can have positive profit. However, the short run profit is not always higher because firms can also have negative profit (when < ATC) SMC SAC x Figure : Long Run Equilibrium rice. Cite as: Chia-Hui Chen, course materials for. rinciples of Microeconomics, Fall 7. MIT

2 Long Run Market Supply At long run competitive equilibrium: All firms are maximizing profit, or MR = MC. No firm has incentive to enter or exit earning zero economic profit (this is the difference between short run and long run). = S. In Figure, suppose the original price is. Existing firms make profit, so new firms enter the market and the market supply curve shifts from S to S. Now the market price is, existing firms make no profit, and new firms stop entering. Thus, the equilibrium is reached. In Figure, the original price is lower than AC. Firms have a loss and start leaving the market, and the market supply shifts from S to S... S.. S (a) Long Run Cost (b) Shift of Equilibrium. Figure : Long Run Equilibrium, High rice... S.. S (a) Long Run Cost (b) Shift of Equilibrium. Figure : Long Run Equilibrium, Low rice. Long Run Market Supply Assume that: All firms have the same technology; Initially firms produce at minimum long run average cost. Cite as: Chia-Hui Chen, course materials for. rinciples of Microeconomics, Fall 7. MIT

3 Long Run Market Supply Constant-Cost Industry In constant-cost industry, price of inputs does not change. If the price is higher than minimum. new firms will keep entering, so the supply is perfectly elastic at = minimum. Long run supply is a horizontal line at the price equal to the minimum (see Figure (b))...8. *.6.. * S L * (a) Long Run Cost in Constant-Cost In- (b) Supply Curve in Constant-Cost Industry. dustry. Figure : Long Run Market Equilibrium in Constant-Cost Industry. Increasing-Cost Industry rice of some or all inputs rises as production is expanded and demand of inputs increases. When the price increase from to, firms are making profit. Old... *... * * S L..... (a) Long Run Cost in Increasing-Cost (b) Supply Curve in Increasing-Cost In- Industry. dustry. Figure : Long Run Market Equilibrium in Increasing-Cost Industry. firms expand and new firms enter, so the demand of inputs increase, and so do the prices of inputs. Firm s cost curves increase to and / Since now firms have zero profit, new firms stop entering. The quantity supplied increases but is still finite. Thus the supply curve is upward sloping. Cite as: Chia-Hui Chen, course materials for. rinciples of Microeconomics, Fall 7. MIT

4 Gains and Losses from Government olicies Gains and Losses from Government olicies Consumer Surplus and roducer Surplus Consumer Surplus. Area between demand curve and market price (see Figure 6). roducer Surplus. Area between supply curve and market price (see Figure 6).. S.. Consumer Surplus roducer Surplus Figure 6: Consumer Surplus and roducer Surplus. CS (Consumer Surplus) plus S (roducer Surplus) is maximized at the quantity when demand equals supply. rice Ceiling When there is no intervention, the equilibrium price and quantity are and, respectively. Now government sets a price ceiling, namely, a maximum price (see Figure 7). The changes in consumer surplus and producer surplus are as follows: ΔCS = A B, ΔS = A C, ΔCS + ΔS = B C. eadweight loss, or net loss of CS + S, is (B + C) in this case. Government should maximize economic efficiency: maximize CS + S. If policies cause deadweight loss, they impose an economy cost on the economy. Cite as: Chia-Hui Chen, course materials for. rinciples of Microeconomics, Fall 7. MIT

5 Gains and Losses from Government olicies.. *. A B C Figure 7: rice Ceiling. rice Floor Government sets a price floor (price support), namely, a minimum price (see Figure 8). The changes in consumer surplus and producer surplus from the competitive equilibrium (, ) to the new equilibrium (, ) are as follows: Thus there is still a deadweight loss. ΔCS = A B; ΔS = A C; ΔCS + ΔS = B C. Cite as: Chia-Hui Chen, course materials for. rinciples of Microeconomics, Fall 7. MIT

6 Gains and Losses from Government olicies 6. S.. A B C Figure 8: rice Floor. Cite as: Chia-Hui Chen, course materials for. rinciples of Microeconomics, Fall 7. MIT