Profit-Maximization in Long-Run (Pure competitive Market)

11 Jul


 In Short-Run only a specific number of firms is present in an industry, each of them having fixed and unchanged plant. They can shut down in sense that they may produce zero output, but these firms don’t have enough time to sell their assets and go out of business. In Long-Run, however, firms can expand or contract their output capacity. The number of firms in an industry can increase or decrease, because they can enter or leave this industry.

 Some assumptions related to Long-Run in this article

  • Entry and exit only- Firms are able or enter industries only under long-run adjustment
  • Identical Costs- Let’s assume that all firms in this industry have identical costs curve, so it’s easier to talk about a firm, knowing that all other firms are affected by any long-run adjustments
  • Constant-cost Industry- We assume that leaving or entry of industry by a firm doesn’t affect the price, consequently the position of average-total –cost curve.

   Important Idea

  The main conclusion we should get here is that: After all long-Run adjustments are completed; product price will be equal to each firm’s minimum average cost.

  This conclusion can be proven by the following facts: each firm tries to get profit and to avoid losses and in a pure competition market firms a free to enter and to leave the industry. If the market price of a good will be higher than average total cost of it, then new firms will enter the industry, this industry expansion will create a higher supply, so that the price will fall and will get equal to initial average total cost of this good. Conversely, if price if the price initial is less than average total cost then firms of this industry will support losses. These losses will push some firms to leave the industry, so as they leave, total supply will decrease, which will make the price equal to average total cost.

Long-Run Equilibrium

 Let’s suppose that each firm produces cell phones. Average total cost for producing them is 100$. Marginal Revenue will initially be 100$. But what happens if the demand for these cell phones will increase?

The answer is quite simple, initially there will be an increase in price to (let’s suppose) 120$, because of that increase in demand, then more firms will enter the industry since there is possible to get economic profit (20$). More firms enter the industry then the supple will increase, prices decreases until the point where marginal revenue equal average-total-cost (take care amount of produced goods isn’t the same with initial one).

Constant Cost Industry- An increase in Demand

What happens if the demand of our cell phone decreases?

If the demand decreases then for a period of time marginal revenue will be less that average total cost, so that our firms will get some loss. Some firms will leave the market, so the supply will decrease. Then this supply will make the average total cost equal to marginal revenue. So again this point of intersection shows that no economic profit is made just normal one. Equilibrium price is the same, but equilibrium quantity is different (less).

Constant-Cost-Industry: A decrease in demand

Long Run Supply for a constant-Cost Industry

In our example we took a constant-cost industry (industry in which entry or exit of new firms doesn’t shift long-run ATC curve of individual firms. In this case industry’s demand for resources is small in comparison to the total demand for resources.  So that industry can expand or contract without affecting resource price and resource costs. How does the demand curve look like in a constant cost industry? Since we saw that demand change doesn’t affect the price, since it always comes back to the original value, then we may say that demand curve is perfectly elastic in constant-cost industry.

 Long-Run Supply for Increasing Cost Industry

  Most of the industries are Increasing Cost Industries, in which average total cost (ATC) moves up as the industry expands and moves downward as it contracts. In Increase cost Industries entry of new firms increases resource prices. Higher resource prices result in higher value of average total cost in long rung for our firms.

If there occurs an increase in demand for the goods of this kind of industry, then new firms will be attracted to it in order to eliminate the economic profit, as we said before more firms-higher ATC value.  For example

50000 units will be sold for 80$, 70000 for 100$ and 90000 for 120$. So if firms leave this increase cost industry then the demand declines, so does the price for goods.

Long Run Supply for an Increasing Cost Industry

Long-Run Supply for Decreasing Cost Industry

In a decreasing cost industry firm experiences a lower costs as the industry expands. An example can be industry that produces PCs. An increased demand for personal computers made new PC manufactures to enter the marker and greater increased the demand for components used to build them. An increase demand for PC’s components made producers to supply more of them and to expand factories, so that they achieved economies of scale. Supply for PCs increased more than demand, so that the price declined.

Long-Run Supply for a decreasing Cost Industry

 

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One Response to “Profit-Maximization in Long-Run (Pure competitive Market)”

  1. Cynthia Ann Katon-Alfonso July 11, 2012 at 10:38 PM #

    Very informative,thanks.

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