The difference between the long run and the short run in perfect competition is the free entry and exit of different firms. There are three different short run scenarios which can predict the long-run movement of firms into and out of industries.
1: Economic Profits- New firms and capital enter the industry
2: Normal Profits- Firms neither exit nor enter the industry
3: Economic Loss- Firms and capital exit the industry
ENTRY INDUCING PRICE:
1: Firms could be making economic profit at the equilibrium price for S0.
2: This economic profit signals other firms to enter the industry to try and take some of that industry-profit for themselves. This increases the industry supply from S0 to S1
3: Due to supply shifting to the right, the industry equilibrium price decreases.
4: This decrease in price lowers the economic profits of each individual firm, and each individual firm must produce less in order for marginal costs to equal marginal revenue (the price). As industry output rises, individual firm output falls
5: This cycle continues until each firm is only making normal profit. After this point, no new firms will enter the industry, because there is no profit-incentive for them to do so.
Let's go over this again:
FIRST- In the short run, an industry sees economic profits
THEN- In the long run, this will adjust to only normal profits. Why?
-In the long run, economic profits act as a signal for new firms to enter the industry
-As new firms enter the industry, industry supply increases
-As such, the price for each individual firm is pushed down to the short-run-average-cost minimum (the lowest price each firm can charge without making an economic loss)
BUT REMEMBER- The Long Run Average Cost for any quantity of production is even lower than the minimum short run average cost for firms. So:
-Firms can lower their costs even further by changing their amount of capital (ie: office space or factory size)
-Economic profits would thus rise, due to decreased costs over the long run
-These economic profits signal more firms to enter the industry, and the cycle repeats itself
THE MORAL OF THE STORY: Firms will continue to increase output, and change their capital investment until they reach the minimum efficiency scale (the minimum quantity of production where the long run average cost is minimized). THIS IS LONG RUN EQUILIBRIUM IN PERFECT COMPETITION
EQUILIBRIUM:
There are 3 conditions for long run equilibrium in a perfectly competitive market.
1: Price must equal marginal costs for each firm (so each firm must be maximizing profits)
2: Price must be equal to minimum short run average cost. This ensures the each firm is only making normal profits.
3: Price must be equal to the minimum long run average cost. This ensures that firms cannot make further economic profits by increasing scale.
If this condition is met, no firms will enter or exit the industry in the long run (due to stable, normal economic profit), so industry supply will not change (STABILITY = EQUILIBRIUM).
LONG RUN SUPPLY: This is the supply curve when firms are no longer entering or exiting the industry (the supply when individual firms are making zero economic profits)
-This is caused by shifts in the long run average cost as the industry size changes
-DO NOT confuse this with short run supply
-"Decreasing cost industry" refers to an industry in which costs are decreasing over the long run
-"Decreasing costs" just refers an an individual firm facing decreasing costs over the short run
THIS IS HOW WE DERIVE LONG RUN SUPPLY:
-Start off with an autonomous increase in industry demand.
-This increases the price of the good over the short run
-Individual firms will make higher economic profits due to this increased price
-Economic profits signals more firms to enter
-Supply increases in the long run due to more firms entering
-LONG RUN SUPPLY IS A LINE CONNECTING ALL POINTS OF DEMAND-INDUCED SHIFTS IN SHORT RUN SUPPLY (so it only includes supply over the log run at points when there is no net entry or exit into firms)
AN INCREASING COST INDUSTRY: This is where long run supply is rising
-Division of labour, bulk discounts and the spreading of overhead occur in these industries
-Input prices rise as quantity increases
-This causes the cost curves to shift up
-The increases the price at which all firms will make zero economic profits
A CONSTANT COST INDUSTRY: This is where long run supply is constant, and horizontal
-Input prices are constant, and the long run average cost for firms does not rise or fall
A DECREASING COST INDUSTRY: This is where long run supply is falling
-Alienation of labour and middle management mush occur in these industries
-New entrants to the industry make it cost effective for suppliers
-Input prices fall as quantity increases
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LONG RUN MISCONCEPTIONS:
TECHNOLOGICAL CHANGE: We assume the technologies change and improve continuously for all firms. One might assume from this that all firms in perfect competition have the same cost curves. In reality, new firms can enter the industry with lower cost curves due to improved technology (ie: a new wool sweater factory will have more efficient equipment, and therefore lower long run average costs than an existing, older factory)
THERE ARE THREE CHARACTERISTICS FOR INDUSTRIES WITH CONTINUOUS TECHNOLOGICAL IMPROVEMENTS
1: Older firms with higher cost will continue to exist... for a while anyways
-As witnessed, new firms usually enter with improved technologies and lower average costs
-These new firms increase industry supply and push price down to a new average cost minimum
-Preexisting firms are stuck with higher production costs, and must produce at a lower marginal revenue rate (think GM after the more advanced Japanese car manufacturers entered the market)
-This may cause older firms to make an economic loss on production
-The older firms should continue to operate at an economic loss, however, as long as the price remains higher than their average variable costs (so they can cover their daily costs). Although this may not be the most efficient use of capital, this will still generate some accounting profits.
MISCONCEPTION: We should eliminate the use of older, higher cost plants as new technology exists.
THE TRUTH: Many different plants with different cost and different levels of technological advancement can exist in any industry and still continue to produce.
2: Price is eventually determined by the minimum average cost of production for new plants
-New firms with the latest technology have lower average costs than pre-existing firms, and will make comparative economic profits
-As more firms enter the industry due to economic profits, the price is bid down to the minimum average cost for the new firms (so at equilibrium, even the new firms are only making economic profit)
3: Old plants are shut down when they become economically obsolete
-Once price is lower than average variable costs for older firms, the plant should be shut down, because continuing production costs more than the product will sell for
MISCONCEPTION: Plants that can still produce products should not be shut down until they are physically obsolete (until the equipment no longer works)
THE TRUTH: Some plants are perfectly well equipped to continue to production, but it would be illogical for any firm to continue to produce goods with these plants, because the goods they could produce would sell for a price lower than the cost of making them.
DECLINING INDUSTRIES: Industries where the long run equilibrium is disturbed to a trend of decreasing consumer demand (think horseshoes and buggy whip industries, or the decline in demand for glass beverage containers following the rise of plastic)
The Response of Firms: Firms generally try to cut costs by forgoing necessary upgrades and equipment maintenance. This leads to further long run economic losses, which leads to further cost cutting measures (it's a slow and vicious cycle).
Government's role in failing industries:
MISCONCEPTION: The government should subsidize failing industries in order to save people's jobs (voters prefer to be employed than unemployed).
THE TRUTH: By subsidizing failing industries, the government is just delaying the inevitable (the industry will eventually become obsolete, and involved firms will go under). A better approach would be for the government to encourage workers to find new jobs with subsidized retraining and temporary income support.
THAT'S ALL!!!!!! =D
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