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

 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).

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).

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 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.

 

Advertisement

Law of Demand and Marginal Utility

   The income effect
   The income effect is the impact that change in real income has on quantity demanded of a good. Let’s suppose our good is cheese. If the price of cheese in declined, then the purchasing power or real income is of anyone who purchases it increases. The increase in real income is reflected in increased purchase of normal goods, in our case cheese. For example, with a monthly income of 100$ you can guy 2 kg of cheese which worth 50 $/kg. If the price decreases to 25$ your purchasing power will increase so you’ll be able to buy already 4kg. A decline in price of the cheese increases consumers’ real income, enabling them to buy more amount of this good. This relationship is known as income effect.

Substitution Effect
          Substitution effect is the impact that a change in a product’s price has on its quantity demanded. When the price of the good decreases, the product becomes relative cheaper to other products, so that consumers will try to substitute it for items that became now relatively more expensive. Lower price increase the relative attractiveness of a product, so that the consumers buys more of it. This relationship is called substitution effect.
   The income and substitution effects combined increase consumers’ willingness and ability to buy a good when its price falls.

Law of diminishing Marginal Utility
   This law is another explanation of downward-sloping demand curve.  Although consumer wants are unlimited, wants for particular goods can be satisfied. More of a product people can obtain the less additional product they want.
   Let’s take an example:  When you don’t have an iPhone, your desire for it can be very strong, but the desire for a second iPhone is less intense and for the third, fourth and so on is weaker and weaker. So, the demanders will buy an additional unit of good only if price of that good or service will fall. So the consumer will spend his/her money rather on goods that provides the same or bigger amount of utility than on that which offer less utility. Thus, marginal utility provides the idea that price must decrease for quantity demanded to increase. We can also state that, if successive unit provide a sharp decrease in MU then demand for this good or service is elastic. Conversely, slow declines in MU imply that demand is inelastic. We can state Law of diminishing Marginal Utility as follows – as consumer increase consumption of a good or service then the marginal utility obtained from each additional unit will decrease.

Utility 
   Utility is the want-satisfying power of an item or a service; the pleasure consumers take from keeping or using that good or service. “Utility” and “usefulness” is not the same, for example paintings of Leonardo da Vinci may offer utility for art lovers but they are useless in functionality. Also utility is something subjective, for example an old wrist watch can offer great amount of utility for a collector, but for someone else it may not have such a great utility.
   Now we must make a difference between two important economic terms: TU (total utility) and MU (marginal utility). Total utility is the total amount of satisfaction a consumer can get from a specific quantity (example 5, 20, 100) of goods or services. In contrast, Marginal utility is pleasure taken from consuming each additional unit of good or service (also equal to Total utility divided by quantity of good consumed).

“Invisible hand” in economics

“Invisible Hand” in Economics
Firms and resource suppliers want to increase their revenue and seek their own self-interest, so that they are like guided by an “invisible hand”. In this environment businesses are the least costly producers of goods and services, because this is their interest is to get higher revenues. In the same way, using few resources to produce goods is in interest of demanders.
Businesses want to make higher profits; resource suppliers want higher rewards, so both of them manipulate resources usage order to get best allocation of them for the entire society.
Competition of self-interests unintentionally furthers fulfilling of society’s needs. The “invisible hand” maximizes profits of firms and also it maximizes the output and wish-fulfillment.
Most important characteristics of market system are:

• Efficiency– Market system produce only that goods and services that are most demanded by society. It forces using the most efficient techniques of production, so that in increases the total output.
• Incentives– Market system requires hard-work and innovation. So ones who are working a lot, get better results and efficiency, so that they also get higher revenues. Implementation of new efficient production techniques also offers higher revenues.
• Freedom-Firms and industries can enter or leave the industry when they want. Entrepreneurs and labour force are free to seek their own self-interest, so that they may get better results or big losses.

Key Terms:
Invisible Hand-The ten­dency of firms and resource suppliers seeking to further their own self-interests in com­petitive markets to also promote the interests of society as a whole.