COMPETITION IN THE LONG-RUN In the short-run the number of firms in a competitive industry is fixed. In the long-run new firms can enter or existing firms can leave a competitive industry.

The key to understanding when new firms will want to come into an industry, or existing firms leave, lies in role of profits. Because profits are the difference between revenue and opportunity cost, the existence of profit means a firm is earning more on its invested resources than it could get in its next best alternative.

On the other hand, if a firm earns losses (negative profits) then it can earn more on its invested resources in some alternative use.

If the typical firm in an industry is earning economic profit, then this provides an incentive for other firms to come into the industry to take advantage of the opportunity. If the best a typical firm in an industry can do is earn losses, then that firm has a strong incentive to leave the industry. The objective here is to see what happens to a market when this sort of entry and exit is possible.

The apple market is in short-run equilibrium at a price p’. There are currently 500 firms, and the typical apple firm can make economic profits. The question to answer here is what will happen in the long-run, that is, when new firms can come into the industry. $/q $/Q S (500 firms) LRAC mc $7 D q Q q’ Q’ Typical firm Industry APPLE MARKET

So Q rises and price falls. The supply provided by newly entering firms will cause the market supply curve to move to the right. So Q rises and price falls. $/q $/Q S (500 firms) LRAC mc S (700 firms) $7 $6 D q Q q’ Q’ Typical firm Industry APPLE MARKET

When and where will this process end? Where is the new equilibrium? A LONG-RUN EQUILIBRIUM MUST HAVE ZERO ECONOMIC PROFIT FOR THE TYPICAL FIRM.

APPLE MARKET $/q $/Q S (500 firms) LRAC S (700 firms) S (1000 firms) $5 q* Q* D q Q Q’ Typical firm Industry APPLE MARKET

APPLE MARKET The LR equilibrium price is p*. The firm’s LR equilibrium quantity is q*. The LR equilibrium market quantity is Q*. $/q $/Q LRAC S (1000 firms) $5 D q Q q* Q* Typical firm Industry APPLE MARKET

Competitive market equilibrium in the long-run: 1) Price must settle at the bottom of the firm’s long-run average cost curve. 2) Profits of the typical firm must be zero. 3) The number of firms will adjust to provide the market quantity demanded at that price. 4) Market price is still determined by short-run supply and demand.

PROBLEMS TO WORK OUT SETUP: Suppose a competitive market for apples is in long-run equilibrium. Then suppose there is an increase in the market demand for apples. QUESTION: What happens in the market for apples in the long-run? That is, what is the new equilibrium price, quantity for the industry, quantity for the typical firm, and profits of the typical firm?

Always start to answer questions about long-run equilibrium from this template. SRS LRAC $5 D q Q q* Q* Typical firm Industry Hidden slides APPLE MARKET

In the new equilibrium: 1) price is unchanged 2) firm’s quantity is unchanged 3) industry quantity is increased 4) firm’s profits are unchanged

Notice that in the competitive model resources flow to their most valued uses. In the last example, people demanded more apples and that’s what they got. More of society’s resources flowed into the apple industry.