The long run

In the long run, the firm can change all inputs. So all costs are variable. In the long run, firms can add more capital and any other input that was fixed in the short-run. New entrepreneurs also have time to acquire the capital and put it to use producing in this industry. The long-run also provides enough time for entrepreneurs to get out of any leases or other obligations. Thus they are free to close a business and move their resources to an alternative use.

Short-run loss

Firms will operate at a loss in the short run when price is greater than AVC but less than ATC because shutting down would result in even larger losses (all of TFC). and they can not shed its obligations to pay these fixed costs. The firm can not shed its obligations to pay fixed costs such as the interest it owes the bank or the rent due on leased space. Economic profit less than zero means the firm's owners are earning less than they would if they put these same resources to their best alternative use. The firm will be planning to go out of business (case to exist as a firm in this industry) if it foresees no change. Once the fixed obligations end, the firms exits from the industry.

Effect of exit

Some firms leave the market. Exit of firms results in a decrease in the number of firms producing and therefore a leftward shift in the market supply curve. As supply decreases, the price rises. The remaining firms can sell their product at a higher price, increasing revenues. As the price rises due to exit, eventually the remaining firms will get enough to cover all their opportunity costs-- enough so that price equals minimum average cost of the typical firm. The remaining firms now have economic profit of zero, meaning they do as well as they could elsewhere. Equilibrium is attained and no more exit occurs. Example: Christmas tree industry in Oregon

Entry

If the typical firm is making economic profit in the short-run then the owners are earning more than they would if they used these resources in the next best alternative. New firms will then enter the market. New firms think they too could be better in this market than in alternatives. The time it takes to change capital and other fixed inputs makes entry a long-run phenomenon. Entry is free and easy in perfect competition. Although firms already in the market would like to keep out the newcomers, there is nothing they can do to stop entry.

Effects of Entry

Entry of new firms producing the same product increases the market supply and lowers market price. The fall in the market price reduces revenues and profits. Entry continues as long as established firms make any economic profit. Eventually, price falls enough so that firms make 0 economic profit. Because the firms can do no better or worse than in alternatives, entry stops. Long-run equilibrium is reached. Examples: Videotape rentals (text); computers; coffee retailing

Long-run Equilibrium

Each firm is maximizing its profits by producing where p = MR = MC. Entry and exit have established a market price such that the typical firm has revenues just sufficient to cover all opportunity costs: TR= TC (or p = LAC). Economic profit = 0. The number of firms is stable. Firms are not doing worse than in alternatives so there;s no reason to exit. Firms are not doing better than in alternatives so there's no reason for entry.

Economic Profit
Economic profit is total revenue minus total costs, including both explicity and implicit costs. Zero economic profit means that the firm is earning no more (and no less) than it would in the alternatives (0 DIFFERENCE). Zero economic profit does not mean zero accounting profit. A firm with 0 economic profit will have a positive accounting profit.

Characterisitcs of Long-run Equilibrium

At long-run equilibrium, the typical firm will be operating where p = MC (profit-maximizing output) and p = LAC (0 profit due to entry/exit). Together they imply that AC = MC. This means the firm is operating at the minimum point on its AC curve. Once the long-run equilibrium is reached, the market will continue to operate with the same number of firms all selling at the long-run equilibrium price

Demand increases - short-run effects

What happens when the long-run equilbrium is disturbed by a change in consumer preferences that increases the demand for this good? An increase in demand will cause the market price to rise. Existing firms will respond to the rising price by hiring more of the variable inputs to increase output, expanding output as long as price exceeds marginal cost. The reponse is limited by diminsihing returns to fixed inputs. The higher market price results in higher revenues and profits firms will make an economic profit (profit greater than zero).

Demand increases-- long-run effects

Short-run economic profits attract new firms, increasing supply and lowering the price. Quantity supplied will also increase as existing firms add more capital and increase production and as new firms enter the industry. Entry results in an increase in demand for resources. Costs at each output (the cost curves) may or may not change depending on whether the industry's expansion changes input prices or quality. Falling revenues will decrease profits. Long-run equilibrium is reached when firms are again operating at zero economic profit.

Constant Cost industry

The inputs used to produce the product are widely and readily available-- their supply is highly elastic. Increased demand for inputs resulting from entry does not cause input prices to rise. If input price and quality remain the same, then the costs of producing remain the same (cost curves doen't shift). With unchaged costs, entry continues until the price falls back to its original long-run equilibrium level, at which point profits will again be 0. The long-run supply curve (the locus of all such long-run equilbria) is horizontal at a price equal to minimum AC. Price deviates form this level in the short run.

Increasing cost industry

The inputs used in the production of this product are more specialized: supply is not perfectly elasic. Entry raise the demand for inputs, driving up the price of inputs and /or lowering quality. The firm's costs of production increase: at each level of output the new firm has highercosts. Firm's find that entry of new firms creates a two-way squeeze on profits as prices fall and costs rise. The long-run equilbrium price is higher than before. The long-run supply curve is upward-sloping.

Decreasing cost industries
Possible but rarely found. Increased demand for inputs brought about by entry allows input-producing firms to better exploit economies of scale and lower their costs. Input prices fall, pushing down the costs ofthe input-using firms. Enty must push the price below the old equilibirum level before profits are again zero. The long-run supply curve is downward sloping.

Positive features-- perfect competition in the long-run.

Each firm is producing at minimum average cost. We get the goods at the smallest sacrifice of alternatives possible. Firms can not be lazy or careless in their handling of resources. Those who are wasteful will have higher costs and will suffer losses and leave the business because those firms which do keep their costs to a minimum will produce enough to force the price down to the minimum level. Also, if firms produced on a larger or smaller scale, their costs would be higher. No firm would do so because it would not be profitable. The total value of all transactions in this market, which is the sum of producer and consumer surplus, is at a maximum. Producing more or less would reduce this value but would also be unprofitable for the firms.