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ECONOMICS SECOND EDITION in MODULES Paul Krugman | Robin Wells with Margaret Ray and David Anderson MODULE 24 (60) Long-Run Outcomes in Perfect Competition Krugman/Wells • Why industry behavior differs in the short run and the long run • What determines the industry supply curve in both the short run and the long run 3 of 14 The Short-Run Individual Supply Curve The short-run individual supply curve shows how an individual producer’s optimal output quantity depends on the market price, taking fixed cost as given. Price, cost of bushel Short-run individual supply curve MC Shutdown price $18 16 14 12 10 0 ATC E AVC B C A 1 2 3 3.5 4 Minimum average variable cost 5 6 A firm will cease production in the short run if the market price falls below the shutdown price, which is equal to minimum average variable cost. 7 Quantity of tomatoes (bushels) 4 of 14 Industry Supply Curve • The industry supply curve shows the relationship between the price of a good and the total output of the industry as a whole. • The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers. • There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given. 5 of 14 The Short-Run Market Equilibrium The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers. Price, cost of bushel Short-run industry supply curve, S $26 22 E Market 18 price MKT D 14 Shut- 10 down price 0 200 300 400 500 600 There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given. 700 Quantity of tomatoes (bushels) 6 of 14 The Long-Run Industry Supply Curve • A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur. 7 of 14 Profitability and the Market Price (b) Individual Firm (a) Market Price, cost of bushel S S 1 E MKT $18 S 2 3 Price, cost of bushel MC $18 E A D 16 16 MKT ATC D B 14.40 C 14 0 500 MKT D Break- 14 even price 750 1,000 Quantity of tomatoes (bushels) C 0 3 Y Z 4 4.5 5 6 Quantity of tomatoes (bushels) A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur. 8 of 14 The Effect of an Increase in Demand in the Short Run and the Long Run (a) Existing Firm Response to Increase in Demand Price, cost 0 Price, cost Price An increase in demand raises price and profit. $18 14 (b) Short-Run and Long-Run Market Response to Increase in Demand Y S MC ATC X Y X Quantity 0 The LRS shows how the quantity supplied responds to the price once producers have had time to enter or exit the industry. 1 LRS S (c) Existing Firm Response to New Entrants Higher industry output from new entrants drive price and profit back down. MC 2 Y MKT Z MKT QXQY D MKT 2 D 1 QZ Quantity 0 ATC Z Quantity Increase in output from new entrants. 9 of 14 Comparing the Short-Run and Long-Run Industry Supply Curves Price Short-run industry supply curve, S A fall in price induces existing producer A higher price attracts new entrants to in exit inlong the long generating a fall the run, run, resulting in a rise in in industry output and lower a rise in price. price. Long-run industry supply curve, LRS The long-run industry supply curve is always flatter – more elastic than the short-run industry supply curve. Quantity 10 of 14 The Cost of Production and Efficiency in the Long-Run Equilibrium • In a perfectly competitive industry in equilibrium, the value of marginal cost is the same for all firms. • In a perfectly competitive industry with free entry and exit, each firm will have zero economic profits in long-run equilibrium. • The long-run market equilibrium of a perfectly competitive industry is efficient: no mutually beneficial transactions go unexploited. 11 of 14 A Crushing Reversal • Starting in the mid-1990s, Americans began drinking a lot more wine. • At first, the increase in wine demand led to sharply higher prices. • As a result, there was a rapid expansion of the industry. • The result was predictable: the price of grapes fell as the supply curve shifted out. • As demand growth slowed in 2002, prices plunged by 17%. • The effect was to end the California wine industry’s expansion. 12 of 14 1. The industry supply curve depends on the time period. 2. The short-run industry supply curve is the industry supply curve given that the number of firms is fixed. 3. The short-run market equilibrium is given by the intersection of the short-run industry supply curve and the demand curve. 4. The long-run industry supply curve is the industry supply curve given sufficient time for entry into and exit from the industry. 5. In the long-run market equilibrium—given by the intersection of the long-run industry supply curve and the demand curve— no producer has an incentive to enter or exit. 13 of 14 6. The long-run industry supply curve is often horizontal. It may slope upward if there is limited supply of an input. It is always more elastic than the short-run industry supply curve. 7. In the long-run market equilibrium of a competitive industry, profit maximization leads each firm to produce at the same marginal cost, which is equal to market price. 8. Free entry and exit means that each firm earns zero economic profit—producing the output corresponding to its minimum average total cost. So the total cost of production of an industry’s output is minimized. 9. The outcome is efficient because every consumer with a willingness to pay greater than or equal to marginal cost gets the good. 14 of 14