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2.6 — Long Run Industry Equilibrium

ECON 306 • Microeconomic Analysis • Spring 2022

Ryan Safner
Assistant Professor of Economics
safner@hood.edu
ryansafner/microS22
microS22.classes.ryansafner.com

Firm's Long Run Supply Decisions

Firm Decisions in the Long Run I

  • AC(q)min at a market price of $6

    • Firm earns “normal” economic profits
  • At any market price below $6.00, firm earns losses

    • Short Run: firm shuts down if p<AVC(q)
  • At any market price above $6.00, firm earns “supernormal” profits (>0)

Firm Supply Decisions in the Short Run vs. Long Run

  • Short run: firms that shut down (q=0) stuck in market, incur fixed costs π=f

Firm Supply Decisions in the Short Run vs. Long Run

  • Short run: firms that shut down (q=0) stuck in market, incur fixed costs π=f

  • Long run: firms earning losses (π<0) can exit the market and earn π=0

    • No more fixed costs, firms can sell/abandon f at q=0

Firm Supply Decisions in the Short Run vs. Long Run

  • Short run: firms that shut down (q=0) stuck in market, incur fixed costs π=f

  • Long run: firms earning losses (π<0) can exit the market and earn π=0

    • No more fixed costs, firms can sell/abandon f at q=0
  • Entrepreneurs not currently in market can enter and produce, if entry would earn them π>0

Firm Supply Decisions in the Short Run vs. Long Run

Firm Supply Decisions in the Short Run vs. Long Run

Firm's Long Run Supply: Visualizing

When p<AVC

  • Profits are negative

  • Short run: shut down production

    • Firm loses more π by producing than by not producing
  • Long run: firms in industry exit the industry

    • No new firms will enter this industry

Firm's Long Run Supply: Visualizing

When AVC<p<AC

  • Profits are negative

  • Short run: continue production

    • Firm loses less π by producing than by not producing
  • Long run: firms in industry exit the industry

    • No new firms will enter this industry

Firm's Long Run Supply: Visualizing

When AC<p

  • Profits are positive

  • Short run: continue production

    • Firm earning profits
  • Long run: firms in industry stay in industry

    • New firms will enter this industry

Production Rules, Updated:

1. Choose q such that MR(q)=MC(q)

2. Profit π=q[pAC(q)]

3. Shut down in short run if p<AVC(q)

4. Exit in long run if p<AC(q)

Market Entry and Exit

Exit, Entry, and Long Run Industry Equilibrium I

  • Now we must combine optimizing individual firms with market-wide adjustment to equilibrium

  • Since π=[pAC(q)]q, in the long run, profit-seeking firms will:

Exit, Entry, and Long Run Industry Equilibrium I

  • Now we must combine optimizing individual firms with market-wide adjustment to equilibrium

  • Since π=[pAC(q)]q, in the long run, profit-seeking firms will:

    • Enter markets where p>AC(q)

Exit, Entry, and Long Run Industry Equilibrium I

  • Now we must combine optimizing individual firms with market-wide adjustment to equilibrium

  • Since π=[pAC(q)]q, in the long run, profit-seeking firms will:

    • Enter markets where p>AC(q)
    • Exit markets where p<AC(q)

Exit, Entry, and Long Run Industry Equilibrium II

  • Long-run equilibrium: entry and exit ceases when p=AC(q) for all firms, implying normal economic profits of π=0

Exit, Entry, and Long Run Industry Equilibrium II

  • Long-run equilibrium: entry and exit ceases when p=AC(q) for all firms, implying normal economic profits of π=0

  • Long run economic profits for all firms in a competitive industry are 0

  • Firms must earn an accounting profit to stay in business

Deriving the Industry Supply Curve

The Industry Supply Curve

  • Industry supply curve: horizontal sum of all individual firms' supply curves

    • recall: (MC(q) curve above AVCmin) (shut down price)
  • To keep it simple on the following slides:

    • assume no fixed costs, so AC(q)=AVC(q)
    • then industry supply curve is sum of individual MC(q) curves above AC(q)min

Industry Supply Curves (Identical Firms)









Industry Supply Curves (Identical Firms)









  • Industry supply curve is the horizontal sum of all individual firm's supply curves
    • Which are each firm's marginal cost curve above its breakeven price

Industry Supply Curves (Identical Firms)









  • Industry demand curve (where equal to supply) sets market price, demand for firms

Industry Supply Curves (Identical Firms)









  • Short Run: each firm is earning profits p>AC(q)

  • Long run: induces entry by firm 3, firm 4, , firm n

Industry Supply Curves (Identical Firms)









  • Short Run: each firm is earning profits p>AC(q)

  • Long run: induces entry by firm 3, firm 4, , firm n

  • Long run industry equilibrium:

Industry Supply Curves (Identical Firms)









  • Short Run: each firm is earning profits p>AC(q)

  • Long run: induces entry by firm 3, firm 4, , firm n

  • Long run industry equilibrium: p=AC(q)min, π=0 at p= $6; supply becomes more elastic

Economic Rents, Profits, & Competition

Back to Zero Economic Profits

  • Recall, we've essentially defined a firm as a completely replicable recipe (production function) of resources

q=f(L,K)

  • “Any idiot” can enter market, buy required (L,K) at prices (w,r), produce q at market price p and earn the market rate of π

Back to Zero Economic Profits

  • Zero long run economic profit industry disappears, just stops growing

  • Less attractive to entrepreneurs & start ups to enter than other, more profitable industries

  • These are mature industries (again, often commodities), the backbone of the economy, just not sexy!

Back to Zero Economic Profits

  • All factors being paid their market price

    • i.e. their opportunity cost — what they could earn elsewhere in economy
  • Firms earning normal market rate of return

    • No excess rewards (economic profits) to attract new resources into the industry, nor losses to bleed resources out of industry

Back to Zero Economic Profits

  • But we've so far been imagining a market where every firm is identical, just a recipe “any idiot” can copy

  • What about if firms have different technologies or costs?

Industry Supply Curves (Different Firms) I

  • Firms have different technologies/costs due to relative differences in:

    • Managerial talent
    • Worker talent
    • Location
    • First-mover advantage
    • Technological secrets/IP
    • License/permit access
    • Political connections
    • Lobbying
  • Let's derive industry supply curve again, and see how this may affect profits

Industry Supply Curves (Different Firms) II









Industry Supply Curves (Different Firms) II









  • Industry supply curve is the horizontal sum of all individual firm's supply curves
    • Which are each firm's marginal cost curve above its breakeven price

Industry Supply Curves (Different Firms) II









Industry Supply Curves (Different Firms) II









  • Industry demand curve (where equal to supply) sets market price, demand for firms

Industry Supply Curves (Different Firms) II









  • Industry demand curve (where equal to supply) sets market price, demand for firms
  • Long run industry equilibrium: p=AC(q)min, π=0 for marginal (highest cost) firm (Firm 2)

Industry Supply Curves (Different Firms) II









  • Industry demand curve (where equal to supply) sets market price, demand for firms
  • Long run industry equilibrium: p=AC(q)min, π=0 for marginal (highest cost) firm (Firm 2)
  • Firm 1 (lower cost) appears to be earning profits...(we’ll come back to this)

Economic Rents and Zero Economic Profits I

  • Long-run equilibrium p=AC(q)min of the marginal (highest-cost) firm

  • The marginal firm earns normal economic profit (of zero)

    • Otherwise, if p>AC(q) for that firm, would induce more entry into industry!

Economic Rents and Zero Economic Profits I

  • “Inframarginal” (lower-cost) firms are using resources that earn economic rents

    • returns higher than their opportunity cost (what is needed to bring them into this industry)
  • Economic rents arise from relative differences between resources

Economic Rent

  • Economic rent: a return or payment for a resource above its normal market return (opportunity cost)

  • Has no allocative effect on resources, entirely “inframarginal”

  • A windfall return that resource owners get for free

Sources of Economic Rents

  • Some factors are relatively scarce in the whole economy
    • (talent, location, secrets, IP, licenses, being first, political favoritism)

Firms Using Resources with Economic Rents

  • Inframarginal firms that employ these scarce factors gain a short-run profits from having lower costs/higher productivity

  • ...But what will happen to the prices for their scarce factors over time?

Economic Rents Examples

Economic Rents and Zero Economic Profits

  • In a competitive market, over the long run, profits are dissipated through competition

    • Rival firms willing to pay for the scarce factor to gain an advantage
  • Competition over acquiring the scarce factors pushes up their prices

    • i.e. higher costs to firms of using the factor!
  • Rents are included in the opportunity cost (price) for inputs over long run

    • Must pay a factor enough to keep it out of other uses

Economic Rents and Zero Economic Profits

  • From the firm’s perspective, over the long-run, rents are included in the price (opportunity cost) of the scarce factor

    • Must pay a factor enough to keep it out of other uses
  • Firm does not earn the rents, they raise firm's costs and squeeze profits to zero!

Economic Rents Reduce Profits









  • Short Run: firm that possesses scarce rent-generating factors has lower costs, perhaps short-run profits

Economic Rents Reduce Profits









  • Short Run: firm that possesses scarce rent-generating factors has lower costs, perhaps short-run profits

  • Long run: competition over those factors pushes up their prices, raising costs to firm, until its profits go to zero as well

    • Increase in fixed cost (scarce factor), raising AC(q), which now includes rents (more info here)

Economic Rents Go To Resource Owners

  • Owners of scarce factors (workers, landowners, inventors, etc) earn the rents as higher income for their services (wages, rents, interest, royalties, etc).

  • Often induces competition to supply alternative factors, which may dissipate the rents (to zero)

    • More people invest in becoming talented, try to create new land, etc.

Recall: Accounting vs. Economic Point of View

  • Recall “economic point of view”:

  • Producing your product pulls scarce resources out of other productive uses in the economy

  • Profits attract resources: pulled out of other (less valuable) uses

  • Losses repel resources: pulled away to other (more valuable) uses

  • Zero profits keep resources where they are

    • Implies society is using resources optimally

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